The Sarbanes-Oxley Act was a reactive piece of legislation, responsive to the public outcry over the excesses of directors and officers of Enron, WorldCom, Adelphia and other high-profile, failed companies. Additional regulation has been pouring down from the SEC and the stock exchanges. With bankrupt companies, lost fortunes and inflated executive pay packages, speaking of measured responses is hardly a politically popular theme. But we nonetheless believe it appropriate to pause a moment and at least ask some questions about all of this recent activity.
Our first concern is the effects on smaller public companies. Reports are that audits of public company financial statements will cost up to 50% more than they did before Sarbanes-Oxley, both as a result of heightened caution by the auditors, new regulatory requirements and the demise of Arthur Andersen, which left a smaller group of major audit international firms to compete for the work. When the new internal control audit requirements become effective (in 2004 for many public companies and in 2005 for the rest), those costs are likely to again increase substantially.
Will financial reporting be better than it was pre-Enron? Probably. But when the increased costs of the outside audit are added to the higher costs of internal controls, increased director fees to fairly compensate stressed audit committee members, rapidly increasing D&O insurance premiums and mounting legal costs, fewer companies will be able to afford to access (or continue to access) the public capital markets. Smaller public companies will also be challenged to find a sufficient number of qualified directors willing to spend the time to do the job right. Some will argue that those companies do not "deserve" to be public anyway, but the reality is that small cap companies have played a significant role in this country's economic growth, particularly over the past twenty years. Will they be cut off from public funding and thereby strangled by reform?
Our second concern is whether the changes will become rote after the initial shock, instead of producing lasting reform. CEOs and CFOs must now certify their company's financial reports and face fines and criminal penalties if those financial statements are wrong. At first, CEOs and CFOs were terrified to sign their certifications. Our concern is that the terror will pass, and certifications will be signed as a routine matter every quarter because there is no other choice. A similar concern is that actions will be taken for the appearance of compliance without true effect. Will the charters required for the various board committees provide a true guide for action, or will they be written by lawyers and filed away? If the latter, there will be a cost when someone wants to litigate over committee inaction and pulls out the charter to demonstrate failure to follow its procedures. Will the new regulation cause independent compensation committees to scale back on executive pay packages, or will we see a continuation of boilerplate disclosure that justifies the status quo? Will the new requirements with respect to nominating committees change who gets selected as directors, or merely justify the current choices?
Our third concern is with unintended consequences. For instance, if shareholder-backed candidates opposed by management break into the boardroom, will they be disruptive or effective? We have seen great benefits to businesses when management receives sage advice from collegial, concerned outside directors, and are concerned that this process, now taken for granted, may suffer if boards become adversarial.
As the new year approaches we encourage Congress and the state legislatures, the SEC, the stock exchanges and the state securities administrators to take a step back and reflect on the situation we are now in. The Internet bubble burst, the public found out that some corporate officers had their entire arms in the cookie jar and some directors were asleep at the switch. But let's not forget that most officers and directors were ethical, hard working and honest before Enron, and have always wanted to do the right thing for the shareholders they represent. Let's now take a deep breath and look at where the reforms already enacted have taken us. And then let's clarify, rather than codify. Let's agree on what these reforms mean before we bury corporate America in even more corporate governance regulation. Let's punish the wicked, but let's also make sure that at the end of the day we haven't burned so many witches that the capital markets can't function as the economy recovers.
In 2004 let's try something novel - let's contemplate before we legislate!
Alan Wovsaniker and Anthony O. Pergola are Directors of Lowenstein Sandler PC (Roseland, New Jersey) where they both represent public and private companies in corporate governance matters, securities offerings and mergers and acquisitions transactions. The views expressed in this editorial are their own and do not necessarily reflect the views of Lowenstein Sandler, its attorneys or its clients.