Relaxation of SarBox Requirements for Smaller Public Companies Is Long Overdue

Leon Gettler of SoxFirst points to a side effect of the Sarbanes Oxley corporate accounting and reporting law passed in the wake of the Enron blowup roughly four years ago:

Last week, Thomson Financial figures showed that more non-US companies were now choosing to list on the London Stock Exchange instead of New York.

Go to the link for the Thomson Financial figures and you see that the margin is nearly 5-to-1 in money raised ($16 billion in London vs. $3.4 billion on the NYSE), and this troubling quote:

(London lawyer Kenneth) Lamb says his clients don’t have New York on their radar screen. “They don’t want do deal with regulatory requirements and the issue of personal liability for directors and officers that you now have in the U.S.,” he says. “I hear this constantly.”

He adds that fees for lawyers and accounting firms in the United States that help companies comply with American rules can easily hit $1 to $2 million a year. “That’s money that would otherwise go to the bottom line,” he says.

Translation: SarBox is keeping us away from the US.

Mr. Gettler then mischaracterizes an attempt to begin solving this problem, which left untreated for a couple of decades could lead to the financial nerve center of the world being someplace other than New York. He describes what is being considered as “exempting 80 per cent of public companies from internal controls over financial reporting.” This is most emphatically not what is proposed (from the same link Mr. Gettler cited):

An advisory committee to the Securities and Exchange Commission voted overwhelmingly to recommend exempting about 80 percent of public companies from a key part of the Sarbanes-Oxley law corporate-reform legislation, saying that small companies were disproportionately burdened by the congressionally mandated requirements.

….. Under the measure (i.e., current law–Ed.), company executives are required to assess their internal controls over financial reporting and to hire outside auditors to assess those controls.

The SEC’s advisory committee on smaller public companies voted to recommend rolling back that requirement entirely for companies with a market capitalization of $125 million or less, or about half of the companies in the market. In exchange, these companies would be subject to stricter corporate-governance requirements.

Larger companies - those with a market capitalization of between $125 million to about $750 million and prior-year revenue of no more than $250 million - would also be exempt from hiring an outside auditor to test internal controls under recommendations approved on Wednesday.

This is a far cry from the “exempting 80%” characterization Mr. Gettler used.

• First, the roughly 50% (not 80%) of companies that would be exempted from the internal control reporting requirement represent just over 1% * of the total market capitalization of all NYSE and NASDAQ stocks (and don’t forget the unexplained but apparently meaningful “stricter corporate governance requirements” intended as a partial offset).
• The second layer, representing at most another 3% ** of total NYSE and NASDAQ market cap, is NOT being exempted from the internal control testing requirement, only the requirement that external auditors perform it. In reality, many companies will still have the external auditors do the testing, simply because they don’t have their own internal audit staff or enough other sufficiently trained accounting staff to do the testing (accounting and auditing are very separate skills).

Over 95% of the NYSE’s and NASDAQ’s combined market cap will not be affected by the proposal, and plenty of fraud prevention and detection mechanisms will still be in place. While I appreciate Mr. Gettler’s concerns, I believe what the SEC is proposing represents a nice step, but only a baby step, in rolling back SarBox’s onerous requirements without a visible sacrifice of either financial transparency or investor confidence.

I don’t believe that what is proposed will open up a noticeable increase in exposure to corporate fraud, because the annual financial statement audit by CPA firms, who by any objective measure have more clout over their client companies than they ever have, will ordinarily catch all but the most collusive enterprises, even without the internal control testing. And, contrary to popular belief, stock manipulation is not an issue SarBox addresses; that is a matter for insider-trading and other laws and regulations to deal with.

So I support what the SEC is proposing, believe that the opposition to it is overreaction, and hope that it is just the beginning of an attempt to establish a more sensible cost-benefit equilibrium for publicly-traded companies and those who invest in them.

And who knows: Maybe small public company execs can use the freed-up capital and management time to engage in a bit more innovation, growth, and market development.
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* - Roughly 3,050 companies [half of NYSE’s 2,800 and NASDAQ’s 3,300 listed companies, at an average cap of at most $100 million per company, would be a market cap of $305 billion. The NYSE’s capitalization is $21 trillion, and the NYSE’s capitalization is 5x as big as NASDAQ’s, leading to a combined cap of about $25 trillion. $310 billion divided by $25 trillion is a bit over 1.2%. Additional companies may be exempt if their revenues are under $250 million, but I do not believe that including these likely very few companies, which I did not identify, would significantly alter the result.
** - Roughly 1,830 companies times a $400 million per-company average cap (a bit below the midpoint between $125 million and $750 million) would be $732 billion, which is a little over 2.9% of $25 trillion.