Over the next several weeks, the S.E.C. has the opportunity to do what it was supposed to do. Whether it can stand-up to the challenges presented by corporate America may be the turning point for the agency. On several fronts, the courts, at the behest of small companies and mutual fund families, will take the S.E.C. to task. Chairman Cox may be one of the few people in Washington that is up to the challenge.

Opponents of Sarbannes-Oaxley desperately want their day in court. While everyone should be granted the right to due process, the law at is written now, reviewed Congressionally and by prominent law scholars before it was passed, should remain intact even if the Supreme Court does decide to hear arguments concerning its constitutionality.

Securities and Exchange Commission chairman Christopher Cox believes that law is necessary. Trouble is, despite the law’s good intentions, how does one make it work for companies big and small. Speaking before the Senate Banking Committee, the elected officials who essentially act as oversight for the S.E.C., Mr. Cox seemed unsure that the law will hold up under scrutiny from the higher court.

At stake is the request by 70% the publicly traded corporations to be allowed exemptions under the accounting and auditing law passed in the wake of numerous scandals in 2002. The exemption would primarily exclude all of the small capitalization companies from adhering to the strict accountability guidelines. Currently, if a publicly traded company has a market cap of less than $75 million, they are already exempt.

Sarbannes-Oaxley requires that the CEO sign-off on his companies accounting and financial filings or face criminal penalties. This has caused many companies to complain about the high cost and relative protective values the law provides to shareholders. Instead, companies big and small have staked their claim that the costs of such auditing have lowered shareholder value by eating away at profits.

At the heart of the legislation, labeled knee-jerk by most corporations, is the strategic placement of internal controls and financial disclosure. The smaller the company, the less likely those controls would be in place. Sarbannes-Oaxley has helped ensure that shareholders are protected.

Investing in the world of small caps has always been fraught with risk. Business models are usually less fully formed and money managers know these inherent challenges when placing investors money in play. Sarbannes-Oaxley has helped with this challenge as the law forces many companies to stand behind their accounting.

Any changes now would essentially weaken the law enough to get it removed from the books for all companies, labeling it as unconstitutional. So far, the majority of folks over at the S.E.C. dislike the exemption.

Mr. Cox also was granted the opportunity to review the hastily agreed upon regulation of mutual funds and their boards. On this one though, Mr. Cox should find a way to make it work without fundamentally changing what his predecessor pushed through, twice.

The debate over regulation, that much like Sarbannes-Oaxley, requires that mutual fund companies seat independent board members as a way to protect shareholders from onerous fees. In many respects, those regulations are unnecessary but for a few fund families. But there are always the bad apples that force just such regulations even if the majority of the investment public knows better.

Surviving the fallout from the stock market tumble in 2000, investors grasped a concept that seemed foreign to them prior to the decimation of their portfolios. Once they understood fully the economies of scale – how even the smallest percentage of a fee can impact a portfolio decades down the road, they began to put pressure on fund companies to rein in the costs of running the fund. This created an atmosphere of better-cost disclosure.

What membership change would essentially achieve is the creation of governing boards that would be 75% independent of the fund itself. Whether the rule change was politically motivated or not – the GOP sees it as such suggesting the former chairman William Donaldson pushed it through while the Democrats had the majority – it has been returned for further review by the D.C. Circuit Court of Appeals.

The first time it was returned for review, the courts wanted the costs of such a rule to be reexamined. The second time was for lack of time allotted to public review and analysis. Unfortunately, the mutual fund industry needs the regulation.

The Investment Company Act of 1940 created the first oversight boards for funds using the basic corporate business model. Mutual funds argue that investors do not necessarily view themselves as shareholders. Instead, the customer based model, one where shareholders flee when something irregular occurs, as it did for Putnam (lost $24 billion of investor’s confidence) Janus ($12 billion in scandal driven outflows) and Invesco – AIM (watched $6 billion walk) is the reason the industry is fighting the rule.

Are we expecting the mutual fund industry to heal itself? Can we embrace the small company CEO’s blessing on their balance sheet without forcing them to swear to it?

The investment community and corporate America will always be blessed with business leaders who will seek to do the right thing. American funds changed their board membership and saw the inflows into their company’s funds soar threefold. Just as there is little likelihood that all mutual funds will follow American’s lead, there is little chance that small company CEOs will fully disclose what investors need without the law prompting them to do so.

Mr. Cox should stand firm and insist that investors remember the events of just several years ago. Investors have short memories. As Shakespeare said, “memory,” is “the warder of the brain” which would make Mr. Cox, the warder of investor safety.

© 2006 Paul Petillo
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