The race to the regulatory bottom continues
An amendment permanently exempting small public companies from complying with a key provision of the Sarbanes-Oxley Act advanced in Congress today, demonstrating the bankruptcy of our approach to reform.
Sarbox was passed in the wake of scandals at Enron, WorldCom and others to protect investors. Sections 404(a) and 404(b) are important provisions.
The first requires executives to sign off on the integrity of internal controls. Can employees walk off with inventory? Are two people signing checks? Is accounting in order? Basic stuff to reduce the risk of misstatements and fraud.
The second requires an outside audit of the above. And that costs money.
At the time, companies with market caps below $75 million successfully lobbied to delay compliance, arguing that the costs were too big relative to their size.
Apparently, a delay is no longer enough. Representative John Adler, a New Jersey Democrat, pushed through the House Financial Services Committee today an amendment that would permanently exempt companies below $75 million from 404(b). And it would direct the Securities and Exchange Commission to “study” how to ease rules for companies with market caps of under $250 million. The amendment has the support of the Obama administration.
“This is an insult to investors given what we’ve experienced over the past year,” says Kurt Schacht of the CFA Centre for Financial Market Integrity. “Small companies have had plenty of time to plan for this.”
In a phone interview, Adler told me that 404(b) is problematic for several reasons. First, it has reduced the number of IPOs. To support his point he compares the 1990s with this decade, conveniently forgetting that the number of offerings last decade was dramatically inflated by the dot.com bubble.
Second, he says, small American companies are either moving their headquarters overseas or listing shares in London to dodge Sarbox compliance. Asked for examples, he cited Princeton Review and Peet’s Coffee & Tea. Actually, Princeton Review is based in Massachusetts, Peet’s in California. And both are listed on Nasdaq.
Are small foreign companies listing less frequently in the United States because of Sarbox? Yes, according to a 2008 paper by Suraj Srinivasan of Harvard and Joseph Piotroski of Stanford.
So shed a tear or two for banks, which may lose underwriting fees, and for small foreign companies, which may get locked out, but American investors are protected as a result because our markets have more integrity.
This benefits larger foreign firms that do comply with Sarbox, Srinivasan notes, because compliance gives their managements more credibility.
The legitimate argument against compliance is that it costs money. Those are dollars that small firms can’t invest in their business. But cost estimates vary widely. Adler points to a 2006 SEC study that put the average cost for small firms at $900,000. Jeff Mahoney of the Council of Institutional Investors, however, cites other studies that suggest the cost is lower.
Because of concerns over cost, regulators have already issued guidance instructing auditors to go easy. So if small companies — which have a much higher rate of accounting misstatements than their larger brethren, by the way — don’t want to comply with Sarbox, that’s fine. But they should issue stock privately.
The race to the regulatory bottom continues. With no natural constituency fighting in favor of tough market rules, those subject to them steadily chip away.
The non-response to last year’s financial crisis — toothless reform for derivatives, “resolution authority” that codifies too-big-to-fail — suggests that it will take a total market collapse before we get real reform.
Glass-Steagall, for example, was a great piece of legislation that protected us from the worst excesses of banking. But it took a Depression to deliver it.