How The Sarbanes-Oxley Era Affected IPOs

By Marv Dumon AAA

The Sarbanes-Oxley Act of 2002, commonly referred to as SOX, is a federal law enacted by Congress in response to massive corporate and accounting fraud in the early 2000s. Investors from major corporations such as Enron, Tyco, Adelphia and WorldCom lost heavily due to deceptive and highly inaccurate financial statements. The loss of billions of dollars in shareholder wealth shook investor confidence in the U.S. financial markets. In an effort to shore up confidence from the capital markets, the legislation aimed at institutionalizing management, financial and accounting controls at U.S. publicly-traded companies.

While complying with the law has its benefits, SOX imposes heavy regulatory and financial costs and compliance burdens on a company. Among the key provisions that require implementation are:

  1. Section 302 mandates the senior officers of a public company to certify that they have established, maintained and designed internal controls to ensure the accuracy of company information found in their periodic reports.
  2. Section 404 requires management and external auditors to report on the adequacy of the internal control over financial reporting. (For more on these key provisions, take a look at An Inside Look At Internal Auditors.)

Sarbanes-Oxley has made listed companies much more transparent to shareholders. Some managers can be notorious in manipulating the perception of operating performance, and there are various ways to distort the financials and performance metrics. When management periodically interacts with government officials (such as the Internal Revenue Service) or with shareholders, they can paint an inaccurate picture of the state of the organization. SOX brings accountability and accuracy to these periodic reporting exercises.

Management, under the watchful eye of external auditors, now must ensure adequate internal controls are in place and that accurate financial numbers are spit out for review. The statute can impose stiff civil and criminal fines and penalties for failure to comply. Such mandated change initiatives result in better processes at these public companies.

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Watch: Initial Public Offering (IPO)

Initial Public Offering (IPO)
Companies that wish to raise capital to fund operations have a variety of mechanisms by which they can secure cash. One way is to sell equity in the company in the form of stock to the general investing public through an initial public offering. The money paid by investors in exchange for equity ownership goes directly to the company, and these funds can be used to increase shareholder value through various operational and strategic efforts.

The U.S. has been historically viewed as the primary place for a company to list its stock on one of the major American stock exchanges. The capital markets are considered relatively efficient. In 1996, there were 675 IPOs. In 2001, IPO activity was down to 80 in the U.S. (Note: we define IPO here as an operating company on the NYSE, Nasdaq or AMEX. This definition excludes ADRs, closed-end funds and shares that trade for less than $5). The terrorist attacks on September 11, 2001, reduced the amount of liquidity in the markets as well as general economic activity - thus, 2001-2003 saw significant decreases in public offerings.

IPO Activity and the Increasing Presence of Foreign Listings
Between 2004 and 2008, the U.S. had the following IPO activity in terms of number of deals:

2004: 174
2005: 161
2006: 157
2007: 159
2008: 20

In 2008 there was a big decrease in global IPO activity due to a global economic recession. In the U.S., IPO activity shrank to 20 deals in 2008 from a total of 159 the prior year. In 2006 and 2007, companies raised more money out of European and Asian exchanges than U.S.-based exchanges. This reflects the heightened positioning of international exchanges given U.S. regulatory requirements for public listings in America. Some view the London Stock Exchange as the new major hub for the capital markets.

Criticisms of Sarbanes-Oxley
Less IPO activity in 2008 meant that companies were less able to raise investment capital for operating purposes. The reduced number of take-public transactions has spurred criticisms of SOX legislation as too bureaucratic, costly and cumbersome. Most senior company officers and auditors can attest that Sarbanes-Oxley is difficult and expensive to comply with. While the legislation prevents accounting fraud and material misstatements, designing, implementing and following lots of internal controls procedures at all levels of the organization prevents employees and managers from focusing on running the company.

Typically, expensive enterprise-wide IT systems must be implemented throughout the organization to help facilitate compliance with SOX. The extensive documentation and procedures involved also stack up the billable hours for large accounting firms. Hourly billing rates for associates and managers run into the hundreds of dollars per hour. Millions of dollars in annual expenses are taken out of the bottom line.

Large corporations with billions of dollars in revenue are much more positioned to absorb these overhead costs. As a percentage of revenue, officers are looking at negligible expense line item. However, small companies that need access to the public capital markets get hurt by not having this capital source available to them, due to associated costs. Venture capital firms, which fund new technologies, products and services, have also traditionally liked the go-public route as a means of securing capital beyond the initial stage of company development. Given that small start-up companies have very limited amounts of cash, they are less able to fund the heightened levels of administrative costs of being a public company.

In addition to the added expenses for the business, employees spend their time doing activities that are compliance-driven and not business or revenue-driven. Focus is taken away from strategy, sales, procurement, recruiting, operations, etc…and diverted toward controls, record-keeping, IT training and approvals.

Several prominent individuals have spoken out against SOX. Congressman Ron Paul argues that Sarbanes-Oxley has placed U.S. corporations at a competitive disadvantage due to the bureaucratic compliance requirements, which drives business away from the U.S. There is evidence that more foreign companies are delisting out of U.S. stock exchanges. Former Speaker of the House Newt Gingrich called for the outright elimination of Sarbanes-Oxley in 2008 - after all, the law did not prevent massive insolvencies at major financial institutions in that year. Gingrich also argues that it now takes longer for small companies to become public as they must raise the cash necessary to comply with the law. (Read Why Public Companies Go Private for advantages of staying a private company.)

The Bottom Line
Sarbanes-Oxley was a law enacted as a response to the massive accounting frauds perpetuated by major corporations in the early 2000s. Congress wished to avoid another Enron or WorldCom. By mandating highly stringent and voluminous procedures throughout an organization, however, complying with SOX has also become very expensive and burdensome.

While large companies are better positioned to absorb these costs, small companies do not have as much cash or resources to accommodate these compliance statutes. Foreign companies are delisting from U.S. exchanges as European and Asian exchanges provide alternatives for raising public capital. Continued reduction in U.S. IPO activity will seem to significantly heighten the pressure to modify and reduce compliance requirements or eliminate the law altogether. It seems the former is a likelier scenario.

Read about Enron's historic failure in our article: Enron's Collapse: The Fall Of A Wall Street Darling.

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