Criticism of Sarbanes-Oxley Legislation is "Utter Nonsense"

Robert Reich says Treasury Secretary Henry Paulson is "either naive or doesn’t want you to know the truth" when he utters the nonsense that Sarbanes-Oxley legislation "could be damaging America’s economic standing":

Oh Henry, by Robert B. Reich, America Prospect: Treasury Secretary Henry Paulson issued a solemn warning this week. He said public companies are going private at a record pace because of regulatory burdens like the Sarbanes-Oxley legislation, which could be damaging America’s economic standing.

This is utter nonsense. If Paulson thinks public companies are going private because of regulations like Sarbanes-Oxley, he’s either naive or doesn’t want you to know the truth.

Companies that go private return to the public market within a few years. That’s the whole point... When they go public again, their stock sells at a far higher price than what the equity firm that took them private originally paid for it. ...

Sarbanes-Oxley has absolutely nothing to do with it. That law, remember, was put into place to regain the confidence of investors ... who got clobbered when CEOs looted their companies by pumping up share prices with false accounting, and then cashing in their stock options before reality caught up. Enron was the tip of a huge iceberg.

That iceberg is still with us. In fact, public companies are restating financial results at a higher pace than ever before. ... The Securities and Exchange Commission reported ... that more than half these restatements are due to companies misapplying basic accounting rules or having the wrong data... Without Sarbanes-Oxley, investors would never know the truth.

Paulson says he’s worried that Sarbanes-Oxley is causing public companies to go private. He’s got it backwards. He ought to be worried about the real reason so many public companies are going private. It amounts to a new kind of CEO looting.

CEOs advise their directors and public shareholders that the private buyout is in the best interests of the company. Then after the public shareholders sell out to the private equity firm, the CEOs stay on. At this point the CEOs typically make fixes -- new products, additional job cuts, new deals with suppliers or distributors -- that increase company profits. The result is to drive share prices sharply up when the company goes public again.

Had the CEOs made these fixes before the private equity deal, the original shareholders would have benefited from the increase in the share price. By making the fixes after the deal is done, CEOs and their equity partners take all the booty for themselves.

It’s a scam. ... If [CEOs] give any advice at all, they shouldn’t be allowed to remain with the firm after it goes private. If Paulson wants small investors to stay confident the market isn’t rigged against them, he should not seek to weaken Sarbanes-Oxley. To the contrary, he should expand the law to prevent this new form of CEO looting.

Comments

[evagrius]

Do you mean that CEO's can be unethical?

I'm shocked, shocked to find that gambling is going on in here!
[a croupier hands Renault a pile of money]
Croupier: Your winnings, sir.
Captain Renault: [sotto voce] Oh, thank you very much.
[aloud]
Captain Renault: Everybody out at once!

[Richard]

Cynical it may be, but I've had the same thought that Reich had, but with a twist: suppose Enron, after being looted by senior management, managed a private equity sale, disposed of the evidence -- and five years later, was floated as a public offering. It doesn't sound all that implausbile to me, but perhaps I'm jaded.

[Lafayette]

“If [CEOs] give any advice at all, they shouldn’t be allowed to remain with the firm after it goes private. If Paulson wants small investors to stay confident the market isn’t rigged against them, he should not seek to weaken Sarbanes-Oxley. To the contrary, he should expand the law to prevent this new form of CEO looting. »

Another bit of moral laxness in the land of stakeholder milk and honey?

Anybody really, really surprised at this? Ho hum, business as usual. (pun intended).

[Greg]

I have no opinion whether or not the rise of private equity has something to do with Sarb-Ox (I rather think not). However, in my experience, Sarb-Ox HAS has a noticeable effect on venture capital investment--indeed, conventional wisdom among VCs at the moment is that there's almost no point in shooting for an IPO (except maybe on AIM), because even at, say $100m in revenues, the cost of compliance is sufficiently high that an IPO is hard to justify. Thus companies that in a previous era would have been groomed for an IPO are instead being groomed as takeover candidates. (This is a noticeable change, by the way; ten years ago, conventional wisdom was that any company that -wasn't- shooting for an IPO wasn't being ambitious enough, even if the likely liquidity event was actually a sale.)

If you believe, as I do, that the spread of VC culture from its roots in Rt. 128 and Silicon Valley to many other areas in the US is a source of hope and strength, and that venture-capitalized start-ups are a primary source of 'creative destruction' in the economy and a primary reason for the US's greater growth rate in productivity relative to other advanced economies, this is not good news.

Yes, the excesses of Enron et alia deserved a regulatory response; but Sarb-Ox was passed quickly, without adequate consideration. I do think this deserves a closer look.

[Lafayette]

In order to understand corporate fiduciary responsibility (i.e., honesty), it is imperative to understand that stockholders are “owners” of the company, regardless of however infinitesimally small their stake may be.

So, corporate management should come under the purview of property law, which means simply that stockholders employ a CEO to look after their property. It is more than guardianship that is allowed to the CEO. This person is responsible for caretaking property they do NOT own. They also have a responsibility to increase its value and avoid losing value, if possible. Big little word, "if".

It’s as if you were a landlord and you gave property management over to a professional … then you found out he was bilking you. You could then make a complaint for fraud or even theft, and it would, after investigation, lead to a criminal procedure.

But, somehow, when dressed with an aura of “CEO”, this is not the legal construct that prevails. What laws prevent top management to abuse themselves of the private property of others? Who has objective oversight responsibility on the BOD, for instance, when it is packed with people who report to the CEO … or once reported to the CEO, or even golf at the same Club, or go to the same Church?

The cleavage between the BOD and the CEO must be complete and distinct. And, it isn’t. It has become one of cronyism, whose intent is personal profit. Not all companies are run like this, but enough of them are such that when the stink finally comes out it fouls the air for all the rest.

And, it never stops. It seems that these corporate hoodlums seem tempted by the enormous fortunes to be had and simply make a risk calculation, like it were an R-O-I analysis. This latest round of criminals is just another group in a long line that goes back half a century.

And, like most crime, those that are caught are only the tip of the iceberg.

NB: "All animals are created equal, but some animals are more equal than others", Animal Farm, George Orwell

[Lafayette]

Greg: "If you believe, as I do, that the spread of VC culture from its roots in Rt. 128 and Silicon Valley to many other areas in the US is a source of hope and strength"

Sarb-Ox will have little effect in styming VC interest. There is no force on earth like an idea whose time has come. A good idea will always find the money necessary to fund it (but that is never promise of success).

Sarb-Ox, however, perhaps changes the ground rules and if it prevents some multibillionaires from making another billion, or so, does that really handicap the process? It perhaps makes the ultimate payback somewhat different, perhaps less. But, so what?

What are VCs going to do otherwise with thier money ... buy T-notes? Real estate? (Been there, done that.) Venture capitalism will still give the more attractive R-O-I yield.

NB: There is such a thing as "abject poverty". Is there not its opposite, "abject riches". I guess the answer is a value-judgement, isn't it? Which depends upon the altar at which you genuflect, the God of Mankind or the God of Mammon.

[Sean]

Lafayette,

I agree. That is why some have proposed requiring shareholder approval by the majority of the minority group of shareholders for mergers as well as shareholder tender offers. See In re Cox Communications, Inc. Shareholders Litigation, 2005 Del. Ch. LEXIS 79 (Del. Ch. June 6, 2005) for a small step in this direction.

But I do disagree with your take on sale vs. IPO from the VC's point of view. Though they are no fan of Sarbanes-Oxley, the number one reason that venture capitalists have almost always preferred a sale to an IPO is the difficulty of selling and restrictions on selling shares in the open market. This goes for private equity firms as well.

[lonesome moderate]

If you believe, as I do, that the spread of VC culture from its roots in Rt. 128 and Silicon Valley to many other areas in the US is a source of hope and strength, and that venture-capitalized start-ups are a primary source of 'creative destruction' in the economy and a primary reason for the US's greater growth rate in productivity relative to other advanced economies, this is not good news.

Considering all the idiotic and/or sleazebag companies that went public in the late nineties, I'm quite happy to see Sarbanes Oxley slow things down a bit.

[save_the_rustbelt]

Reich doesn't know what he is talking about.

Paulson is wildly exaggeraging though.

There is a pretty thorough consensus that Sox 404 is unweildy and very expensive.

Not as expensive though as the crime wave in the corporate suites.

A little integrity would fix most of this, but does not seem possible.

[tom s.]

I'm with Greg on this. There are two issues: (1) CEOs will find a way to make money off just about anything, including SarbOx and (2) SarbOx is basically a fixed cost, and so makes life difficult for small companies.

These two observations do not contradict each other. To be concerned about (2) does not imply denying (1).

[Lafayette]

"the number one reason that venture capitalists have almost always preferred a sale to an IPO is the difficulty of selling and restrictions on selling shares in the open market. This goes for private equity firms as well."

We can all understand the beneficial simplicity of their preference. However, the "preference" of VCs is not important.

What is important is clarity in the transaction.

Weren't you pissed off when you asked your broker for a chance at some pre-IPO stock purchase to benefit from the rocket-effect? And the stockbroker told you that they were reserved for "privileged clients".

Just who do you think those privileged clients were? The family of CEO's concerned and CEO's that the investment company organizing the IPO wanted to please in view of future business.

Come on, we're not fools just because we don’t walk with the angels.

[Lafayette]

"SarbOx is basically a fixed cost, and so makes life difficult for small companies"

In an recessive economy, the burden might push some over the cliff. Such is not happening.

There is an axiom by which the measure of "good legislation" is the decibel count of the moans and groans it engenders. SarbOx is doing just fine.

[anne]

Please do show me the least evidence of a pause in information technology or biotechnology financing. I sure do not notice a pause, happily.

[anne]

As for the possibilities and niceties of venture capital, can you say "YouTube?"

[No Name]

If you want to stop CEO's from feeding at the trough, then you need investors that are going to do their due diligence instead of just listen to management. Investors actually paying attention will fix a lot of the problems we are seeing.

[evagrius]

As for "YouTube"- while interesting it's not exactly a creative advance in anything- somewhat like the fact there's 500 TV channels offering the same football game or porno movie.
A culture that's in decline loves repetition, with variations.

[foo]

Mark,

Are there any examples or data to support the claims in the article? Which companies have gone private and then re-floated as public companies?
Has anybody written about this phenomenon in a rigorous way?

Without this info. it sounds like Reich is inventing boogeymen. And, judging by the comments, CEO as boogeyman is a notion that is not hard to believe (not surprisingly given recent history and scandals and the pervasive belief in corporate America that "greed is good" no matter the morality or ethical implications of the decision being made.)

But I'd like some data and some examples to support Reich's assertion. Otherwise he is just raving.

Cheers.

[calmo]

Rusty, I sorta know what you feel about Reich not knowing about what he's talking about: it would be alot more forceful and compelling if it was coming from the mouth of an investment banker.
But it isn't...and sadly, (so sadly), this isn't.
But I'm going to squeak up anyhow. Just warnin ya...

Those investment bankers are pretty much saying what Paulson is saying: Sarbanes-Oxley is a burden (Actually they say, smiling of course, "It's too much of a burden" and that explains the private equity surge and record LBOs...and why they are smiling.) [Remember people, we are all camels and just love burdens (this is one)...up to a point.]
And if CEOs benefit from this process, it is accidental (some might say 'justifiable', others, 'reasonable', yet others 'a blessing') and...fortuitous for the public who benefit from more efficiently run and more profitable companies.

So Sarbanes-Oxley is a catalyst not a burden. We should bring this to Paulson's attention and suggest he turbo-charge this legislation rather than scuttle it (or make adjustments as per Greg).

Who's burden is it? [~Who is fleeced?]
Stockholders who watched their company's shares plummet before the LBO.
Less obviously, the consumer who bought the product and watched it decline before the LBO only to see the product rebound later but at a higher price? 'Might be harder to show the hedonically superior product. (Basically, the product does not change like its price, yes?)
Even less obviously, (but in the end most importantly) the public whose income streams do not derive so directly from the credit creation that is invoked by these LBOs.

The conspicuous M&A and LBO transactions never seem to burden the CEOs.
The Sarbanes-Oxley legislation requiring all that burdensome paperwork ("More accountants! --financial terrorists!" is the message Paulson is bearing, yes? lol ] to limit the Enron-style fleecing appears to be in need of some repair...like SEC but I digress
No, I ramble unexpertly and need some other camels to take the load.
Last thing: Those minutes from the Fed that are supposed to help us immensely with the transparency. You figure we could just skip it and get live recordings from some little bug on the wall? So in those LBO, the same bug on the wall? Would that settle this issue? If I were an investment banker having a Litvinenko moment say, would this do it?

[dryfly]

If you believe, as I do, that the spread of VC culture from its roots in Rt. 128 and Silicon Valley to many other areas in the US is a source of hope and strength, and that venture-capitalized start-ups are a primary source of 'creative destruction' in the economy and a primary reason for the US's greater growth rate in productivity relative to other advanced economies, this is not good news.

Agreed.

Yes, the excesses of Enron et alia deserved a regulatory response; but Sarb-Ox was passed quickly, without adequate consideration. I do think this deserves a closer look.

Again, agreed. But Paulson is the LAST person I would want leading that 'closer look'. Something about foxes & hen houses you know.

As far as STRB's assertion that 'integrity would fix most of this'... that applies to ALL human behavior... which is why we need thorough enforcement & fair judgment of good laws. Sarb-Ox looks from my somewhat uninformed perspective to be lacking on all three points.

As for VCs & new floats - the recent issue of the Economist has some pretty interesting articles backing up the claims that start ups are more likely to IPO in London than say NYC.

Down on the street

No longer can America take for granted its global superiority as a market for capital. Regulatory reform might let it keep up with the pack

What's wrong with Wall Street

It is good that the world's leading market faces competition; bad that it has done so little to confront it

In my estimation Sarb-Ox is only part of the problem, not THE problem.

[save_the_rustbelt]

Keep in mind that in every sophomore accounting text there is a chapter on internal controls (my lecture on that chapter is absolutely dazzling by the way :-)) outlining such controls as a primary duty of management.

SarbOx requires nothing that CEOs shouldn't be doing anyway, except that since the fraud orgy we now need to certify the controls.

Granted, the first couple of years are expensive. My Congressman, the Oxley in SarbOx, says the fraud bubble cost investors $8 - 12 trillion, with a T. So weighing cost vs. benefits 404 it isn't such a burden.

It can be tweaked for small businesses and start-ups without killing the bill.

Paulson is such a whore for Wall Street and the Chinese I worry about what he might come up with next. It will not be good for Main Street, count on it.

[dryfly]

It can be tweaked for small businesses and start-ups without killing the bill.

Absolutely - in fact I'd bet there is a buisness model right there for some of those entrepreneurial sophmores you teach - do for Sarb-Ox what QuickBooks did for small business accounting.... call it 'Sar Box - Sarbanes Oxley in a BOX!'

Don't these guys have faith in capitalism?

[James Killus]

I've been ruminating about a similar bit of looting that has taken place over the past several decades.

Thirty or forty years ago, most hospitals were non-profit institutions and most insurance companies were "mutual" with the ownership embedded into the insurance policies themselves, which were not (and could not be) publicly traded. Then came the great wave of "privitization," and now we have all the "benefits" of full public stock corporations in the health care industry, a health care system that is close to utter collapse, while its share of the national budget increases with each passing year. Health industry executives, however, now enjoy the same ability to acquire extreme wealth as their peers in other industries.

Often, the increasing cost of health care is blamed on "new technologies" which is a little odd, because the experience with most technology is that it gets cheaper at a rapid rate (compare the price of a word processor in 1976 with a desktop publishing setup now). But health care costs just keep on rising. An honest Chicago School economist would take this as prima facie evidence of governmental interference in the market.

When the Soviet Union broke up, and vast state holdings were privatized, those who were politically connected skimmed the cream of the capital stock and became fabulously rich. It's worth considering that something similar has perhaps happened in U.S. health care, where large sections of the industry have become markers for the same sort of wealth skimming operations that occurred in the former USSR, all the way down to the importance of political connections (and government subsidies) in the acquisition of wealth.

There was a trope in the 1960s that the US and USSR were "converging" with the US getting more socialist and the USSR getting more capitalist. In the event, it looks like both took a hard right turn toward kleptocracy.

[Adrasteia]

James, I'm not sure when you last purchased an MRI machine, but I can assure you that they're much more expensive than xray. So is the database software which keeps all your records from that machine, and the datacentre they're backed up in.

And when exactly was the last time you priced out a neutron therapy cyclotron? That's what I thought.

[cm]

James, Adrasteia: The (consumer/downstream) price of technology only declines to the extent that the respective products are discretionary, and to the extent producers can benefit from economies of scale. That's generally not the case in medicine.

Even when you look at consumer electronics, prices fall only when everybody who wants the respective product at a particular price point already has one.

[lonesome moderate]

Are there any examples or data to support the claims in the article? Which companies have gone private and then re-floated as public companies?

foo, Business Week had an article about this last year:

http://www.businessweek.com/magazine/content/05_11/b3924102_mz020.htm

More recent examples include Burger King, Hertz, and Morton's Restaurants.

[adam]

foreign stock exchanges and england's government have expressed fear that a buyout of thier exchanges by the new york stock exchange could force their listed companies to comply with the more stringent sarb-ox. law.

paulson is not the only one saying it is too extreme but it seems like i've also heard that chile and japan were going to pass very similar laws to the u.s. sarbox.

personally, i doubt the first law got everything right and nothing wrong. libertarian "reason" magazine had an interesting roundtable on the law. one accountant said she feels like she has to account for every square of toilet paper now. the link to "you can be too careful" is below.

http://www.reason.com/news/show/33058.html

[EZRider]

Sarbanes Oxley did what the SEC was unable to do. It's the cost of doing business.

[adam]

it is the cost of doing business. that is what the debate is about. should it continue to be such a large cost of doing business and will it simply drive new companies to other stock exchanges?

[Lafayette]

"it is the cost of doing business. that is what the debate is about. "

Too easy, that. EVERYTHING within the corporation has a "cost".

Compensation is a cost. The corporate jet is a cost. Stock-options have a future cost (diluting the value of existing stocks). And, filling out numerous government documents to adhere to the law has a cost.

So what? The cost is proportionately the same for everyone, big or small. And, that cost is recuperated on the price of the product/service, so ultimately it is the consumer that pays the cost.

And, it is consumers that the law was originally envisaged to protect.

Fixating oneself on the "bottom line" is like taking drugs. (It's the cost, stupid!) Nothing else is then seen to matter - which is tantamount to arrogant blindness.

[adam]

lafayette-

my response was to the post above mine. a comment heard too often on sarbox is that it is "just the cost of doing business".

if that cost penalizes too many entrepenuers or means that companies list on foreign exchanges because the compliance is too high then we need to make sure we consider these costs when evaluating the law.

the largest ipo's of this year have not been on the u.s. exchanges. is this due to sarbox? maybe not but passing the law and then just saying too bad that is the law and we're not reconsidering regardless is equally blind and arrogant.

compliance with sarbox is regressive in that it hurts small companies more than large ones. as i understand it, the baseline auditing costs it imposes are a much larger percentage cost to the small company.

[Ethan Jacobs]

SarbOx is simply a way to transfer money away from shareholders and to accountants. IMO accountants already take too much money from shareholders. I suggest we do away with the requirements for audited financials and simply trust the officers to tell the truth. That ought to save a pile of dough year after year. And it would give investors the thrill of running a risk without any (or only very little) concomitant gain.

[adam]

no ethan. instead let's "beef" up sarbox and require a 1 to 1 accountant to employee ratio. if we require them to be onsite it couldn't be outsourced and would solve our unemployment issues if we trained enough accoutants with a really good federal program.

maybe we could fund it with a per share fee. think of the value to the investor. no doubt they'd sleep well at night.