The trouble with SOX: it's not just small firms

There seems to be a myth going around that the problems with SOX can be solved by a simple amputation of small firms.

The latest adherent is Bob Greifeld, head of Nasdaq and self-styled "consistent supporter of the principles of Sarbanes-Oxley," writing in today's WSJ. He's worried about all those foreign firms leaving US capital markets, including NASDAQ.  His solution is to support the recommendations of the SEC's Advisory Committee on Smaller Public Companies to exempt small public firms from 404.

This attempt to solve the SOX problem by amputation won't work. First, 404 is a problem for both large and small foreign firms. So the bandaid Greifeld's suggesting won't even accomplish his limited objective of bringing foreign listings back to Nasdaq.

Second, it's not clear the SEC can exempt small firms from 404 -- it's not covered by the SEC's general Exchange Act exemptive power, and it's arguably not within the SEC's rulemaking authority under SOX.

Third, the problems of SOX are far more widespread than small firms and foreign firms. The costs of 404 compliance are huge for all firms, not only in terms of direct compliance, but in terms of massive new auditing costs, diversion of executive time, deterring risk taking, and on and on. Moreover, far from seeing the end as industry adjusts, we have hardly seen the beginning. A liability time bomb lurks in the combination of SOX 404 and the executive certification provisions, set to go off the next time a market dip gets trial lawyers' juices flowing.

Fourth, SOX's problems extend far beyond 404. They include, for starters, the misbegotten executive loan prohibition, still causing fits because Congress forgot to spell it out; the problems inherent in lawyer monitoring under section 307, which still haven't been solved by the QLCC; and the whistle-blowing provision, being administered by OSHA, of all people.

It's time to repeal or massively revise and shrink SOX. This is looking increasingly realistic. One spur, as I've said, will be the suit over the constitutionality of the PCAOB. But ironically, the SEC Advisory Committee report may provide another. As support grows for the Report from folks like Greifeld, the idea of a broad small firm exemption may become unstoppable – even after it turns out the SEC lacks the authority. And once Congress gets this issue, other issues may go on the table.

Anyway, more on all this at the AEI next Monday.

Comments

[Eric Talley]

Larry --

A few other problems with "small amputation" solution, which were not in your post:

(1) There's little to no evidence that the $75 million market cap threshold is an appropriate one for allowing 404 exemptions. A recent empirical study (on which I was a co-author) finds that to the extent that overall costs of Sarbox were visitied disproportionately on small firms, the cutoff appears more like the $15-$25 million market cap range.

(2) No one has paid much attention to whether adding yet another regulatory discontinuity at the $75M level will artificially stunt growth trajectories of firms attempting to avoid the threshold, or -- possibly worse, cause them to use increased leverage for financing (which can create problems for corporate decisionmaking).

Of course, both of the above points cabin the ultimate questions of (a) whether SOX was a good idea to begin with, or (b) even if it was a bad idea a priori it's worth repealing after many of its promulgation and compliance costs have been sunk. I personally don't think I can answer those questions definitively, given that the benefits of SOX are more diffuse and difficult to measure, and the data for such measurements is only now coming avaiable. But like you, I'm sympathetic to the view that one should think carefully about whether partial solutions like this are a good idea.

[Eric Talley]

A brief addendum to my prior post (though the substantive point remains the same): the SEC Advisory Committee on Smaller Public Companies, in its forthcoming report, appears likely to advocate staggered market cap thresholds that kick in at the first and fifth percentiles nationally, nominally above the $75 million float threshold for non-accelerated filers. See http://www.sec.gov/rules/other/33-8666.pdf

[Larry E. Ribstein]

Eric--
All good points. The threshold was really based on number of firms affected, rather than on disproportionality of costs. Which shows the basic nature of the policy decision the SEC would be making here -- and another reason why Congress, rather than the SEC, should be making it.