Investors may question how often justice is done when it comes to companies playing fast and loose with their accounting, but the SEC does have a history of issuing fines in the tens of millions (and into the hundreds of millions) to those companies that are caught going too far. But what about the companies that do nothing wrong? (After the infamous collapse of companies like Tyco, Enron and WorldCom, the government responded to try and prevent it from happening again. To learn more, see How The Sarbanes-Oxley Era Affected IPOs.) In the wake of the scandals that came out as the tech bubble collapsed, including the likes of Enron, Tyco, and Adelphia, Congress passed the Sarbanes-Oxley Act and demanded a higher standard of auditing and compliance from public companies. Now in the wake of the mortgage lending debacle that led to the credit crisis and recession, Congress has passed still more legislation aimed at improving company operations.
While these measures may be laudable in their efforts to improve reporting, increase transparency and hold company managers more responsible for how they run public companies, all of this comes at a cost. In the case of public companies, this is a very literal cost and it has had significant impacts on many segments of the stock market.
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The Fallout from SOX
Sarbanes-Oxley (SOX) was one of the most significant pieces of securities legislation in many decades, but it has also proven to be an expensive change in the way public companies do business. Among other requirements, SOX required more financial disclosures from companies and a more through auditing process. These requirements have, in turn, led to higher costs for public companies - companies have had to hire additional personnel to manage the process and auditing firms have raised their prices as well.
Unfortunately, these costs have not been borne evenly. Compliance with SOX regulations requires a certain minimum infrastructure, and that creates diseconomies of scale for small companies. For large companies it appears as though the SOX changes resulted in higher costs amounting to only a fraction of 1% - not surprising, given the army of accountants, analysts and managers already on staff at companies like IBM (NYSE:IBM), General Electric (NYSE:GE), and Exxon Mobil (NYSE:XOM).
For small companies, though, the impact has been considerably more severe. There are a host of surveys and studies out there, but even the SEC's own research would seem to support the idea that companies with less than $1 billion in revenue saw their costs more than double after the new legislation. Not only were there large initial costs in setting up the infrastructure for compliance, but audit fees increased by double (or more) in many cases. That, in turn, depressed earnings, depressed valuations and discouraged companies from going or staying public - so much so that there was a spate of acquisitions in the years immediately following SOX that could credibly be seen as driven by the legislation.
Nearly 10 years after Sarbanes-Oxley, how are conditions today? Most sources seem to agree that compliance costs have dropped somewhat steadily since the beginning of the legislation. Some of this is due to more competition among auditing firms (resulting in lower fees), while some of it is also due simply to growing familiarity with the rules and a larger pool of employees to draw from who have the requisite experience.
Even if SOX no longer imposes an unbearable burden on U.S. companies, it has appeared to have a very definite impact on how foreign companies approach the U.S. Foreign listings in the U.S. have declined in the years since SOX. While it may be true that some of this is due to more mature overseas markets that allow companies to meet their equity needs locally, some of it is clearly due to these regulations.
More Regs, More Problems?
The collapse of the credit and housing markets has led to a new round of legislation in the United States, highlighted by the Dodd-Frank legislation of 2010. Although this legislation is not nearly so broad as Sarbanes-Oxley and will primarily affect just financial companies, the ultimate impact could be quite similar.
Unlike SOX, Dodd-Frank will have more to say about what sort of business banks, insurance and securities companies can engage in, and will also increase the regulatory and oversight burden borne by these companies. As readers may imagine, that costs money - not only money lost in the form of business that is no longer allowed (including certain deposit and checking account fees), but also higher costs of compliance. Unlike with SOX, though, there may be a chance for companies to recoup some of this through their normal business - companies like Coca-Cola (NYSE:KO) could not hike their prices to recoup SOX-related costs, but banks have already started cutting back benefits like free checking and reintroducing fees like annual credit card charges. (The SEC has continued to make the market a safer place and to learn from and adapt to new scandals and crises. Check out The SEC: A Brief History Of Regulation.)
Is Regulation Worth the Cost?
It is fair to wonder whether Sarbanes-Oxley has been worth the cost and whether Dodd-Frank will fare any better. Although higher reporting standards for large companies may well be helping to prevent another major accounting-fueled stock scandal (another Enron, in other words), it is harder to ascertain the same benefits for investors in smaller companies.
Simply by virtue of the fact that small companies are not so widely owned, the damage from a scandal here would be smaller if one were to occur. Moreover, smaller companies are often important sources of innovation and employment in the economy and increasing their operating costs crowds out R&D investment, hiring and sometimes even the decision to go public altogether. By the same token, it is not as though the IPO market or the market for small-cap companies has vanished, so SOX has not been a crippling blow.
The Bottom Line
It is worth mentioning, though, that regulation is in itself a process that transfers the cost of the wrongdoing of other people onto those who have broken no laws and committed no crimes. Moreover, regulation can offer a false sense of security - Sarbanes-Oxley, for instance, has done very little to prevent a spate of Chinese reverse-merger companies from playing fast and loose with their accounting and reporting. Still, regulation is not going to go away, and government leaders understand the value of being seen as responding aggressively to crises. As a result, investors have little choice but to make their peace with what is likely to be a never-ending march towards increased regulatory burden and higher costs. (Regulatory actions usually have lofty intentions that end up with unintended and negative consequences. See The Pitfalls Of Financial Regulation.)