Resident Fellow Alex J. Pollock

Our topic is reform of the Sarbanes-Oxley Act to correct its unintended negative effects on investors. It should be no surprise that we have learned things in the almost five years since its enactment and that these lessons can now be applied.

Virtually everybody now agrees that Sarbanes-Oxley unintentionally resulted in unproductive cost, paperwork and bureaucracy, and that something should be done to correct this. Some people think that regulatory action from the SEC and PCAOB will be enough. Others (including me) think that reform legislation is required.

I will briefly address five key topics:

• Cost
• The accountants' perverse incentives
• Checks and balances
• Investor choice, and
• The "independence fetish"

Cost

Let's begin with a fundamental proposition in Business Economics: Excess costs are bad for investors, since all costs of the company are borne by the investors.

If the costs of Sarbanes-Oxley are greater than its benefits, then by definition Sarbanes-Oxley is bad for investors. If the costs of Sarbanes-Oxley are a lot greater than they need to be, regardless of benefits, that is by definition bad for investors. These statements are true no matter how sincere the attempt was or is "to protect investors."

We cannot understand why the costs of Sarbanes-Oxley got out of control without understanding the behavior of the public accountants. Even the SEC and the PCAOB have criticized the accountants for obsessive bureaucracy--without, of course, admitting responsibility for the role their own regulations played in causing it.

Perverse Incentives of the Accountants

Fear and Greed are usually said to be opposite forces in financial markets, cyclically taking turns as the prevailing mood. But the Sarbanes-Oxley era created a self-reinforcing combination of fear and greed for the accountants--further reinforced by giving them additional power.

The fear arose from the destruction of Arthur Andersen, the huge risks of litigation they have come to suffer, the risks to personal careers as well as firms, and intense public criticism in the wake of the Enron and other scandals. Such intense public criticism, by the way, is a normal historical cycle: about once a decade financial busts of various kinds recur, which generally get the accountants in trouble.

There is a great incentive to assuage this fear by demanding the maximum amount of procedures and documentation for their own self-protection. This happens to coincide with greed, because the more bureaucracy they create, the bigger the accounting firms' revenues and profits become. Moreover, they are able to impose these outcomes, because Sarbanes-Oxley shifted power from boards and managements to the accounting firms.

With these incentives, as will be obvious to an audience of economists, the explosion of costs is no surprise. Equally unsurprising, as a recent Roll Call article on Sarbanes-Oxley reform amusingly notes, is that "the big accounting firms are not calling for statutory change." No indeed, they are not calling for an end to their own bonanza.

Here are two ideas for legislative reform of this situation, both operating on the "fear" aspect:

• Remove any private right of action against accountants under Section 404 of Sarbanes-Oxley. This excellent proposal is contained in the Sarbanes-Oxley reform bill which Congressman Scott Garrett has introduced in the House.
• Let accounting firms be organized as normal limited liability corporations. The notion that the major accounting firms with their huge size and geographical extent can really function as "partnerships" with any form of partnership liability is, in my opinion, utterly outmoded.
  Checks and Balances

Insuring checks and balances is a fundamental principle of sound government. This principle should be applied in Sarbanes-Oxley reform by creating an Ombudsman in the PCAOB. This is also a provision of Congressman Garrett's reform bill.

The Ombudsman should report directly to the Chairman and be available to all accounting firms or companies to discuss any disputes, complaints, or suggestions concerning the activity of the PCAOB. These discussions must be on a completely confidential basis, to avoid the possibility of retribution from the regulatory staff.

Creating the Ombudsman function is also desirable for the SEC, where I believe the fear of retribution from the regulatory staff is an even more serious problem.

Further, the PCAOB should be brought into the system of normal government checks and balances. Although it is thinly disguised as a private organization by Sarbanes-Oxley, the PCAOB is in fact a regulatory agency of the government and should be treated in all ways as such, including appointments, appropriations and Congressional oversight.

A suit brought by the Free Enterprise Fund charges that the PCAOB is unconstitutional because is not so treated for appointments. It seems to me this suit is right on the merits, but in any case, Sarbanes-Oxley should be reformed to treat the PCAOB in the normal fashion as a regulatory agency, which it is.

Investor Choice

Two competing theories are:

• Sarbanes-Oxley Section 404 is bad for investors because the costs exceed the benefits, and
• Sarbanes-Oxley Section 404 is good for investors because it protects them.

Theory B is expanded by Arthur Levitt and others to argue that because the investors are thus protected, the companies complying with Section 404 will have a lower cost of capital. A "lower cost of capital" is equivalent to saying that investors will pay more for the securities of a company because of Section 404. This strikes me as unlikely, and the National Venture Capital Association has commented that its members see no evidence of it, but it is a logical possibility.

In either case, the arguments are about investors' preferences. So why not let investors choose?

This can be done simply by making Section 404 voluntary. I would say it should be voluntary for all companies, but at the very least, for smaller public companies, as provided in the Sarbanes-Oxley reform bills recently introduced in the House by Congressmen Meeks and Feeney, and in the Senate by Senator DeMint.

Under a voluntary regime, if Theory B is right and investors love how they are protected by Sarbanes-Oxley 404, they will bid up the prices of securities issued by companies who implement it, and everyone will end up following suit.

But if investors think the money would be better spent on research and development or marketing than on excessive accounting routines, the companies will respond accordingly.

The "Independence Fetish"

Finally, I come to the "independence fetish."

Independence is a central idea in Sarbanes-Oxley and in a multitude of fashionable discussions of corporate governance. Independence is an important idea, but it is not the be-all and end-all, has important limitations, and must be kept in balance with other factors.

In particular, it must be kept in balance with:

• Knowledge: One of my colleagues on a board of directors had described the ideal "independent director" as follows: somebody you keep locked in a dark room, who is not allowed to talk to anybody else or know anything about the affairs, issues or plans of the company, but is available to be wheeled out whenever you need an "independent committee." This is a way of pointing out that knowledge is equally or more important than independence in making judgments and decisions.
• Professional Consultation: One of the absurd results of Sarbanes-Oxley has been to make accountants unwilling to provide advice on the application of complex accounting standards for fear of compromising their "independence." Equally bad have been accounting engagement teams who could not provide advice because of second-guessing by their head office bureaucracies. Either way, the essential professional duty to provide advice on complex and uncertain matters requiring judgment has been sacrificed.
• Checks and Balances in Government: In my view, it was a major mistake of Sarbanes-Oxley to mandate what are functional taxes on all public companies to fund the PCAOB and also the FASB, in order to make them "independent" of whether people found their performance worthy of being funded. Nobody should be independent of check and balances: not PCAOB, not FASB, not anybody. Nothing could be more consistent with Madisonian constitutional principles than that.

In Summary

I think there is a lot that could and should be done to reform Sarbanes-Oxley, and appreciate your inviting me here to discuss these ideas.

Alex J. Pollock is a resident fellow at AEI.