The Wall Street Journal suggested the following in a recent article concerning an important internal control, Section 404 of the Sarbanes-Oxley Act: “Companies say auditors have become too conservative because they fear being sued by the S.E.C. or investors if fraud is uncovered at a company they advised.” The issue, cited by the administration and Secretary of the Treasury Henry Paulson as a waste of billions of corporate dollars, is about to be reviewed. 

Think about it for just a second. Fear of prosecution that would have come because of poor disclosure during the audit process makes auditors nervous. This nervousness leads to caution and attention to details large and small. And if that saves billions in investor dollars, how can section 404 be so bad in the eyes of those who are supposed to watch over us?

Would diligence due to fear of litigation have saved billions of investor dollars had the auditory process that Sarbanes-Oxley requires been in place prior to accounting meltdowns such as the ones that occurred at Enron? Yes. 

Has it prevented similar investor disasters since? Probably. Here is how the contested section of SOX reads:

Section 404 -- Management Assessment of Internal Controls

 1. Rules Required. The Commission shall prescribe rules requiring each annual report required by section 13(a) or 15(d) of the Securities Exchange Act of 1934 to contain an internal control report, which shall--

 1. state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and

 2. contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.

 2. Internal Control Evaluation and Reporting. With respect to the internal control assessment required by subsection (a), each registered public accounting firm that prepares or issues the audit report for the issuer shall attest to, and report on, the assessment made by the management of the issuer. An attestation made under this subsection shall be made in accordance with standards for attestation engagements issued or adopted by the Board. Any such attestation shall not be the subject of a separate engagement.

In order for companies to abide by this rule, they must first audit themselves. Then those facts and figures are turned over to the auditors for rechecking. Aside from the costs, which have dropped dramatically since the section became a required part of compliance, the main complaint lodged by company executives is the unnecessary disclosure of costs that do not affect the bottom line.

In any situation where shareholder money is involved, and when it comes to the operation of the business every penny should be accounted for, all costs are business related and ultimately impact the bottom line.

The claim made by many companies forced to comply with the rule that hundreds of wasted man hours and millions of squandered dollars do not offer any real benefit may lie in the hands of the S.E.C. chairman, Christopher Cox. He has intimated that he may give the section 404 another look in the next month. He would be wrong to consider the opposition’s stance before he sees the long-term benefit that this law has added to investor confidence.

In the first year of the regulation, costs did soar for companies big and small. Some faced audit fee increases of sixty percent over previous years – years when the accounting process was less thorough. 

Those costs, estimated at four billion dollars in 2004 dropped 26% a year later and continue to fall. Many auditors have since built these rules into their review process further streamlining the process and as a result, lowering the cost of detecting shareholder fraud.

I have never encountered an investor who thought these protections were unnecessary. The increased thoroughness of the audit process, first conducted by the business and then by the independent auditor may be partially responsible for the steady increase in market participation. Dow 12,000 would not have been possible had Sarbanes-Oxley not been in place to prevent additional corporate scandals. 

To listen to the Secretary of the Treasury tell the story, SOX has decreased our global competitiveness. Lowering our audit standards, as Mr. Paulson would like, doesn’t make us less competitive. In fact, quite the opposite is true. Current standards lead to less risk and higher overall returns making our marketplace the “gold” standard for investor safety. 

Using the lagging IPO market as an example of this trend away from U.S. markets doesn’t tell the whole story. Instead, it only suggests that investors who buy into new equity offerings from companies who are reluctant to report and be audited as our laws require should purchase those shares with extreme caution. 

The rules, it should be noted, are waived temporarily for new listings as foreign companies align themselves with the most investor friendly rules in the world. Paulson often cites the drop off of listings here in the US as the result of SOX when in truth it is not the result of increased regulation but globalization that has altered this trend. 

The new Democratic chairman of the House Finance Services Committee, Barney Frank should take notice. Mr. Paulson contends, that the drop-off in foreign IPO listings from nine of the top 20 IPO’s brought to market in 2002 to just three of twenty so far this year might be the result of higher US market standards. Perhaps Mr. Frank should consider the list below before agreeing to any review of this important regulation:

Under Armour Inc.                      UARM   11/17/2005        77.4%
IntercontinentalExchange            ICE                   11/15/2005        112.7%
Riverbed Technology                  RVBD   9/20/2006          80.7%
Chipotle Mexican Grill                CMG                 1/25/2006          28.6%
Brookdale Senior Living              BKD                 11/21/2005        85.4%
Acorda Therapeutics                  ACOR   2/9/2006                        120.7%
Omrix Biopharmaceuticals          OMRI                4/20/2006          137.3%
Volcano Corporation                   VOLC               6/14/2006          105.7%
MasterCard Incorporated             MA                   5/24/2006          91.7%
Crocs Inc.                                             CROX   2/7/2006                        56.6%
Techwell                                                TWLL                6/20/2006          105.5%
Vocus Inc.                                             VOCS               12/6/2005          69.1%
New Oriental Education              EDU                 9/6/2006                        34.7%
SunPower Corp                          SPWR              11/16/2005        32.1%
Copa Holdings                           CPA                 12/14/2005        53.2%
Home Inns & Hotels Mt              HMIN                10/25/2006        13.6%
Pacific Airport Group                  PAC                 2/23/2006          36.9%
Liquidity Services                                   LQDT    2/22/2006          42.8%
DivX, Inc.                                               DIVX                 9/21/2006          48.9%
Suntech Power Holdings                         STP                  12/13/2005        23.1%
Houston Wire & Cable Co.          HWCC 6/14/2006          46.5%
Synchronoss Technologies         SNCR               6/14/2006          53.4%
CTC Media                                            CTCM   5/31/2006          36.5%
Acme Packet                            APKT                10/12/2006        -2.1%
Osiris Therapeutics                    OSIR                8/3/2006                        62.6%

Tailoring any changes, as some have suggested, for small business, while on the surface seems smart only undercuts the spirit of the bill. In most cases, the risk to investors increases as the market capitalization declines.

Stock exchanges in foreign countries currently do not require the accounting disclosures mandated by Sarbanes-Oxley. Mr. Cox should ride the current trend of openly disagreeing with the White House on this issue, ignore the closed door wrangling of the Working Group and stick to the law as it is written. 

SOX is too new to be redefined and should be left to investor confidence to decide whether the rules are worth keeping. 

© 2006 Paul Petillo
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