Avoiding Hasty Judgments about Sarbanes-Oxley

Implications: Hasty analysis leads to hasty judgments which, in turn, produce bad decisions.  Any consideration of the costs of Sarbanes should include identifying who bears the costs, what benefits are achieved, and who enjoys those benefits.  Taking these points into the analysis shows that perhaps the law has produced a great deal of benefit well in excess of the compliance costs.  We may never know for sure, but the political discussion must include more than the absolute cost of compliance if it is to lead to a wise decision to keep, modify, or repeal the law.

Analysis: These two discussions (the original and Mr. Pugh’s) of SOX are typical and unfortunately may be too hasty and superficial.  

The issue at hand should not be merely how much it costs to comply.  Obviously, compliance with any new law creates new costs.  To some extent, these costs are like those incurred with repairing a roof after it leaks and damages the interior of a building.  Many of the costs of assessing and strengthening internal control should have been incurred a long time ago.  By not directing attention to the quality of their financial statements, managers left their financial reporting roofs in leaky condition.  A penny saved in the short run often brings much greater costs when the damage must be undone.

It seems to me is that a more complete analysis must include addressing the questions of (1) who incurs the cost, (2) what are the benefits of compliance, and (3) who enjoys those benefits?  A conclusion that compliance costs too much may be fatuous without considering these additional factors.

The costs, of course, are borne by the shareholders.  No manager has paid a dime of the extra fees and salaries associated with compliance.  In fact, some managers are better off because they now have more staff to supervise and higher salaries reflecting their additional responsibilities.  The decision of whether the costs are too great, then, will be made by those who own the stock or who might wish to own the stock.  The ultimate expression of that assessment would be a depressed stock price if the costs are too high and a higher stock price if the costs are in line with the benefits of compliance.

As to those benefits, I noted that Mr. Pugh did not incorporate the cost of capital in his analysis.  The purpose of any information is to reduce the uncertainty of those who receive it.  The result of high uncertainty in the capital market is investors’ demand for higher rates of return, which are, in turn higher capital costs for the corporation.  The rate of return is also the discount rate applied to future cash flows by the market, such that an increase in uncertainty will produce a decrease in the market value of a security while a decrease in uncertainty will increase that value.  The benefit for the shareholders of compliance with SOX is thus a higher stock price because risk has been reduced.  Although this benefit may be difficult to discern because many factors affect a stock’s value, it should not be simply ignored as if it doesn’t exist.

In addition to this micro level analysis, there is also a macro effect in that the combined efforts of all public companies to improve internal control (and management of internal control) should produce a lower level of systemic risk that affects all securities.  In other words, a massive effort to comply with higher standards could very well have increased the aggregate level of confidence in the capital markets such that stock prices on the whole have gone up.  A quick glance at a chart of the DJI since the passage of SOX shows that it has moved steadily upward to and above 13,000 since it was at around 8,000 when the law was passed.  Not proof, but certainly food for thought when assessing the benefits of SOX.

As to the third question of who enjoys the benefits of compliance, the answer has to be that everyone does.  If the cost of capital can be reduced by driving down the perceived risk that management might be purposely or accidentally producing misleading financial statements, the result is more efficient capital markets that, in turn, make the economy more efficient because capital is being priced more appropriately for risks and returns.  Again, one could see some suggestion that SOX has worked because interest rates have declined and stayed low since it took effect.  Is SOX the only factor behind this phenomenon?  Of course not, but an analysis of the costs and benefits of compliance is incomplete without considering it.

As with any law, the ultimate decision of whether SOX should be repealed or amended will be resolved through a political process.  To the extent that economic analysis can enlighten the politicians, so much the better.  To the extent that the debate is engulfed in incomplete or otherwise inadequate analysis, then we could all be worse off.

An additional point also deserves our attention.  Some suggest that American companies are going offshore to raise capital to avoid the high costs of compliance.  What is often completely unaddressed is the question of whether that strategy actually produces benefits in the form of higher stock prices.  Unless compliance does absolutely nothing to reduce the perceived uncertainty and risk, we should expect these companies to incur a higher cost of capital when they go overseas.  It makes little sense to save a few million in compliance costs if doing so produces many more millions in capital costs and lower market cap.  In a sense, this flight to overseas markets actually strengthens the U.S. markets by getting rid of those managers who do not like disclosing more about what they’ve been up to.  Rather than reflecting a competitive disadvantage, it seems to me that the flight to lower quality reporting is actually producing a competitive advantage for participants in U.S. markets.