Transparently Expensive

The Sarbanes-Oxley Act , more efficiently referred to as "SOX", was written to make publicly traded companies more transparent to investors.

Turns out SOX created a case-study for the trades-offs between transparency, regulation, and the cost of information.  Looking at how market dynamics have changed since SOX was implemented, it should come as no surprise that the U.S. Securities and Exchange Commission wants to reduce the cost of SOX quickly.

In their attempt to make public companies more transparent, legislators and regulators overlooked the costs of SOX.  SOX implementation alone costs a small company over $1M easily, with accounting fees and technology costs usually running well over $5M for a mid-sized firm.  After implementation, it costs companies even more to stay SOX compliant, usually $2M and up for a public company.  With little guidance from the S.E.C. on exactly what constitutes compliance, with accountants having little incentive not to charge as much as possible because their reputation is on the line, and with CEOs accepting personal liability for non-compliance, SOX created a perfect storm to drive up accounting and compliance costs.

Let's do some math.  Let's say we run a company called Acme Socks.  Acme Socks has just passed $100M in revenue.  Naturally, we would like to take our stock public so the company can take advantage of public equity markets for financing further growth.  What will it cost us?  Our accountant says about $5M up front, and then $3.5M per year in operational and accounting costs -- about 10% less than the average public company pays.  Acme Socks has good EBITDA earnings for a fast-growing company at about 5%, or $5M.  Wait!  So, instead of 5% earnings, our company would have about 1.5% earnings if we go public and pay for SOX compliance.  That's too risky for our taste.

One side-effect of SOX, which was supposed to make companies more transparent, is to keep companies from bothering.  The main reason a small company attempts SOX compliance these days is to make it easy for a large company, that already is SOX compliant, to buy the small company.  As a result, Venture Capital funds and Hedge funds, which don't need to provide SOX compliant results to their qualified investors, have become primary investors in small companies.  SOX was supposed to give Joe Normal investor better decision making guidance for his investments, but what it did was take away the opportunity to invest in small-cap equities.  It has also made financing of early stage companies more difficult since, more often than not, investors must look for a larger company to acquire a start-up rather than depending on an IPO for a liquidity event.

Another side-effect of SOX, and the effect that seems to be prodding regulators to re-think SOX, is that the U.S. IPO market as a percentage of the worldwide IPO market has dropped precipitously, so U.S. individual investors have less access to the IPO market.

Back in 2000, our markets handled half the world's initial public offerings. Last year, we handled just 5 percent. Foreign companies are shying away from listing their shares here. And American companies are going undergound. One out of every four takeovers in the past three years have been transactions that take public companies private. -- Glenn Hubbard, NPR Marketplace

Hubbard brings up a third side-effect of SOX, the de-listing of public companies.  Hedge funds and large private equities firms like KKR and The Carlyle Group invest in public companies for the purpose of taking them private and avoiding SOX scrutiny.  While investors in the public entity usually enjoy a gain on their share price in such a transaction, the private equity investors and company management often receive even more gain as they break up and sell off company assets.  Once again, SOX has fostered market conditions that benefit wealthy investors and large investment funds over Joe Normal investor.

SOX demonstrates the power of markets.  What is clear is that SOX, which was supposed to level the playing field for all investors, large and small, ended up tilting the field significantly to the advantage of wealthy investors by depriving small investors access to some of the best investment categories.  Since the impact of regulation is easily measured in financial markets -- in what other market can you see the U.S. give up 45% of IPO market share to foreign markets in five years? -- SOX gives legislators and regulators a clear lesson in the impact of high-cost regulation.

Regulation for the regulators?  Good regulation calculates the true cost-benefit ratio, not its political impact.  An emerging idea for regulators would be a standard for determining the costs and benefits of new regulation.  If such a standard existed, it also would give regulators a way to measure their regulatory performance.  A regulation that failed to meet its cost-benefit objectives would be adjusted or dropped.  Such a process might have kept the Sarbanes-Oxley catastrophe from taking place.