Has Sarbanes-Oxley Harmed Entrepreneurs?

As Professor Geddes's paper says, Sarbanes-Oxley was intended to protect investors. The theory was that having "lost confidence," they were crying out for political action. We know Sarbanes-Oxley was very popular at the time among politicians. The Senate vote was 97 to nothing, and in the House there were only three votes against. So it's clear what the politicians thought.

It's a very good idea to measure, as this paper does, what investors in the aggregate were thinking, and in particular, what they were thinking about small firms. As the paper points out, these firms often compete on flexibility, as opposed to large scale operations. So as the investors in stocks in general, and in small stocks in particular, were watching the politicians pass Sarbanes-Oxley, were they saying to themselves, "Oh boy, I'm going to be better protected," so bid up the price of the stocks, and of small stocks in particular? Or were they saying, "Oh no, it looks like this will unleash a host of cost and bureaucracy, which will reduce the value of my investment?"

The paper is pretty clear that it was the latter. The market didn't like political events that made Sarbanes-Oxley more likely, and small firms were even more negatively affected in this investor behavior than large firms. So, the second view, "Oh no, looks like I'm going to get a lot of cost and bureaucracy," is consistent with the observed stock price behavior.

We now know, after the fact, with five years experience, that Sarbanes-Oxley did indeed unleash a host of expense, paperwork and bureaucracy, and this disproportionately affects small firms. So it looks like the pessimistic ex-ante investor reactions the paper measures have turned out to be correct. It makes me think of a line from the Declaration of Independence which says, in the bill of particulars against King George III, "He has sent hither swarms of officers to harass the people and eat out their substance." You might say analogously about Sarbanes-Oxley that it has sent hither swarms of accountants to harass the people and eat out their substance.

After the fact, as I say, virtually everybody now agrees that Sarbanes-Oxley unintentionally created a lot of unproductive cost, paperwork and bureaucracy, and that something should be done about it. The SEC and the PCAOB are changing their regulations to try to reduce the excess costs. That's good. Some people think that regulatory change should be and would be enough. I think we should have reform legislation in addition to it. But that's another issue.

Consider a fundamental proposition in business economics: if the costs of Sarbanes-Oxley are greater than its benefits, then, by definition, it is bad for investors. Even if the costs are less than the benefits, but the costs are simply a lot greater than they need to be, that's bad for investors also. These statements are true no matter how sincere the attempt may have been to protect investors.

As the paper points out, there is also debate about the opportunity costs involved. These are very hard to measure, if not impossible, but they reflect distracting managements and boards as they shift their efforts from production and innovation to dealing with accountants, corporate governance consultants, checklists, the regulators, the SEC, and arguably from entrepreneurial risk-taking to risk-avoidance.

I don't know whether that's true or not: I tend to believe it is. A wonderful example of the mindset that goes along with Sarbanes-Oxley is contained in a statement by the Fannie Mae and Freddie Mac regulator, OFHEO, which recently has produced this biting criticism of Fannie Mae (and, by the way, I'm not a fan of Fannie Mae, in general). This biting OFHEO criticism is that Fannie "focused more on business innovation than on backend accounting."

Now there's a really terrible problem. Imagine a company that would focus more on business innovation than on backend accounting! This statement by OFHEO is deadpan. In writing it they were obviously not aware of how silly it sounds. It is an example of the sort of opportunity cost which is likely to be real.

Speaking of regulators, I want to take up the paper's idea of opaque industries, specifically banks and insurance companies. It's really hard to have any kind of an idea about what's really going on in a financial company by looking at its financial statements. Financial statements may tell you virtually nothing about its soundness. So, one social reaction to that is to put on a lot of regulation, so you have regulators and examiners running around inside these companies. For financial institutions, Sarbanes-Oxley is just more regulation on top of existing, already heavy regulation. A very common argument among smaller banks is, "Look, we've already got all this stuff, and now you just layered it on again."

On the question of whether accounting statements are opaque or transparent, one of the problems I have with the Sarbanes-Oxley era is that there is no simple way in which any financial statements can ever be "transparent." It is simply impossible in principle. In other words, "transparency" is an ill-conceived and unfortunate metaphor when applied to the whole set of problems that Sarbanes-Oxley attempted to address.

This is why: transparency suggests that you can actually see the object as it is, as if you were looking through a transparent window and seeing whatever is on the other side of the window, whereas financial statements are nothing like a window. Financial statements are a set of highly debatable, highly theoretical constructs, which take the data and form it in complicated ways, add in all kinds of guesses, estimates, and modeling parameters, which are themselves guesses and estimates, and produce a statement. So they can't ever be transparent. They're constructions. They are creations of the theories which result in the statements. I point this out as a reality check on what politicians may think they're doing in legislating for "transparent" or "accurate" accounting statements.

The Institute of Chartered Accounts in England and Wales has an excellent statement on this. They say, "Financial reporting attempts to measure inherently abstract and debatable concepts such as income and net assets and has particular features that make it, to some extent, inevitably subjective and arbitrary. It tries to portray a reality that's constantly changing, partially in response to changes in the measurement itself. Financial reporting measurement is therefore a matter of evolving conventions, not something to which there are immutably right and wrong answers." So, when we layer on a lot of costs and bureaucracy to try to create "transparency," there is always going to be some frustration.

I said before that virtually everybody agrees about the fact that the costs of Sarbanes-Oxley are large and excessive, but how about the benefits? The benefits, obviously, are debatable. We've seen in this paper an ex-ante judgment by investors that the costs were going to be greater than the benefits, but what would we say ex-post? This is very hard to measure, and debate continues.

Members of the Sarbanes-Oxley faith offer an exoneration of the Act: they say it increases "investor confidence." I leave aside the fact I think it's a bad idea to make investors confident, since I believe confident investors are stupid investors. However that may be, Sarbanes-Oxley makes investors confident, they say, and therefore "lowers the cost of capital." "Lowers the cost of capital" means it makes investors willing to pay more for securities.

Does Sarbanes-Oxley make investors willing to pay more for securities? In my mind, this sets up a natural experiment that we could do by amending Sarbanes-Oxley, particularly with respect to small companies. That is, simply make Section 404 of Sarbanes-Oxley voluntary, as opposed to mandatory.


This would be a good step anyway, if you believe in market economies and market discipline. It would not be simply "exempting" small companies, because that suggests you just get a pass. I suggest rather that small companies (better all companies, but at least small companies) should be able to make a decision about how they want to manage internal controls in compliance or not with Sarbanes-Oxley, and then explain to their investors what decision they've made and why.

I believe the argument that Arthur Levitt and others make, that if you do the Sarbanes-Oxley bureaucracy and certification of controls, and so on, it will lower your cost of capital--that is, make investors pay more for your shares--is actually a marvelous argument for having a voluntary system. If the companies find that they can make their shares go up by doing Sarbanes-Oxley, they certainly will. So I suggest we ought to run this experiment: make 404 voluntary (preferably for everybody, but at least for small companies) and then observe what happens.

If you choose to implement Sarbanes-Oxley, what happens will be one of two things. One possibility is that because you will have created a lot of cost and bureaucracy and opportunity cost, the share price will suffer, the abnormal returns will fall. The second possibility is that because investors view this as a good thing, the returns will rise, and the share price will go up. If we would do this experiment I'm suggesting, then in a couple of years, Professor Geddes could do a wonderful, similar study of price movements in small company stocks (or in all company stocks) to measure the market's reaction to this choice, the market returns depending on how you make this choice, and we would learn something highly interesting and useful.

For the present, the paper concludes that "Reform of Sarbanes-Oxley is worthy of consideration," and I certainly agree.

Alex J. Pollock is a resident fellow at AEI.

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