Mending SOX

Steve Bainbridge, reviewing the high cost of SOX 404, particularly to US international competitiveness asks whether SOX can be fixed. But he concludes:

In the long run, however, it may be that SOX 404's main detrimental effect is to make US capital markets far less attractive to foreign investors, at precisely the moment in our demographic history when we need foreign capital more than ever. Instead of trying to band-aid the situation by yet another round of purported "fixes," Congress should simply repeal 404.

This is obviously (to my readers) a question that's dear to my heart. In my book with Henry Butler, The Sarbanes-Oxley Debacle (abstract here) we discuss Section 404's costs in detail. My article Cross-Listing and Regulatory Competition discusses the problem of SOX's effect on the US's role in international securities markets. Henry and I conclude in our book:

SOX section 404 goes much too far in penalizing and even criminalizing executives’ failure to spot not just problems, but even risks that later happen to turn into problems. If Congress concludes that it must retain section 404, it can at least revise the provision so that it does not impose the huge costs discussed in chapters 4–6. The revised law should clarify that managers can exercise reasonable business judgment about risks to report, and that these risks will be assessed as of the time the report is completed rather than in light of subsequent events.

A related option for defining the internal controls standard is in the COMPETE Act, introduced last may in House and Senate versions, and since then languishing. The Act provides, among other things:

(e) In implementing the requirements of this section, the Commission and the Board--

(1) shall alter the standard for review from a remote likelihood standard for noting weaknesses under this section to a 5 percent de minimus material weakness criteria (based on 5 percent of net profits);

(2) specific guidelines for measuring the terms `reasonable', `significant', and `sufficient' in the context of internal control over financial reporting for issuers, including--

(A) reference to specific examples of the appropriate application of those terms; and

(B) establishment of a means for timely response by the Commission or Board, as applicable, to requests by issuers and registered public accounting firms for guidance as to the appropriate application of those terms; and

(3) shall modify the rules concerning the independence of registered public accounting firms to perform assessments under subsection (b) to allow prudent interaction between such firms and internal consultants.'.

I agree in principle that it would be better for 404 to be repealed. But let's face it – Congress won't do it (unless led there by a finding of unconstitutionality in the PCAOB suit). So we have to think about second-bests, and they would include my and Butler's proposal and the COMPETE proposal.

A more radical alternative at the edge of possibility is a small firm opt-out, also proposed in COMPETE. Even better, and consequently further out, is Butler and my proposal (at 88-90) to allow opt-out by all firms.

Comments

[M.D. Fatwa]

Bainbridge says, "In the long run, however, it may be that SOX 404's main detrimental effect is to make US capital markets far less attractive to foreign investors, at precisely the moment in our demographic history when we need foreign capital more than ever." However, Bainbridge's blog actually focuses on foreign issuers, not investors. I don't get it. How does a law that discourages foreign issuers from listing on a U.S. exchange necessarily discourage foreign investors from investing in the securities trading on U.S. exchanges? If Sarbanes-Oxley improves issuer internal controls and offers better investor protections (regardless of costs to issuers), wouldn't that encourage foreign investors to invest in the United States? The only way SOX would discourage foreign investors would be if the costs of SOX implementation were so high that it reduced issuer profits to an extent greater than investors valued the improved transparency. If that happened, it wouldn't effect just foreign investors, but U.S. investors as well. (And, at any rate, that's not what Bainbridge is saying. He's just confused.)