After four years of Sarbanes-Oxley, are we any better off?

America's most long-standing rivalry? You might guess Yankees vs. Red Sox. But the answer could just as easily be business vs. government, with brawls over taxes, regulation and subsidies erupting throughout the nation's history. The fracas dates from virtually day one of the republic, with the fight over creating a national bank (Hamilton's First Bank of the United States).

The Constitution itself incorporates two basic economic principles: free trade and the government's limited but direct role in the economy. Balancing the inherent tension between the two is like a game of tug-of-war. It has been written that the opponents must continually struggle for dominance, but at no time can either side be permitted to walk away with the rope.

Balancing the ledger

Back in 2001 and 2002, it seemed as if Corporate America hadn't just walked away with the rope—it had sprinted away with it like a baton-carrying Olympian. From Adelphia Comunications to WorldCom, revenues and assets were overstated and expenses and liabilities understated. On December 2, 2001, energy trader Enron—under investigation by the Securities and Exchange Commission—filed for Chapter 11 bankruptcy protection. It was the largest-ever filing—until scandal-plagued WorldCom one-upped it on July 21, 2002.

Nine days later, government grabbed the rope back and pulled hard. That's when President George
W. Bush signed the Sarbanes-Oxley Act, named after Sen. Paul Sarbanes (D-MD) and Rep. Michael Oxley (R-OH). Securities attorney Stewart Landefeld of Perkins Coie in Seattle calls Sarbanes-Oxley "the heaviest piece of financial regulation in my 26-year career" and quite possibly the most interventionist since the Depression-era securities reforms that followed the stock market crash of 1929. For his part, free-market-fan Bush called it "the most far-reaching reform of American business practices since the time of Franklin Delano Roosevelt."

Both houses of Congress passed the act by wide margins in an effort to clean up public companies and restore investor confidence. The idea was to increase transparency and accountability while simultaneously reducing conflicts of interest. Among its many provisions: the certification of financial reports by chief executive officers and chief financial officers, a ban on personal loans to officers, a prohibition on audit firms providing extra "value-added" services such as consulting, and a requirement that companies furnish independent annual audit reports on the existence and reliability of internal controls for financial reporting.

The votes are in.

So has Sarbanes-Oxley done its job? "It has worked," Landefeld says, "but at great expense. And as it turns out, the least expensive aspects have been the most effective and the most expensive aspects have been the least effective." For instance, a company's auditing firm must report to an independent audit committee. There are also regulations protecting "whistleblowers" and barring document destruction, plus longer jail sentences and larger fines for corporate executives who give misleading financial statements. "Boards of directors, senior executives and outside advisers now all have reason to pay greater attention to good governance," Landefeld adds.

None of those steps incur huge costs or are particularly controversial. The same can't be said of Section 404, a 200-word section in the act that requires companies to document and detail their methods for determining and assuring the accuracy of their financial statement. They also have to disclose any weakness in those internal controls. Many executives have complained that this provision has resulted in auditing and legal costs that far exceed whatever benefits it brings— not to mention the cost of lost productivity from the time spent on compliance. Echoing the gripes of many CEOs, Scott McNealy Sun Microsystems has likened Sarbanes-Oxley to "buckets of sand in the gears of the market economy."

Now there's no doubt that compliance is costly, far more expensive than many had originally anticipated. A 2005 survey by Financial Executives International of 217 public companies with an average $5 billion in revenue found that compliance costs for one year averaged $4.36 million, 40% higher than they expected to pay a year earlier. Compliance costs this year for U.S. businesses are expected to exceed $6 billion, according to consultancy AMR. To Alex Pollock, a resident fellow at the American Enterprise Institute, those higher-than-expected costs, "tell me that [legislators] really didn't know what they were unleashing. But that is what happens when you make decisions in a political panic, and people are saying that investors have lost confidence."

Benefits and consequences

Are the costs worth it? An analysis by bond-rating agency Moody's Investors Service opined that "reports on internal controls are a significant development in restoring investor confidence in financial reporting, which has been badly shaken in recent years…companies are strengthening their accounting controls and investing in the infrastructure needed to support quality financial reporting." Yet some question whether Sarbanes-Oxley is really the answer investors were looking for. In a 2005 paper, Ivy Xiying Zhang of the University of Rochester's graduate business school tracked how the stock market reacted to various legislative milestones as Sarbanes-Oxley wound
its way through Congress. Zhang concluded that the consideration and passage of the act contributed to an astonishing $1.4 trillion in stock market losses.

The paper is controversial in academic circles, but one perceived Sarbanes-Oxley affect isn't: Fewer initial public offerings. More than 300 companies went public every year, on average, during the 1990s. During the past three years, there have been just 478 IPOs as the cost of compliance
and increased legal exposure have persuaded businessman to stay private or sell to larger, more established companies.

What's more, says investment banker Ted di Stefano, Sarbanes-Oxley has meant that "there are many foreign companies who want to do IPOs, but will not do them in the United States—even though our capital markets are the most efficient in the world." Plus, he adds, some smaller companies have "gone silent," meaning that they have decided to de-list from U.S. exchanges rather than deal with the increased scrutiny. "SOX has enhanced corporate governance, but has hurt the small guy," he concludes. A survey of CEOs of fast-growing private companies by PricewaterhouseCoopers found that 67% of those CEOs considering eventually going public say the cost of compliance with Sarbanes-Oxley is a potential barrier to them doing so.

Even the SEC admits some changes need to be made. It has established an advisory committee on "smaller public companies" to assess the impact of Sarbanes-Oxley. The panel is supposed to make recommendations for changes before summer. But some would go further. In 2005, Republican congressman Jeff Flake of Arizona introduced a bill that would make Section 404 voluntary.

Would a voluntary system work? Pollock says that if investors really want the kind of heavy documentation that 404 demands, then the companies will do it or suffer in the marketplace. Then again, "if investors conclude that resources would be better spent elsewhere, like on research, developing new products or marketing, then companies will do that and the investors will respond."

About James Pethokoukis

James Pethokoukis is a senior writer for US News & World Report.