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“The SEC’s Sarbanes-Oxley Fix Needs Fixing”
Summary of Remarks by
Alex Pollock
Resident Fellow, American Enterprise Institute
January 11, 2007
Alex Pollock, Resident Fellow of the American Enterprise Institute for Public Policy Research, addressed the National Economist Club on Sarbanes-Oxley reform. He argued that the Sarbanes-Oxley Act is bad for investors and for the international competitiveness of American business and American capital markets, and articulated how it has weakened America’s international competitive advantage particularly in social infrastructure. He proposed fundamental changes to the Sarbanes-Oxley Act and identified possible obstacles to its reform. In closing, he underscored the need for reforms, realizing that although reform has started, it has a long way to go.
Since the cost that implementation of the Sarbanes-Oxley Act has imposed greatly exceeds the benefits, by definition it is bad for investors. This is despite its intention to “protect investors.” It is also bad for the international competitiveness of American business and capital markets. Prominent economist Charles Kindleberger observed that “The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom.” This fact of human nature is unlikely to be changed even by an infinite number of accounting procedures, or vast library of three-ring binders filled with risk control memoranda. Fraud will remain illegal, but will cyclically emerge.
The historical context is that Sarbanes-Oxley and its implementation followed the time-honored tradition of imposing costs on everybody—including the innocent 99 percent—to try to avoid repetition of the scandals caused by a guilty few. The lessons of financial history are clear: these overreactions never prevent the next scandals when the fever of the next financial boom or bubble sets in, and Sarbanes-Oxley will not either. But the costs imposed are ongoing and real—not only the cash costs, but also the opportunity costs.
We need to realize that America no longer has an international competitive advantage in labor, natural resources, capital or knowledge. However, America has a continuing advantage in social infrastructure: the rule of law, property rights, political stability, financial markets and keeping a lid on stifling bureaucracy, which has long attracted and still attracts investment as the safe haven. This advantage is being weakened by the bureaucracy, cost, and accountants-rampant generated by Sarbanes-Oxley Act.
In terms of reforming the Sarbanes-Oxley Act, the first fundamental step is to make Section 404 voluntary, at least for small public companies. This would provide small public companies an ability to opt out of Section 404 with corresponding disclosure to their equity investors and anyone who reads their financial statements, including creditors, of their approach to internal controls.
The second step relates to the funding of two organizations, namely the Public Company Accounting Oversight Board (PCAOB), created by Sarbanes-Oxley Act, and the Financial Accounting Standards Board (FASB). Although both organizations are theoretically private bodies, their funding has become effectively a tax because it is now a mandatory assessment of public companies. The constitutionality of the PCAOB is currently being challenged. It is in fact a regulatory body but does not have the checks and balances that a regulatory body should have. PCAOB should be subject to an appointment process that runs through the President with advice and consent of the Senate, and subject to appropriations. It should be treated under a revised statute as a regulatory body for accounting firms and should have all the normal appointments, oversight, and appropriations that go along with being a government body. The FASB should have voluntary funding from corporations and accounting firms, which at least provides some checks and balances.
Third, Congress ought to establish an Ombudsman function in both the PCAOB and the FASB reporting directly to the Chairman on a confidential basis, to provide a voice from the public as check and balance inside these agencies. Currently it is very difficult for companies subject to Sarbanes-Oxley Section 404 bureaucracy to complain through the normal enforcement channels of the regulatory bodies, because of the quite justifiable fear of regulatory retribution.
The fourth proposal addresses the biggest problem of the implementation of Sarbanes-Oxley’s Section 404, which is the nit-picking and trivial paperwork owing to the focus on “remote likelihood.” Congress should specify that in terms of controls and attestations, audits, or certifications of controls, the focus should be on “material risk of loss, mistake or fraud,” not on “remote likelihood.”
Fifth, Congress ought to unambiguously state in its Sarbanes-Oxley reform bill that rendering advice on the application of accounting standards by auditors is not only permitted, but expected and required as part of their professional responsibility.
Accounting firms and journalists are obstacles to the proposed reforms. Accounting firms have a very strong and large financial incentive to defend the status quo it has developed and do not want their wonderful profit bonanza taken away. Perhaps Sarbanes-Oxley’s Section 404 should be made a statutory requirement for accounting firms themselves. Journalists suffer from thinking that more bureaucracy is better, and they suffer from the belief that accounting is something objective. This is an extremely naïve misunderstanding of the nature of accounting.
In sum, the Sarbanes-Oxley Act in its implementation has had a negative net effect on investors because the cost exceeds benefits. It was a normal historical overreaction to the scandals which normally accompany booms and bubbles. It involves built-in perverse incentives for accounting firms because of the accountants’ financial bonanza it created. It needs reform. Reform has started but has a long way to go.
Rapporteur: Percival Pineda
