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Sarbanes Turns Two: Do We Protest Too Much?

Published: July 29, 2004

Sarbanes-Oxley compliance is helping regain public confidence and for most companies, is becoming a routine cost of business.

As Sarbanes-Oxley prepares to celebrate its second birthday, it is being met with an onslaught of criticism: smaller companies lament that they are being forced out of business due to the high cost of compliance; we hear that the supply of qualified independent directors willing to serve is dwindling despite increased directors’ fees and other forms of compensation (compensation packages for directors can now exceed $150,000 annually); D&O insurance premiums are skyrocketing; and the workload for directors has increased significantly for those who continue to serve responsibly.

On the other hand, we are emerging from a crisis in corporate governance that resulted in greed and deception unlike anything seen in most of our lifetimes.  We needn’t rehash here what happened; the major problems and failures are well-known.  What we might consider though, is whether Sarbanes has resulted in any meaningful improvement over the prior rules.  

There were approximately 7,500 public companies in the United States at the end of 2000.   First, we should recognize that the transgressions, though monumental in financial scope, were problems of a relatively small percentage of public companies; the overwhelming majority of public companies in the United States conducted business responsibly and continue to do so.  It is unfortunate that those companies must now incur the significant additional expense of compliance with Sarbanes.

So what happened?  As we know, the central tenet of the Securities Act of 1933 and the Securities Exchange Act of 1934 (“1934 Act”) was supposed to be one of disclosure, not the imposition of substantive law.  That had been left to the individual states.  And even though we would like to think that the two systems were complementary and collectively thorough enough, they weren’t.  In point of fact, state corporate law imposes few substantive measures of accountability on corporate officers and directors.  The body of law on the subject of fiduciary duties of directors and officers is well-settled, but that is of limited value when trying to gauge what directors and officers are doing on a day-to-day basis and how well they are doing it.   We will leave for another time a discussion of the evolving “federalization” of substantive corporate law, of which Sarbanes-Oxley represents the most drastic incursion to date.[1]

Over the past several decades, the Securities and Exchange Commission (“SEC”) has adopted scores of rules for the disclosure of information about company operations, performance, financial results, management, management compensation and conflicts of interest, to name a few.  But the rules became so complicated and the language used to respond to the rules so dry and Faulkneresque, that the rules were of modest help to impart meaningful information to investors.  Worse, these rules led to the development of “disclosure” documents with hundreds of pages of boilerplate and legalese, which, though legally sufficient, were really not meaningful “disclosure” at all.  As an example of how bad things had become, the SEC launched its now famous “Plain English” initiative in 1998.  That initiative intended to rewrite the rules and require companies to do away with the extensive “legalese” that had become commonplace in prospectuses and periodic reports filed under the 1934 Act.  The initiative was never fully implemented; to date, only a small number of disclosures are required to be in “Plain English.”  To the credit of many companies, however, there appears to be a voluntary effort to extend the plain English idea beyond the minimum required disclosures.

Are the requirements imposed by Sarbanes too extensive?  Taken in context, probably not.  In fact, many companies have had procedures similar to the Sarbanes requirements in place for years.  However, the most dramatic changes impose significant additional obligations on directors and senior management.  The preparation time required, especially for directors who serve on a company’s audit committee, has increased dramatically.  Many experts recommend that directors should plan on spending 200-250 hours per year on director functions and further suggest that a person serve on no more than two or three boards, in order to have time to discharge their duties properly.  Also, prospective directors are scrutinizing companies much more extensively before they sign on, said Robert Beal of Sullivan Associates, a search firm dedicated solely to the identification and placement of directors.  “Candidates are taking a much harder look at a company’s financial condition, prospects and the quality of their SEC filings.”

What is unclear, is whether two years of Sarbanes has caused any existing directors to step down or has resulted in any meaningful increase in risk for directors and senior management.  There has not been a notable increase in the number of class-action lawsuits since 2002.  It may be that most companies have been doing it right, and those that weren’t are now being forced in the right direction.

What is clearer is that the cost of being a public company has increased significantly, not only in terms of financial outlay but also in time commitments of management and directors.  This may be moderated somewhat in future years once the required procedures and compliance programs have been developed, implemented and become more routine.  As an example, much attention now is being given to Section 404 of the Sarbanes-Oxley Act, which requires companies to establish and maintain adequate internal control structure and procedures for financial reporting.  It then requires management to periodically provide a written assessment of the effectiveness of the internal controls and further requires that the company’s accountants provide a written attestation as to the effectiveness and accuracy of management’s report.  Though rules implementing Section 404 were adopted in August 2003, the SEC has extended the deadline for compliance with these rules to early 2005.  Accordingly, those procedures and policies are now being developed, which may explain the increased press regarding the currently high cost of compliance with Section 404.

The bottom line is that the complaints about cost will fade over time.  For the smallest public companies, the increased cost of compliance may represent a sufficiently high expense from a percentage standpoint that it may be in the best financial interest of those companies and their shareholders to consider de-listing or going private.  For the rest, it will become a routine cost of doing business.  But the investing public has benefited and will continue to do so.  Reading periodic reports and proxy statements is becoming easier, and the information investors need to know is being presented in a more reader-friendly format.  Moreover, investors can now have a confidence that off-balance sheet arrangements and other devices to disguise questionable dealings will be either prohibited or disclosed in a way that can be more easily understood, and that senior management will be less able to escape responsibility for their decisions.