Darning SOX

As promised, the Committee on Capital Markets Regulation (CCMR) released its interim report Thursday concerning how the US might improve its quickly deteriorating lead in capital markets. The report basically divides into two sections, with the first setting the scene as it were, and the second offering up a very general outline of what the remedies should be.

By now we are all very aware of what the problem is. Over the past two years in particular, the largest initial public offerings of stock have listed anywhere but the US, typically in London, Frankfurt, Paris, and East Asia. Even American companies are now seeking to list abroad. This stands as an almost complete reversal of the state of affairs prior to 2004, when New York was the undeniable financial capital of the world.

In explaining why this has happened, the CCMR points to two areas. First, only recently have their been foreign markets able to compete with New York; this applies especially to East Asia. Thus, the Committee reported,

Where there was once only one viable market, there are now several such markets. Companies and investors can now find markets outside the U.S. that are deep and highly liquid. Technology now provides the possibility of easily trading anywhere.

Because multiple markets have created choices that never used to exist, issuers seeking capital are now using a cost benefit analysis that focuses on the competitive differences between markets, including the potential cost of litigation and the complexity of regulation. U.S. public capital markets must now compete for business in a global marketplace. Access to capital is no longer a competitive advantage.

While the rise of competing markets by itself is significant, the Committee reports that the US has strengthened this development by (a) placing burdensome requirements on companies concerning compliance and reporting; (b) neglecting to reform the rights of minority shareholders; (c) neglecting to reform abuses of shareholder class-action litigations, and (d) allowing the regulatory environment to become overcrowded with various agencies and actors who often place onerous, duplicative demands upon companies. These things, in sum, create a competitive disadvantage that must be addressed, particularly in a marketplace offering numerous options to companies seeking money with which to grow.

The Committee then offered a series of key recommendations—sketches for recommendations, really—meant to reverse the recent decline of US capital markets.

Obviously, the Sarbanes-Oxley Act (SOX) is at the center of many of these recommendations, but notably, the interim report made clear that “The Committee believes that changes in implementation, not statutory change, are necessary.” Taken at face value, this is an encouraging sign that the Committee does not seek to turn Wall Street into the Wild West, that the investor protections of SOX will survive this review process. In particular, the Committee would like to see reform concerning the dreaded Section 404 requirements, which call for exceedingly costly internal-control reports. The accounting charges for complying with Section 404 are fixed and quite high; therefore; they fall most heavily on small companies. The Committee realizes this, and summed up its recommendations by suggesting

If a revised Section 404 is too burdensome for small companies ($75 million market cap and less), even after the general reforms outlined above are implemented, the SEC should recommend to Congress that small companies be exempt from auditor attestation and be subject to a more reasonable standard for management certification.

Otherwise, there is some vagueness surrounding the SOX component of the recommendations, not so much in the overall message, but in terms of the getting the weights and balances right. I guess that’s why they’re calling the report an interim one. Also, if taken far enough, some of the recommendations would open an enormous can of worms concerning the current US accounting standards, but all in all, the recommendations on the table are as good a place to start as any. The report allayed my fears that, in attempting to create more efficient and competitive markets, we might swing too far in the other direction and leave investors less protected than they were before. On the contrary, the initial recommendations seem very commonsensical.

Over time, I suspect much of Section 404 may just go away altogether, not just for small companies, but all companies. As I wrote last month, much of the impetus behind SOX was political, rooted in perception not reality; if regulators and legislators feel that public confidence in the markets has recovered since the accounting scandals of a few years ago, then I would expect a gradual climb-down from the stringent regulations now in place, for in reality, only a few true believers ever actually thought all this hubbub was over accounting. In this regard, the recent fracas over the back-dating of stock options at several companies cannot be welcome news, for it reveals that many of America’s executives are not only shady, but blind to their own shadiness. At the end of the day, you can’t regulate integrity into existence—either people have it or they don’t.