Archives For sarbanes-oxley

Roberta Romano has just posted her paper, Regulating in the Dark. Here’s the abstract:

Foundational financial legislation is typically adopted in the midst or aftermath of financial crises, when an informed understanding of the causes of the crisis is not yet available. Moreover, financial institutions operate in a dynamic environment of considerable uncertainty, such that legislation enacted even under the best of circumstances can have perverse unintended consequences, and regulatory requirements correct for an initial set of conditions can become inappropriate as economic and technological circumstances change. Furthermore, the stickiness of the status quo in the U.S. political system renders it difficult to revise legislation, even though there may be a consensus to do so. This essay contends that the best means of responding to this dismal state of affairs is to include, as a matter of course, in crisis-driven financial legislation and its implementing regulation two key procedural mechanisms: (1) a requirement of automatic subsequent review and reconsideration of the legislative and regulatory decisions at some future point in time; and (2) regulatory exemptive or waiver powers, that encourage, where feasible, small scale experimentation, as well as flexibility in implementation. Both procedural devices will better inform and calibrate the regulatory apparatus, and could thereby mitigate, at least on the margin, the unintended errors which will invariably accompany financial legislation and rulemaking originating in a crisis. Given the centrality of financial institutions and markets to economic growth and societal well-being, it is exceedingly important for legislators acting in a financial crisis with the best of intentions, to not make matters worse.

It’s worth noting that Henry Butler and I, in our book about SOX (at 96-97, footnotes omitted), also suggested “sunset” provisions as an antidote to crisis-driven regulation:

[S]ignificant new financial and governance regulation like SOX that displaces and supplements prior regulatory approaches should be subject to periodic review and sunset provisions. Although Congress, of course, can always undertake such reviews, prior experience indicates that it will not. Legislation is a one-way regulatory ratchet. It arises when the conditions for reform are ripe for a regulatory panic. The conditions for a “deregulatory panic” are less likely to develop. Firms learn to live with the extra costs and may not be willing or able to bear the costs of lobbying for repeal, at least in the absence of a regulatory cataclysm. Thus, it is not surprising that SOX sponsor Michael Oxley, despite recognizing that SOX was “excessive” in some respects, and admitting that it had been rushed through Congress, suggested that Congress would not be revisiting the issue, even as to the seriously affected small companies. He said, “If I had another crack at it I would have provided a bit more flexibility for small- and medium-sized companies.” In other words, Congress normally does not have “another crack” at regulation. A sunset or review mechanism would change that.

Perhaps Congress can learn some lessons from itself. The USA Patriot Act was passed less than one year before SOX and, like SOX, was passed by an overwhelming majority. Unlike SOX, the USA Patriot Act includes sunset provisions for some of its most controversial provisions. The Patriot Act’s sunset provision forced Congress and the president to reevaluate and debate those provisions, in an atmosphere far  removed from the immediate post-9/11 panic. American investors would benefit from a sober reevaluation of SOX. Perhaps the courts will provide that opportunity. For future regulatory panics, Congress would do well to remember the lessons of the Patriot Act.

One footnote in Romano’s article particularly grabbed my attention.  Referring to Jack Coffee’s criticism of sunset provisions in a non-yet-public manuscript (“The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated”), Romano notes:

Coffee (2011:4, 6,9) sweepingly seeks to dismiss the scholarship with which he disagrees by engaging in serial name calling, referring to the authors, Steve Bainbridge, Larry Ribstein and me, as “the ‘Tea Party Caucus’ of corporate and securities law professors” (a claim that would have been humorous had it not been said earnestly), “conservative critics of securities regulation,” (a claim, at least in my case, that would be accurate if he had dropped the adjective), and further referring to Bainbridge and Ribstein, as “[my] loyal adherents.”

 She also observes in this footnote:  

[I]n the American political tradition and academic literature, advocacy of sunsetting has historically cut across political party lines. It has had a distinguished liberal pedigree, having been advocated by, among others, President Jimmy Carter, Senator Edward Kennedy, political scientist Theodore Lowi, and Common Cause (Breyer 1982; Kysar 2005).”

Like Butler and me, she cites the Patriot Act precedent.

Well, I’m proud to be included in Romano’s and Bainbridge’s “tea party” and surprised at being there because I advocated an idea also endorsed by Carter, Kennedy, Lowi and Common Cause.  It’s sad a scholar of Coffee’s stature sees a need to resort to such rhetoric, though almost understandable since Romano’s devastating critique doesn’t leave him much of a ledge to sit on.

 As for Romano’s article, definitely do read the whole thing.  Rather than simply condemning Dodd-Frank, she argues persuasively for a way to avoid future financial over-regulation.

Update:  Matt Bodie confuses blogs and scholarly articles, statutes and people. Bainbridge sets him straight, and Leiter agrees.  But do read Bodie’s post anyway because he links to some great Gretchen posts which even I had forgotten.

We have heard much about the costs of internal controls reporting under SOX 404. Proponents argue that the fraud reduction is worth the costs.  One might question this in light of anecdotes like all the missing cash at MF Global (and many other post-SOX securities fraud suits where auditors and executives had signed off on internal controls).  But more comprehensive evidence would be helpful.

The latest word on the evidence front is Rice and Weber, How Effective is Internal Control Reporting Under SOX 404? Determinants of the Non-Disclosure of Existing Material Weaknesses.  Here’s the abstract:

We study determinants of internal control reporting decisions during the SOX 404 era using a sample of restating firms whose original misstatements are linked to underlying control weaknesses. We find that only a minority of these firms acknowledge their existing control weaknesses during their misstatement periods, and that this proportion has declined over time. Further, the probability of reporting existing weaknesses is negatively associated with external capital needs, firm size, non-audit fees, and the presence of a large audit firm; it is positively associated with financial distress, auditor effort, previously reported control weaknesses and restatements, and recent auditor and management changes. These results provide evidence that detection and disclosure incentives play a role in whether existing material weaknesses are reported, which has implications for the effectiveness of SOX 404 in providing investors with advance warning of potential accounting problems.

There are three remarkable things here. 

  • The authors study only firms that had internal controls weaknesses to see which reported, reducing the problem of confounding the existence of problems with the weakness of reporting. 
  • “Only a minority” (32.4%) of these weak-controls firms actually report their weaknesses, despite SOX. 
  • These firms are least likely to report weaknesses when they most need money.  This shouldn’t seem too surprising, because this is when the firm has most incentive to misreport.  But if you hoped SOX would be effective in counteracting those incentives, forget about it.

The authors explain on the Harvard blog

The usefulness of internal control reports in providing advance warning on the likelihood of misstatements in the financial reports is reduced if control weaknesses are not disclosed until after the misstatements themselves are later revealed. * * *

The results of this study make several contributions to the literature. By documenting that SOX 404 reports are not always effective in identifying existing control weaknesses and, further, that the effectiveness has not improved over time, our results lend some support to criticisms of internal control reporting in practice and suggest that recent declines in reported material weaknesses may not be reflective of improvements in underlying control practices, consistent with concerns voiced by the SEC. These results also inform recent debates over the value of requiring control reports to be audited. Despite the audit requirement of SOX 404, our evidence indicates that the majority of restating firms provided no advance warning of the control problems that led to their misstatements. Finally, our results also have implications for future academic research. We document considerable variation in whether existing weaknesses are actually reported and our evidence on the determinants of that reporting should be considered by future research using public disclosures to study internal control practices.

The authors note the caveat that “the generalizability of our results to firms with control weaknesses that do not lead to restatements is unclear. This is particularly true of our results for Big 4 vs. non-Big 4 auditors because of the direct role that auditors play in certifying the reliability of financial statements (and thus in the likelihood of restatement).” They offer the following explanation of the curious negative correlation with Big 4 accountants:

Given previous evidence that larger auditors tend to provide higher quality financial statement audits (see Francis [2004] for a review), larger auditors may be better able to “audit around” control weaknesses and avoid the misstatements that would lead to inclusion in our sample.

The bottom line is that even if internal controls reporting is generally a good idea, this evidence indicates the current approach is failing: it’s not only imposing high costs, but it’s getting low results.  One might hope that in light of these results SOX would at least be revised to target mandates where they are most needed. This could happen in a more dynamic regulatory system.  But in 2002 Congress locked internal controls reporting in a vault impervious to post-2002 data.  The PCAOB can tweak auditors’ obligations, but it can’t change the basic regulatory framework.

A Macro Conference

Paul H. Rubin —  14 October 2011

I was invited to attend the Financial Times Global Conference “The View From the Top: The Future of America” and since I was in New York anyway I thought it would be fun.  I don’t hang around with macro types much, and even less with liberal macro types.  I will not summarize the entire conference, but a few observations:

  1. Reinhart-Rogoff was a hit, mentioned several times.  Aside from the merits of the book, I think people were trying to give Obama cover for no recovery.  R-R apparently says it takes an average of 7 years to get out of a financial crisis.
  2. The first speaker (Gene Sperling) was late and the Gillian Tett of the FT, the moderator, took some informal polls of the audience (mainly business journalists.)  Pretty pessimistic: Thought that there would be a double-dip, the EU would lose at least one member, and yields would not increase.
  3. Sperling (Director of the National Economic Council) spent a lot of time talking about how bad unemployment is and arguing for the President’s Jobs plan (which the Senate has already rejected.)  Not much new to propose.
  4. Peter Orszagh (former OMB Director, now with CITI) made a few interesting points.  He said that the Administration got the original forecast wrong, and did not realize that the recession was “L” and not “V” shaped.  He also predicted that middle class incomes will not return to their original level and that policy should not fool people into thinking they would.
  5. Several speakers (Laura Tyson of Berkeley and former CEA Chair; Steve Case , AOL founder) argued for better immigration laws (no quarrel there: the Republicans have got themselves into a terrible position on immigration).  Tyson in particular argued for more STEM (science, technology, engineering, mathematics) education.  I asked her if she thought the increasing gender imbalance in colleges (now about 2 women per man) was responsible for the STEM problem and she indicated that it might be part of the problem.  Really something worth further examination and some policy analysis.  Of course the immigration mess makes this problem worse since it is harder to import engineers from abroad.
  6. Someone (I think Steve Rattner, former Auto Czar) made the point that while the American economy is doing badly and unemployment is a real problem, American companies are doing very well, in part because of foreign earnings.  There were also several inconclusive discussions of a tax holiday for repatriation of foreign earnings.  Some said that this would be “unfair” but others understood that future effects, not past fairness, was what was relevant.  Not clear what the effects would be, however.
  7. A few mentions of Sarbanes-Oxley and Dodd-Frank, but mostly the role of regulation was ignored.  Health care was mentioned but not, I believe, Obamacare.  Everyone agreed that businesses were “afraid” to spend money but little discussion of the source of the fear.
  8. Most were not worried about conflict with China.  I asked about Chinese demographics (aging population, gender imbalance with too many males.)  Whenever I hear discussions of China I raise this issue since people seem to ignore it and it is a serious issue.  Michael Spence (Nobel Laureate, now at NYU) said that China was in a position to establish a viable retirement program (no details) but that the gender issue was not one that was being dealt with.  There seemed to be almost envy of the ability of the Chinese to do what they wanted independent of the desires of the people.
  9. Laurence Fink of BlackRock made the interesting point that the current situation seems a lot like the 1970s, including the widespread pessimism.  Martin Wolf, Chief Economics Commentator of the FT, agreed.  But the lesson he drew was that we need more and wiser regulation.  I spoke with him briefly and indicated that I was in the Reagan Administration, and that last time we got in a pessimistic mess like this deregulation al la Reagan was the solution.  He rejected this approach.  But I am hopeful.

Six years ago Henry Butler and I wrote about what we called the Sarbanes-Oxley Debacle. Well, it’s still a debacle after all these years, and having significant effects on business and international competition.

Yesterday’s WSJ opined, concerning the potential NYSE/Deutsche Borse merger that 

whoever ends up owning the iconic trading venue, the question is whether Washington will allow any U.S. stock exchange to be an attractive destination for young companies. It’s clear to most stock-exchange watchers that no business combination can relieve the burden that the 2002 Sarbanes-Oxley (Sarbox) law places on firms seeking to join the public markets. This is no doubt one of the reasons that Mr. Niederauer sees advantages in a merger with a foreign partner that has most of its business overseas.

The editorial suggests expanding Dodd-Frank’s exemption from SOX 404(b) from companies with less than $75 million in public securities to those with less than a $250 million float. It relies on the SEC’s own 2009 study showing that the vast majority of companies find that the benefits of SOX compliance outweigh the costs.

Ironically, the same issue of the WSJ reports that Chuck Schumer is “favoring the German deal as the best way to protect New York.” Schumer says: “My sole motivation here is keeping New York the No. 1 financial center in the world, and I will be guided by that criteria far above anything else in making a decision.”

Schumer is supposedly worried about Chicago’s rise in the competing derivatives market.  But Roger Altman, whose Evercore Partners is advising Nasdaq on its proposal to take over the NYSE, says “the greatest threat to New York is not Chicago. It’s Hong Kong and China, by a mile.”

All of which suggests that Schumer should have thought about all this back when he was helping to provide an entrée for these foreign competitors by backing SOX and Dodd-Frank.  There’s still time for him to read Butler and my book.

A couple of months ago I asked, “what happened to IPOs.”  Today’s WSJ asks almost the exact same question and gets the same answer:

The elephant in the room is the 2002 Sarbanes-Oxley law, which triggered billions of dollars in new compliance costs for public companies.

* * * The question for companies now, as ever, is whether the benefits of going public are worth the costs. It’s indisputable that America has raised those costs in recent years. In addition to Sarbox’s Section 404, Congress has made it easier for big labor to get proxy access, increased the opportunities for lawsuits, too often turned reporting mistakes into major fines or potential felonies, and meddled into corporate pay decisions. None of these make going public more attractive.

With America still suffering close to 9% unemployment, it’s time for both parties to bring the cost/benefit calculus for IPOs back into balance.

The WSJ opines on the impending sale of the NYSE to Deutsche Börse of Frankfurt.  It describes the merger as “a story of inevitable capitalist change and how no country or institution can take its dominance for granted” and a “lesson in how easily capital, both financial and human, can relocate.” It describes the 171 IPOs in the US last year as “dwarfed” by the 1,295 IPOs overseas.

Why did this happen?  As I noted last month:  overregulation of public companies.  As the WSJ says:

The Securities and Exchange Commission’s own exhaustive 2009 survey of U.S. and foreign firms showed that the burden of complying with Sarbox remains a major deterrent to going public in the United States. Yet the agency still hasn’t made a serious effort to pare these burdens. * * *

The Dodd-Frank law requires mountains of new rules that will further burden U.S. financial players, not least in the new derivatives regime emerging from the Commodity Futures Trading Commission. We would not be surprised if the NYSE Euronext managers view the Deutsche Börse merger as a potential refuge for its derivatives business if CFTC Chairman Gary Gensler realizes all of his regulatory ambitions.

See also Butler & Ribstein for a detailed examination of the effect of the burdens under SOX, and my article on the effect of regulation on the cross-listing market.

The WSJ concludes:

If we want the U.S. to be home to the next great financial institution, or even to keep the ones we have, our politicians need to make America a more inviting place to trade and do business.

Yesterday I noted, anticipating the President’s call tonight for spending to encourage US growth and competitiveness, that “a better way to increase U.S. competitiveness is by changing the law rather than spending money.” 

One law to consider is Sarbanes-Oxley. 

In our book, The Sarbanes-Oxley Debacle, Butler and I discuss, among other things, SOX’s effect on innovation.  We noted how SOX internal reporting requirements tax change and innovation, as well as particularly burdening smaller, riskier firms which are important sources of innovation.

Now we have some evidence of this effect:  Waters, The Effect if the Sarbanes-Oxley Act on Innovation.  Here’s an excerpt from the abstract:

This paper adds to the literature on the Sarbanes-Oxley Act’s net effects by looking at whether its passage was associated with a change in innovation and patenting. Its effects are separated into temporary uncertainty and changes in long term investment incentives in a dynamic programming problem faced by innovators who learn over time about SOX’s effect. Innovation is found to fall under uncertainty for potential losses that are low relative to the potential profits. As companies learn, innovation rates readjust to SOX’s long term persistent effect. We examine US patenting in stem cell technologies from 2001 to 2009 for SOX related changes. * * * We find a large and statistically significant change at a date consistent with a SOX effect under both testing methods. * * * Four competing explanations are found to account incompletely for the observed data.

A simple fix Congress might consider:  Let the shareholders decide if SOX is worth the costs.  We’ve got “say on pay.”  How about “say on SOX”?

In a must-read op-ed in today’s Wall Street Journal, Yale Law’s Jonathan Macey weighs in on Goldman Sachs’s decision to allow only foreign gazillionaires — no Americans, regardless of their wealth or sophistication — to invest in new shares of Facebook. 

Numerous observers have portrayed Goldman’s move as a “victory for the SEC.”  The New York Times‘ Dealbook called it “a serious embarrassment for Goldman.”  In reality, Macey contends, “[i]t is the SEC that should be embarrassed” for fostering a system in which, as Larry put it,  “the US securities laws exclud[e] US investors from investing in a US company in the US.”  

Echoing a number of Larry’s observations, Macey explains:

Thanks to SEC regulation and the litigious atmosphere it fosters — not to mention Sarbanes-Oxley’s onerous burdens on corporate executives — the whole capital formation process is moving offshore. The U.S. share of total equity raised in the world’s capital markets is shrinking, while the number of U.S. companies listing their shares for trading exclusively in foreign markets has risen steadily for the past five years.

Macey then points a finger at the SEC’s overarching regulatory philosophy, which views investors — even rich, sophisticated ones — as needing governmental protection and displays scant regard for the unintended consequences of paternalistic limitations on the freedom of contract: 

The SEC’s fundamental approach to regulation involves depriving investors of opportunities in order to protect them. This was not much of a problem in the immediate post-World War II period. Before Japan and Europe rebuilt, and before China emerged as an economic giant, the U.S. had the only large pools of investment capital in the world and dominated the financial scene. During this happy period of U.S. primacy, the SEC, along with most academics, took the rather ludicrous view that it actually deserved the credit for the primacy of U.S. capital markets. That world is long gone.

Still, according to the SEC, all investors large and small must be protected against the danger that they will succumb to a feeding frenzy of enthusiasm when given the opportunity to invest in a new deal. For example, the SEC rules governing the Facebook offering until Goldman pulled the plug include the requirement that the stock being sold “cannot be the subject of advertising, general promotional seminars or public meetings in connection with the offering.” The concern here is that publicity about a deal might, heaven forbid, create interest among investors. …

The investors who supposedly are being protected by the SEC’s rules here are not unsophisticated small investors. Goldman had limited the marketing of Facebook’s shares to the billionaires and large institutions that constitute its wealthiest clients.

Finally, Macey suggests that the Obama Administration, which has recently committed itself to ferreting out cost-ineffective regulations that “make our economy less competitive,” take a long, hard look at the “investor-protective” securities rules that drive capital overseas and prevent American investors from having access to the wealth-enhancing opportunities available to their European and Asian friends:

Ironically, the Goldman decision to move the Facebook deal offshore was announced just as President Obama was acknowledging in these editorial pages that “regulations do have costs” and saying that he would order a government-wide review to eliminate rules that cripple economic growth. That review should include the rules promulgated by the SEC, lest we continue to see U.S. capital markets fade into irrelevance.

If we ever get another President who believes that markets, while imperfect, generally work well, that government intervention often fails to make things better, and that regulations should be narrowly tailored to fix legimitate market failures, he or she should look hard at Prof. Macey for a spot on the SEC.

Last week I noted that Facebook’s big private sale to Goldman was a symptom of how higher disclosure costs have helped make private firms reluctant to take the once-expected step of going public:  “[I]t seems the increased costs of being public have helped exclude ordinary people from the ability to own the stars of the future.”  Gordon Crovitz picked this up yesterday in his WSJ column.

Today comes some evidence that higher disclosure costs, and specifically SOX, in fact have something to do with this phenomenon — Bova, Minutti-Meza, Richardson and Vyas, The Sarbanes-Oxley Act and Exit Strategies of Private Firms.  Here’s an excerpt from the abstract:

[W]e establish three principal findings. First, SOX appears to have shifted the incentive for firms to exit the private market via IPO to exit via acquisition by a public acquirer. Second, * * * [f]or our median-sized private target, the estimated dollar value decrease in deal proceeds when one moves from a high level to a low level of pre-acquisition SOX compliance is $1.3 million. Finally, public target deal multiples are not affected by a public target’s level of pre-acquisition SOX compliance. These findings suggest that SOX-related costs have both restricted the action space of possible exit strategies for private firms and led to lower deal multiples for those private acquisition targets that are less likely to be SOX compliant prior to acquisition.

The study’s basic intuition is that SOX makes it cost less for a public firm to acquire a private target than for a private target to do an IPO because the public firm can apply its existing SOX infrastructure to the newly acquired firm. This is consistent with the basic idea that SOX’s big problem for private firms is that its infrastructure costs are not perfectly scalable.  The effects of variations in target firm SOX compliance support the inference that this is, indeed, a SOX effect and not attributable to some other cause.

This means that in order for an IPO to be preferable to being acquired, a firm has to meet a higher value threshold than it would without SOX.  Thus, the authors conclude, “as a result fewer private firms should choose the IPO option as an exit strategy, post-SOX.”

Moreover, because increased SOX compliance costs are impounded into the price of the acquired firm, SOX compliance affects the price of private, but not public firms. (To be sure, SOX compliance also affects the value of the firms because they are more transparent and hence less risky.)  This could make it harder for private firms to be acquired by public firms post-SOX, although the authors don’t directly measure that effect.

Thus, the authors conclude, “[t]he combined results suggest that the costs to SOX are not restricted solely to public firms, and that an indirect cost of SOX may be its impact on restricting the exit opportunities for owners of private firms.”

To return to the conclusion of my prior blog post, “rules designed to make the markets safe for ordinary investors have ended by excluding them.”

We usually think about jurisdictional choice for corporate law as applying to state business association laws, not the federal securities laws.  But this distinction has never been clear given global securities markets, and it’s less true now than it used to be.

The WSJ discusses the securities bar’s and regulators’ lamentations over last summer’s Morrison v. National Australia Bank holding that that foreign plaintiffs who transacted in foreign shares on a foreign exchange (i.e., “f cubed”) could not bring a 10b-5 action.  The article notes that the ruling seems to be helping foreign-based companies like BP and Toyota that are facing investor suits over non-disclosure of risks that turned into big liabilities. It says  judges have been barring U.S. suits even by U.S. investors who bought shares on foreign exchanges (i.e., “f squared”).

Plaintiffs’ securities lawyers and some state officials are trying to get Congress to reverse the decision because, according to the article, “in a global marketplace in which U.S. capital increasingly flows into foreign stock exchanges, it is unfair to deprive U.S. investors of the protection of domestic law because they purchased stock overseas.”

But as I pointed out when the Morrison decision came down, the ruling “promotes globalized securities markets . . . by adopting a test that enables investors to choose the applicable regulation by deciding where to trade.”  In other words, investors may not want to be “protected” by U.S. law because it’s better for plaintiffs’ securities lawyers than for investors.   The exchange-based test gives investors clear notice of when they’re protected and when not.

At the same time, foreign firms can more easily choose, just by deciding which exchange to trade on, whether the extra credibility they get from the application of U.S. law is worth the extra costs.  As I’ve written, this may be less likely the case after federal laws like SOX (and now Dodd-Frank), which try to impose U.S. governance norms on foreign firms.

In other words, a true “global marketplace” depends at least in part on jurisdictional choice, and not necessarily on the application of the same law everywhere.