The road to heck is paved with good intentions and I think Sarbanes-Oxley currently falls into the "good intention" category. US businesses and markets are now having to wrestle with the problems that the Act is causing such as a restraint on growth, restrictions in accessing to capital, and an increase in bureaucracy.
The cost of additional regulations always has to be weighed against the benefits and right now the cost of Sarbanes-Oxley is outweighing the benefits. Despite the high profile public company frauds in the past five years, I think US accounting rules and reporting requirements were by far the best in the world, even before Sarbanes-Oxley. US accounting standards surpassed the accounting regulations in almost every other industrial country according. Significant changes weren’t needed – just an adherence to existing standards and regulations.
The existing accounting regulations and reporting requirements already provide plenty of information for investors to spot fraudulent activity. Additional regulations won’t be able to prevent investors from being complacent and not examining all the information already available to them. For instance, numerous sources highlighted the potential of fraud at high profile companies such as WorldCom and Enron. First, the two companies were the favorites of short sellers. The incomparable Herb Greenberg highlighted the companies numerous times in his articles. Second, the cash flow statements highlighted the fact that neither company was generating any free cash flow despite the fact that they were not in the "capital intensive" cycle of their growth. Third, Enron’s filings were filled with references to a substantial number of oddly named subsidiaries that should have raised the eyebrows of any investors. It seems that the existing filings gave investors plenty of clues that something could be amiss at the companies.
The high-profile company frauds such as Worldcom and Enron should be viewed as a "cost of doing business." The potential for fraud can be viewed similarly to a bank or company extending "credit". All business needs to extend credit to a certain % of customers that might not be able to pay. If a business has absolutely no defaults, its credit policies are probably too stringent and the company is restricting growth because of its stringent credit policy. The opposite is also true. If business extend too much credit, then it will suffer from poor cash flow as it’s customers aren’t able to pay. There’s a fine balance between extending too much and too little credit.
The same goes for fraud in the public markets. Anytime you create the opportunity for wealth through public markets, a certain amount of fraud is going to occur. All the regulation in the world won’t stop bad people from trying to skirt the system for their own benefit. Protecting investors should therefore be a decision of how much companies and markets should spend to try to prevent fraud.
I think the cost of Sarbanes-Oxley has tipped the scale – it’s too costly for the small additional benefit. I don’t know the exact number of companies that can’t file their 10-k on time because of more than one material deficiency in their financial controls but the number is probably in the 100s. In the last two days probably 20 companies alone have said they can’t file on time.
The added cost of Sarbanes-Oxley is reducing the potential for capital appreciation, especially for small cap investors. Numerous small companies have added a separate line item to their pro-forma financials – "Cost of Sarbanes-Oxley Compliance." For many companies, these additional costs will cost three or four cents to their quarterly earnings per share calculation. If you take a multiple of that (20x to 30x earnings for small cap growth companies) it can knock a $1 off the stock price. Multiply that by a couple thousand small cap companies and the costs, in terms of actual expense and of reduced market cap, really start adding up.
In addition, the added layer of cost and bureaucracy will act as a drag on economic growth. Small companies will decide not to access the public market to raise capital because of the high cost of being a public company. Ready access to capital is the fuel that drives job and economic growth. If exciting and growing small cap companies don’t access public markets, not only will investors lose out, but the economy will as well.
And many more companies will simply drop out of the system. Recently S&K, a small cap men’s clothing company, has decided to delist from the Nasdaq instead of comply with Sarbanes Oxley because of the added costs. This hurts existing shareholders who won’t have access to quarterly financial reports and it hurts the company because many investors will decide simply to pass the stock over because it isn’t listed on the NASDAQ.
So while the Sarbanes-Oxley Act was intended to protect investors, the costs of enforcement could well outweigh the benefits. Hopefully, the costs will become apparent after the recent spate of filing delays and Congress will act to reduce the more costly requirements for small companies.
From the Richmond Times Dispatch –
S&K to pull stock from exchange
Men’s clothier says trading costs on Nasdaq outweigh benefits
Richmond-based retailer S&K Famous Brands Inc. said yesterday that it has filed to have its common stock deregistered.
S&K announced the decision in its fourth-quarter earnings release, saying that the costs of meeting increasing regulatory requirements outweigh the benefits of keeping the stock listed.
As a result of the voluntary filing with the Securities and Exchange Commission, S&K said its common stock has ceased to be listed on the Nasdaq stock market, although it will continue to trade on the over-the-counter market. The stock closed yesterday at $17.50, down 21 cents.
The deregistration also frees S&K from having to file annual and quarterly financial reports with the SEC, but the company said it will still provide quarterly information on its Web site.
S&K, which sells men’s apparel at 236 stores in 27 states, said it expects the deregistration to become effective within 90 days. Davenport & Co. LLC is a sponsor of the company’s shares in the pink-sheets market and has indicated its intention to be a market maker, S&K said.
S&K said its board decided to terminate the registration to save money that otherwise would be spent complying with federal regulations, especially certain requirements of the Sarbanes-Oxley Act of 2002, a law designed to bring more transparency to corporate financial reporting.
"The increasing financial cost and commitment of management’s time to regulatory compliance have become a burden that will only increase over time," Stewart M. Kasen, the company’s president and chief executive officer, said in a statement. Kasen said the company has estimated that the financial costs of remaining a public company would be about $300,000 annually.
Stuart C. Siegel, the company’s chairman, said S&K "has not enjoyed many of the benefits traditionally associated with being listed on the Nasdaq," given the company’s small size, thinly traded stock and lack of analyst coverage.
"The financial and administrative burdens of being a publicly traded company have become disproportionate to the limited benefits our shareholders are receiving," Siegel said.
The company said its board of directors "took into consideration the possibility that the liquidity for the company’s stock may be reduced and the price of its stock may decrease, at least in the near-term," because of the deregistration.
"However, the board of directors unanimously determined that the disadvantages of remaining a public company significantly outweighed the potential advantages," the company said. — John Reid Blackwell