Fostering An International Regulatory Consensus

[FaGal]

More than 1,200 foreign companies file reports with the U.S. Securities and Exchange Commission and are thus affected by changes to U.S. law, including the Sarbanes-Oxley Act of 2002. To ease the path to compliance for those and other firms, U.S. regulators have been working with their foreign counterparts and the business community to remove barriers and reconcile differences in national standards and practices.

The Sarbanes-Oxley Act is the most comprehensive and important U.S. securities legislation affecting public companies and independent accountants since the Securities and Exchange Commission (SEC) was created in 1934. The broad reforms in the act address disclosure and financial reporting by public companies, corporate governance, and auditor oversight. But what is especially striking is the interest, concern, and debate that the act has generated outside the United States. When the SEC was created, no one could have imagined that revisions to the U.S. securities laws could have such an impact abroad. Today, the more than 1,200 foreign companies that file reports with the SEC represent nearly 10 percent of all SEC reporting companies. Some of these companies' shares are among the most actively traded on U.S. markets.

More than ever, capital markets around the world are interdependent, and changes to national laws can have repercussions outside of borders.

THE SARBANES-OXLEY REFORMS

The principal reforms contained in Sarbanes-Oxley generally can be grouped into three categories. First, the act includes important reforms aimed at improving the performance of and restoring confidence in the accounting profession. It ends self-regulation of the accounting profession where the audit of public companies' financial statements is concerned. In its place, it creates the Public Company Accounting Oversight Board, an independent private sector body that, in turn, is subject to SEC oversight.

Rep. Michael Oxley, left, and Sen. Paul Sarbanes
Rep. Michael Oxley, left, and Sen. Paul Sarbanes, co-sponsors of the United States' corporate governance overhaul, speak to reporters outside the White House.
(© AP/WWP/Ron Edmonds)

Second, the act provides new tools to enforce the securities laws. The Securities and Exchange Commission has been using those tools to broaden the scope of its enforcement program. Over the past two fiscal years, the commission has filed more than 1,300 enforcement actions, more than 370 of which involved financial reporting and accounting frauds. We have obtained orders for penalties and repayment of ill-gotten gains totaling nearly $5 billion, and have sought to bar more than 330 executives from serving again as officers or directors of public companies.

Third, the act mandates new requirements designed to improve public companies' disclosure and financial reporting practices. The provisions concerning chief executive officer (CEO) and chief financial officer (CFO) certifications of reports containing financial statements, including the adequacy of disclosure controls and procedures, are intended to leave no doubt as to senior management's responsibilities for financial reporting. Also in this category are the provisions that are currently receiving the most attention from companies and auditors—the requirements for an annual management report on and audit of companies' internal control over financial reporting.

NATIONAL BOUNDARIES AND CONCERNS OVER SOVEREIGNTY

While Sarbanes-Oxley represents a U.S. legislative response to the financial failures of U.S. companies such as Enron and WorldCom, the financial problems that have come to light in non-U.S. companies, such as Ahold, Parmalat, Royal Dutch Shell, and Vivendi, confirm that the issues that the act was intended to address transcend national boundaries.

Today, lawmakers and regulators around the world are actively working to improve corporate governance, auditor oversight, and other aspects of the financial reporting process. There is a fast-developing international consensus on many critical goals, as illustrated in statements by the International Organization of Securities Commissions on the reporting of price sensitive information, management's discussion and analysis of financial statements, auditor independence, and auditor oversight. Many jurisdictions, including some European Union (EU) member states, are undertaking efforts to reform their auditor oversight systems, and the EU has announced Priorities for Improving the Quality of Statutory Audits in its member states. Additionally, the 2004 amendments to the Organization for Economic Cooperation and Development's Principles of Corporate Governance place increased emphasis on the role of independent directors and audit committees in the financial reporting process.

Although the SEC shares the above regulatory goals with our foreign counterparts, we have recognized from the outset that certain aspects of the Sarbanes-Oxley Act raise potential conflict of laws and sovereignty concerns for some non-U.S. regulators and market participants. The U.S. Congress was clear that the act generally should make no distinction between domestic and foreign companies. Certainly, U.S. investors transacting on U.S. markets are entitled to the same protections regardless of whether the issuer of a security is foreign or domestic.

At the same time, the SEC recognizes that its rules applicable to non-U.S. market participants must be implemented in a reasonable and measured way that fosters cooperation and consensus building. One of the greatest challenges that the commission has faced in implementing Sarbanes-Oxley is to fulfill our congressional mandate while respecting potential conflicts with foreign laws and regulations. Our willingness to address foreign concerns is a testament to the importance that we place on open dialogue and to the strong relationships we have with our non-U.S. counterparts.

Chairman William Donaldson testifies
Securities and Exchange Commission Chairman William Donaldson testifies before the Senate Banking Committee on Capitol Hill.
(© AP/WWP/Dennis Cook)

ACCOMMODATING NON-U.S. FIRMS

Among the most important of the Sarbanes-Oxley reforms are those that address the role of the audit committee of the board of directors in overseeing accounting, auditing, and financial reporting. The SEC's approach toward implementation of the audit committee requirement for listed companies is an example of our efforts to address potential conflicts and to accommodate different, non-U.S. regulatory requirements.

The act required the commission to adopt a rule directing the national securities exchanges and the National Association of Securities Dealers to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements mandated by the act. All members of the audit committees of listed companies must be independent directors, and audit committees must be directly responsible for the appointment, compensation, and oversight of the issuer's independent accountants.

Based on a consideration of potentially conflicting non-U.S. legal requirements raised by foreign commenters, the SEC's rule includes certain accommodations for foreign private issuers that take into account foreign corporate governance schemes, while preserving the intention of the act to ensure that those responsible for overseeing a company's outside auditors are independent of management. These accommodations:

* allow nonmanagement employees to serve as audit committee members, consistent with some countries' requirements for employee representation on the board of directors;

* allow shareholders to select or ratify the selection of auditors, also consistent with requirements in many countries;

* allow alternative structures, such as statutory auditors or boards of auditors, to perform auditor oversight functions where they are authorized by home country requirements, they are not elected by management of the issuer, and no executive officer of the issuer is a member;

* allow for foreign government representation and controlling shareholder nonvoting representation on audit committees, provided the representatives are not members of management.

Some observers do not believe that the Securities and Exchange Commission has gone far enough in accommodating non-U.S. market participants, and they have called for exemptions based on principles of mutual recognition. Of course, we respect those views, but we believe that the SEC, as well as any other national regulator, has the sovereign right to determine the terms and conditions under which companies and their representatives may access investors in its jurisdiction. The real challenge is to do so in a reasonable manner and on an equitable basis that fosters international acceptance.

CHALLENGES FACING FOREIGN FIRMS

Though the Sarbanes-Oxley Act does not provide an exemption for foreign private issuers, the SEC will continue to be sensitive to the need to accommodate unique foreign structures and requirements. Many non-U.S. companies and their auditors are currently working hard and are well on their way to completing the processes necessary to report on internal controls. We recognize that the internal control disclosure provisions of the act are the most difficult and expensive to implement. However, of all the reforms contained in the act, getting these processes right may have the greatest long-term impact on improving the accuracy and reliability of financial reporting. But for non-U.S. companies, in some cases, these reforms require significant rethinking of the control environment. This is one of the reasons that the commission extended the compliance date for non-U.S. companies to fiscal years ending on or after July 15, 2005.

Subsequently, the commission has taken steps to provide additional time for certain U.S. companies with less than $700 million of unaffiliated market capitalization to comply, and we intend to be sensible in addressing the requirements for non-U.S. issuers as well. Perhaps most important, many companies abroad, especially in Europe, face additional challenges in the near term that go above and beyond those faced by U.S. companies as they adopt international financial reporting standards for the first time in 2005. To address these burdens, the commission has proposed amendments to our reporting requirements that would facilitate foreign private issuers' conversion to International Financial Reporting Standards (IFRS). We will continue to monitor progress in these areas. We are prepared to reach out and engage in an open dialogue to address concerns regarding both internal controls and IFRS implementation.

EXPANDING THE SHAREHOLDER SOCIETY

Our regulation of U.S. markets and our foreign counterparts' regulation of their markets is part and parcel of a broader issue: the movement of millions of people throughout the world into what has been called "the shareholder society." Today, more than 13 million households in India are directly invested in debt or equity shares. There are believed to be approximately 60 million active equity investors in China. Share ownership creates new opportunities to accumulate savings and wealth and to put capital to use in entrepreneurial ventures that are the lifeblood of growing economies.

The fundamental issue for everyone involved in financial markets, regardless of company or country, must be to maintain high standards that foster trust and confidence. Investors can—and do—move capital around the globe with a few keystrokes on a computer. Capital will flee environments that are unstable or unpredictable—whether that's a function of lax corporate governance, ineffective accounting standards, or a lack of transparency. Investors must be able to see for themselves that companies are living up to their obligations and embracing the spirit of all securities and governance requirements.

One of the highest priorities for the United States and for the SEC is helping to foster the growth of capital markets and the multiple benefits that flow from dynamic markets and enlightened corporate governance. These benefits help to reduce the cost of capital and provide a more stable platform for long-term economic growth. These conditions, in turn, spark prosperity and create opportunities for investors to achieve higher returns. Only with the widespread acceptance of these values will our capital markets maintain their rightful place as an engine of prosperity in the United States and throughout the world.

Promoting Growth Through Corporate Governance

Ethiopis Tafara and Robert D. Strahota are director and assistant director, respectively, of the U.S. Securities and Exchange Commission's Office of International Affairs. The views expressed are those of the authors and do not necessarily reflect the views of the Commission, other commissioners, or the staff of the Commission.

[FaGal]

Sarbanes-Oxley

A price worth paying?
May 19th 2005
From The Economist print edition

America's response to Enron and other scandals was the Sarbanes-Oxley law. It is costing plenty—but is it working?

THE Sarbanes-Oxley statute, which the United States enacted in an atmosphere of extraordinary agitation in 2002, is one of the most influential—and controversial—pieces of corporate legislation ever to have hit a statute book. Its original aim, on the face of it, was modest: to improve the accountability of managers to shareholders, and hence to calm the raging crisis of confidence in American capitalism aroused by the scandals at Enron, WorldCom and other companies. The law's methods, however, were anything but modest, and its implications, for good or ill, are going to be far-reaching.

Since the new accounting rules and regulatory infrastructure that goes with them are still bedding in, it is too soon for a definitive judgment. (That time may never come, in fact: academics are still arguing about the pros and cons of the Glass-Steagall act of 1933, a similarly momentous initiative.) It is early days for academic appraisals, but the ones that have been ventured so far tend to the view that costs will exceed benefits. Meanwhile, many of America's businessmen are deeply unhappy, and with reason: the initial costs of the new law have been bigger than expected. And it can be argued that, when it comes to repairing American corporate governance, the law anyway addresses symptoms more than causes.

With time, no doubt, the law's balance of costs and benefits will improve significantly: some of the costs have been once-and-for-all. Right now, though, the balance looks pretty unfavourable.

Alan Greenspan, chairman of the Federal Reserve, spoke up in defence of the statute this week. It was faint praise. He said he was surprised that a law which had been passed so rapidly had worked as well as it has—less of an endorsement than it first seemed, since laws dealing with issues as complex as these and passed as “rapidly” as was Sarbanes-Oxley can normally be expected to fail abjectly.

Mr Greenspan also noted that the law will be fine-tuned as experience accumulates. Quite so. Next day, the Securities and Exchange Commission (SEC), along with the Public Company Accounting Oversight Board (PCAOB, created by the law), told accountants that they were being too inflexible, “overly cautious” and “mechanical” in interpreting the statute. They called for the exercise of greater discretion—something which, three years ago, the architects of the statute had seemed to frown on. Whether good or bad, therefore, SOX, as it has become known, is by no means as yet a settled regime, but a work in progress.

Its initial provisions are wide-ranging. As well as establishing the accounting-oversight board, the statute prohibits audit firms from doing a variety of non-audit work for their clients (in order to address some obvious conflicts of interest). It requires companies to establish independent audit committees. It forbids company loans to company executives. It calls on top executives to certify company accounts. And it extends protection for whistleblowers: no company may “discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee” because of any lawful provision of information about suspected fraud. (Tip-offs from insiders are by far the most common method of detecting fraud.)

The law's most complained-of provision, however, is its section 404. This makes managers responsible for maintaining an “adequate internal control structure and procedures for financial reporting”; and demands that companies' auditors “attest” to the management's assessment of these controls and disclose any “material weaknesses”. Draconian new criminal penalties await transgressors.

Worse than the disease?

The cost of all this is steep. According to one study that has attracted a lot of attention, the net private cost amounts to $1.4 trillion. This astonishing figure comes from a paper by Ivy Xiying Zhang of the William E. Simon Graduate School of Business Administration at the University of Rochester. It is an econometric estimate of “the loss in total market value around the most significant legislative events”—ie, the costs minus the benefits as perceived by the stockmarket as the new rules were enacted. In principle, this ought to reflect all the anticipated costs and benefits, direct and indirect, that impinge on company values. If this number were true, SOX would have to prevent an awful lot of unforeseen losses due to fraud before it could be judged a good buy.

To help see whether the estimate is plausible, can any more light be shed on different categories of costs? Direct costs are much the easiest to measure. A survey by the FEI, an association of top financial executives, found that companies paid an average of $2.4m more for their audits last year than they had anticipated (and far more than the statute's designers had envisaged). Deloitte, a big accounting firm, has said that large firms have on average spent nearly 70,000 additional man-hours complying with the new law.

This underlines a notable unintended consequence of the legislation: it has provided a bonanza for accountants and auditors—a profession thought to be much at fault in the scandals that inspired the law, and which the statute sought to rein in and supervise. The demand for accountants has surged to such an extent that the PCAOB has had to curb its own growth plans. In January, Thomas Hohman, the agency's CFO, told Accounting Today, “We would like more [experienced auditors], but we recognise this is a very tight employment market.” This shortage of personnel in a profession on whose shoulders the law has placed heavy new responsibilities is one of the uncertainties hanging over the act's future effectiveness.

Already reduced in number by consolidation and the demise of Arthur Andersen, the big accounting firms are now known more often as the Final Four than the Big Four, since any further reduction is thought unlikely. Section 701 of the new law instructed the General Accounting Office (GAO), the investigative arm of Congress, to look into the concentration of the accounting industry and its impact. The GAO, in its findings published in July 2003, said that there was a potentially unhealthy degree of concentration.

The Final Four—Ernst & Young, Deloitte, PricewaterhouseCoopers (PwC) and KPMG—audit 97% of all large companies in America. The GAO also noted that smaller accounting firms face “significant barriers to entry” and that “market forces are not likely to result in the expansion of the Big Four”. The American Electronics Association (AeA), which represents 2,500 companies and is an outspoken critic of the law, maintains that lack of competition “is significantly increasing the costs of section 404 certification”.

Last year a number of big companies switched to smaller auditors. AuditAnalytics.com, an online research company, reckons that the big firms lost more clients last year than they gained. After 25 years with PwC, Scientific Technologies, an instrument-maker with a turnover of $58m, switched to BDO, the largest of the pack pursuing the Final Four auditors. The company reckoned that the switch could cut its audit fees by 25-50%. Many firms have seen much bigger increases than that. According to AuditAnalytics.com, the fees paid by Advanced Micro Devices more than trebled last year. Bristol-Myers Squibb paid fees of $27.4m in 2004, more than twice as much as the year before.

[FaGal]

The burden on smaller firms is a particular concern to the AeA and others. Regulators have already been obliged to bend the rules for them. Smaller companies were given extra time to file their accounts this year, the first in which they had to include section 404 reports. More such flexibility is likely in future. In December last year, the SEC set up a panel to review the act's impact on smaller companies.

The auditors emphasise that a good deal of the cost arises from a one-off learning process involved in first adopting the act's requirements. Samuel DiPiazza, chief executive of PwC and an enthusiastic advocate of the new law, says that the costs of applying section 404 were exceptional in the first year and will fall in due course. Eugene O'Kelly, the head of KPMG's American business, has said he reckons auditors' attestation fees related to section 404 should fall by 15-25% this year.

Less visible costs have also been incurred. Far harder to measure, these may be even larger than the direct costs—and would certainly have to be, if the total, net of private benefits, were ever to amount to anything like $1.4 trillion. Some non-American companies have threatened not to list in New York because of the cost of the legislation; others that have recently delisted from an American stock exchange are said to have done so partly because of Sarbanes-Oxley; and some 20% of public companies in a study by Foley & Lardner, a law firm, said that they were considering going private to avoid the costs of the act. It would be regrettable if a law intended to improve the quantity and quality of financial information available to investors led many companies to seek relatively unregulated forms or jurisdictions—but that does seem to be happening.

[FaGal]

Another hidden cost which many business leaders complain of is the effect which the law will have in discouraging risk. Steps to discourage risks of the kind taken by Enron might seem entirely warranted—indeed, you might argue, that was the whole point of the law—but many of the statute's critics say that in threatening (as they see it) to criminalise ordinary business mistakes it goes too far. Small firms, put at a particular disadvantage by the added regulatory burden, also tend to be more inclined than big ones to take risks.

Be patient

What then of the benefits? PwC told the SEC, “The costs are tangible, quantifiable and immediate, while many of the benefits are intangible, harder to quantify and longer term.” Donald Nicolaisen, chief accountant of the SEC, echoed the sentiment: “I suspect that the costs are not easy to estimate,” he told an audience in October 2004, “but I know that it is even tougher to quantify the benefits.”

Michael Oxley, co-sponsor of the law, himself said earlier this year: “How can you measure the value of knowing that company books are sounder than they were before?” The chairman of the House of Representatives' financial-services committee acknowledged that the act, named after him and Senator Paul Sarbanes, imposes real costs on firms. It is, he said, “an investment for the future”.

This year, for the first time, companies have been filing the reports required by section 404. Fewer large companies are reporting problems with their internal controls than had been expected. Moody's, a rating agency, says that about 5% of the companies that it rates had reported material weaknesses up to April 1st this year, compared with the 10-20% that the market had been expecting. That figure might rise as smaller companies, which have been given an extension to their reporting deadline, start to file. There is also a fear that there may be a disproportionate number of problems with companies (typically retailers) whose financial year closed at the end of January.

Moody's says that the most serious control problems lie not with the reported delinquents, but with the late filers—the companies that were unable to get their reports to the SEC on time. This group includes notorious cases such as AIG and Fannie Mae, but also Delphi, a big car-parts manufacturer with close links to General Motors that has said it needs to restate its accounts back to 2001, and the Interpublic group of advertising agencies.

Moody's, a front-line consumer of financial reports, takes a positive view of the impact of section 404. In April it wrote, “We perceive that companies are strengthening their accounting controls and investing in the infrastructure needed to support quality financial reporting.” In the past, companies used to rely on their auditors for advice on many of their more complicated accounting issues. “Many companies,” says Huron, a consulting firm, in its latest review of financial reporting, “are just now realising how much they used to depend on their auditor, and that the burden is on them to adjust to a new reality.”

Because of Sarbanes-Oxley, firms now have to make accounting decisions for themselves. This has, says Moody's, “inspired companies to reinvest in accounting personnel”. It has also spurred many of them to look more closely at their business processes, the fountainhead of their raw accounting data.

At a discussion in April chaired by the SEC, the act was said to have had a “chilling effect” on the relationship between managers and auditors. A good thing too, you might say. Many of the problems at Enron remained hidden because the relationships between its managers and its auditors, Arthur Andersen, were far too warm, with accounting personnel even switching between the two organisations. A little chilling might be just what was needed. Big chunks of the act were explicitly intended to keep a distance between the two parties. Hence the limits on other services that auditors can provide to their audit clients, and the requirement that audit committees (the interface with the auditing profession) consist of independent directors receiving no other form of compensation from the company.

But will the law really help reduce financial fraud in corporate America—and by enough to justify its formidable costs? It might. It has certainly been a salutary reminder to corporate leaders that they are paid a lot of money because they are responsible for a lot of things—in particular, for ensuring that their companies' accounts provide investors with as honest a view as possible of the state of their organisation. At the end of April, Dennis Nally, the chairman of PwC (admittedly not a disinterested observer), said that he believes, over time, America will see “fewer incidents involving accounting fraud”.

Time will tell. But it is also possible that Sarbanes-Oxley will come to be seen as both too much and too little. In due course it might well be argued that the act was right to make the relationship between auditors and their “clients” more distanced and adversarial—but then went far beyond what was necessary in that respect by, among other things, imposing responsibilities on CEOs that they are not, in fact, in a position to discharge. At the same time, this argument might go, the underlying failures at Enron and the others were not accounting irregularities as such but other kinds of corporate-governance failure altogether, not even addressed by Sarbanes-Oxley. The first great post-SOX corporate scandal—you can bet there will be one—should be very revealing.