How to Win the Fight Over Sarbanes-Oxley

Relying on long-shot legal challenges won’t undo Sarbanes-Oxley's most burdensome provisions.

After five years of legal wrangling, the Supreme Court earlier this week upheld all substantive provisions of the Sarbanes-Oxley law. Even though the law, an overbearing, poorly drafted, government-knows-best monster, easily ranks among the worst portions of the entire United States code, it’s difficult to argue with the Court’s majority reasoning. In hoping that the law might somehow be defeated in the courts, the free-marketers that challenged it made a mistake.  Rather than trying for legal long-shots, it’s time to challenge the law’s burdensome core section.

Some background: in the wake of the Enron and Worldcom scandals, President Bush signed Sarbanes-Oxley into law in 2002. The single most important provision of the law, known as section 404, requires an independent audit of nearly every public company’s internal controls on financial reporting. Other provisions of the law stiffen already large penalties for outright fraud, require CEOs to personally sign off on financial statements, and make it much harder for companies to hide liabilities in “off balance sheet” entities like those that brought down Enron. To oversee the entire enterprise, Congress created the semi-independent Public Company Accounting Oversight Board (PCAOB—commonly pronounced “Peek-A-Boo.”)

The Court ruled that the board’s ultimate lack of accountability to the President violated the constitution’s appointments’ clause—which lets the President appoint executive branch officials--and that members of PCAOB could be removed at will rather than only for cause. The entire Sarbanes-Oxley law, PCAOB and all, however, remained in force. Contrary to some fears given voice in the mainstream media this decision seems unlikely to impact governance overall.  Certain agencies for whom a degree of independence is desirable (the Federal Reserve Board, for example) already have insulation from momentary political whims. Even if it may become theoretically easier to dismiss them, likewise, administrative law judges and Congress would rightly raise a stink if their true independence were challenged.  Other agencies, whose members are appointed by the President, should be accountable to elected officials. In making a narrow based ruling on the meaning of the Constitution and the statute itself, the Court took the correct, narrow and restrained view of its own powers and left Congress’ handiwork intact.  Good enough.

But Sarbanes-Oxley is still a bad law. Yes, it has a few decent provisions—CEOs should have to sign off on their accounting statements and pre-SarbOx regulations made it too easy for public companies to hide things off-balance-sheet—but section 404 is a real problem.  For medium-sized companies thinking of going public, the marginal costs of Section 404 compliance drive them away from investors. For larger companies with many operating subsidiaries--conglomerates like GE and Berkshire-Hathaway in particular—the compliance costs simply impose an unnecessary burden since these firms very existence already depends on top-notch internal controls. (A firm with many distantly related moving parts can only realize synergies between them if it has these controls.) On the other hand, while large companies with simple structures like Wal-Mart may whine a bit about the law’s costs, ultimately, it amounts to a rounding error on their balance sheets.  Most big businesses really aren’t hurt by the law but certain types of enterprises are.

And this is bad enough.  There’s no point in calling for repeal of the law (many of its provisions are okay) but it’s time for a frontal attack on section 404’s mandates.  So long as they inform investors of their decision, there’s no real possibility of macroeconomic harm in letting smaller newly public firms simply opt out of section 404 altogether even if they’re somehow dishonest. Larger firms certainly need internal controls of some sort but many are so complex that outside auditors appear to impose costs with no benefits to investors. Firms that find it useful should be able to design their own audits and disclose their results outside of the specific federal guidelines. If government supervised internal control audits really are “the gold standard”, then companies that forgo them will, of course, face severe punishment in the markets.  There’s simply no reason to keep section 404 as it now exists.

It’s time for venture capitalists and firms with complex structures—the real losers under SarbOx—to make their case in public and explain how little good the law does.  Sarbanes Oxley needs serious changes. Court challenges won’t cut it. It’s time for a frontal, practical attack on the law’s worst provision.