How about optional SOX?

With all the calls for new regulation, it’s bracing to hear somebody calling for a rollback. Not surprisingly that would be Newt Gingrich, who with a co-author suggests repealing SOX.

Needless to say, after all I’ve written against SOX (e.g.here and here), I’m sympathetic. And although one might think that this is the wrong time to press these arguments, in fact, as Gingrich points out, repeal now makes more sense than ever.  SOX is best seen as a tax on entrepreneurs (the difference between regulatory costs and benefits) in difficult times when they most need a break. Moreover, we now can see clearly how little SOX accomplished in dealing with the unwise risk-taking it was intended to prevent.

But given the difficult politics of calling for a rollback now, and even on policy grounds, it’s worth exploring an alternative: make it optional. That would let the small firms avoid the “tax” while letting large firms, and particularly financial firms, post a SOX “bond” to assuage wary investors. Indeed, Bobby Bartlett, in Going Private but Staying Public, has found that some firms that could avoid SOX apparently have been doing just that. For the small firms, the economic effect of optional SOX would be equivalent to a significant tax break or subsidy, but without burdening the taxpayers (though the hit to accountants would be substantial).

A possible variation on my proposal is to disaggregate SOX's grab bag of provisions and let firms opt for some separately rather than having to choose the whole bundle.

Clearly investors have every incentive in this risk-averse environment to pay close attention to who is and is not subject to SOX’s risk-disclosure provisions.  This reduces the potential for a lemons market in a post-mandatory environment. So what’s the counterargument?

The main one I can see is investor complacency. Particularly given the recent meltdown of SOX-compliant firms like Bear, Lehman and AIG, SOX seems not to be delivering the promised risk protection. So investors in SOX firms might think they're more protected than they actually are. However, as just suggested, investors have every incentive to be wary.

More importantly, I do believe in contracts and markets don’t I? Then why not let the market decide whether the SOX bond is worth it? Presumably firms’ cost of capital will accurately adjust.

So, ironically, the choice between keeping SOX around as an option and getting rid of it altogether switches the sides in the SOX debate. The argument for optional SOX is based on free markets; the argument for total abolition is based on paternalism.