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  • 10 Years After Enron, Time to Throw Out Sarbanes–Oxley's Section 404

    Exactly 10 years ago today, the Enron Corporation filed for bankruptcy after it was revealed that it had blatantly falsified its earnings statements for many years. Although most of the accounting irregularities that caused its collapse were already illegal, Congress overreacted and passed Sarbanes–Oxley, a massive and deeply flawed accounting reform law. A decade later, it is time for cooler heads to prevail, and to consider repealing Section 404.

    This onerous provision is supposed to ensure that the financial reports of publicly traded corporations meet certain standards, but in reality its major role is to greatly increase compliance costs. It continued presence discourages growing companies from going public to raise capital by imposing on them very high compliance costs in the name of protecting their shareholders.

    The result is lower job growth by these companies and fewer workers hired by new businesses. Congress partially recognized this in 2010 by granting an exemption to publicly traded companies whose stock is worth a total of $75 million or less, but this threshold is far too low, and questions remain if Section 404 is needed at all.

    Section 404 duplicates part of Section 302 and requires the management of any publicly traded company to produce an internal control report describing the scope and adequacy of its financial reporting procedures and internal financial control structures. The company is required to include this information in its annual report, send it to investors, and file it with the SEC.

    In addition, the company must produce “an assessment…of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.” In the same report, an outside auditor must both attest to and report on the management’s assessment of the effectiveness of the company’s internal controls and procedures.

    In short, Section 404 requires both an internal audit and external audit of financial accounting controls, which has turned out to be costly and time-consuming in practice.

    As The Heritage Foundations’ David Addington stated in a recent paper:

    Congress should reconsider carefully the requirements in Section 404 for company management to assess the effectiveness of its internal control structure and procedures and then for the company’s registered public accounting firm to attest to that management assessment. Given the traditional role of each state in regulating the corporate governance of corporations incorporated in that state, Congress should first examine anew whether federal law should address those subjects, or whether they should be left to state law. In a society based on limited government and free enterprise, and in light of the traditional role of the states in our federal system, Congress should start its examination with a presumption in favor of repealing Section 404 and leaving the subjects addressed by Section 404 to the states.

    An immediate repeal would be the best option, but if that is not possible, Congress should seriously consider increasing the current $75 million market cap exemption to at least $1 billion. The current exemption is so tiny that all but the very smallest newly publicly traded firms could exceed it almost immediately. Medium-sized companies that fall outside of the current exemption are still discouraged from seeking the lower-cost capital available to publicly traded companies. A smaller exemption would not have the same effect on new registrations or job creation.

    Sarbanes–Oxley is an object lesson that congressional overreaction to a crisis or scandal can have serious negative consequences. Although Sarbanes–Oxley initially calmed investors’ fears and strengthened the internal controls of U.S. companies, it has also had a number of damaging unintended consequences. These are mainly, but not exclusively, due to Section 404 and how it has been implemented. Congress can partially address this problem by increasing the existing Section 404 exemption to firms with market capital of $1 billion or less.

    Posted in Featured [slideshow_deploy]

    8 Responses to 10 Years After Enron, Time to Throw Out Sarbanes–Oxley's Section 404

    1. Richard says:

      Yes, it does increase compliance costs; however it greatly reduces the costs attributed to errors and poorly planned acquisitions. Emphasis on change management not only forces best practices to be observed, but reduces greatly the possibility for expensive low value projects to be implemented. There is so much emphasis on the use of best practice companies actually operate better once it becomes part of an organization's culture. SOX has only served to make companies operate as they should have all along.

    2. Ahmad AbdulQadir CPA says:

      If by quoting Addington's paper, you are endorsing the concept of leaving internal control monitoring state securities laws, let me point out why that might be one of the most absurd things that could happen in the eyes of the investing public. In order for the "law of one price" to hold, an investor wants to believe that a security is going to have its price reflect the intrinsic value of its discounted future cash flows.

      If each state is responsible for defining how internal control over financial reporting (ICFR) is achieved, then Delaware would inevitably have the highest burden, and other states would need to develop systems that do not currently exist. Having 50 different state securities bodies working independently would provide a dramatically different governance structure to the publicly-traded companies incorporated in those states, which is not in the best interest of any investor, because the companies themselves trade on NATIONAL exchanges, not state exchanges. How could anybody propose that a firm that's regulated at the state level should be able to access NATIONAL or INTERNATIONAL capital markets, and not expect the differences in states' monitoring mechanisms to impact the price of the securities traded??? There's no evidence to support that state securities bodies could do a better job than the PCAOB, which has actually performed substantial reviews of audits performed internationally as well as domestically. States have absolutely no track record here, so even if the mechanism to monitor ICFR could be improved–and it certainly can–passing onto states is not the way to achieve that improvement.

    3. Ted Spickler says:

      How about the current failure of these systems to constrain wall street from outright lies? Apparently the lack of enforcement of these provisions is rendering them moot and we still have serious corruption within investment banking and other chillingly nefarious places linked to wall street.

      • Doug says:

        Ted, SOX was intended to uncover accounting fraud, the problems in the investment banking industry in the last few years were not predominantly accounting fraud and those that were were largely in closely held companies that aren't even subject to SOX. These failures in the system need to be addressed but cannot be attributed to problems with SOX. There may be some instances where banks overlooked, intentionally or otherwise, SOX non-compliance or where banks were not complying with SOX internal control requirements, these argue for greater enforcement not less. But SOX compliance has frequently led to better controls, less fraud, and implementation of continuous improvement processes that have actually produced net gains for many companies in a surprising reversal of the popular wisdom that regulation inhibits growth.

    4. Mike, Wichita Falls says:

      Why not repeal the whole law? Even if there is a move to just repeal section 404, however, some lawmakers may reply, "Well, how do we protect stockholders from bad actors?" to which I would reply, "Is anybody forced to buy stock in any company?" No…at least not yet although we may soon be required to buy government-approved health insurance.

      Are there not brokerage companies whose sole job is to research the "stories" of publicly traded companies for the benefit of their clients? There are scores upon scores of public companies in which to invest and scores upon scores of brokers who will vet them out? Why not let the market, or at worse the states, deal with the bad actors in any situation not enumerated in the Constitution?

      The more illegitimate functions Uncle Sam assumes, the worse he will perform those legitimate functions.

    5. Charlie says:

      Why bother to repeal it? As plainly seen, CEO's and CFO's regularly sign SOX knowing full well that their companies are NOT certifiable. Note CITI Corp… It's been a total sham from the get go. Wouldn't it be nice for DOJ to prosecute at least one obvious violation of the law before you can it???

    6. TimAZ says:

      We also have the GM situation where the regime forced the shareholders to sell short so the regime could take over GM. I don't believe that this govt. has much concern for share holders.

    7. jack fields says:

      include congress and cabinet officials into the law. if the sign a bill or issue numbers that are false they would be criminally and civilly liable……just as ceo,cfo and board members of a corp.

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