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Scott S. Powell, Ph.D.
Visiting Fellow
Hoover Institution of Stanford University

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

Some executives are on the record as saying that Sarbox costs more than it is worth. What do you think?

Rumblings of despair might lead one to believe a new disease threatens us from foreign shores. Instead, Sarbox Is a set of regulations intended to prevent the next Enron or WorldCom by improving corporate governance. It is now entering its first year of enforcement, and according to many participating in recent SEC roundtable hearings it may be the most costly and counterproductive regulation ever imposed on public companies.

In fact, the Act empowers the federal government in unprecedented ways by dictating areas of corporate governance previously left to states. Complying with Sarbox will levy $35 billion of additional costs on corporate America this year—twenty times more than the SEC originally estimated. Washington bureaucrats can now impose a one-size-fits-all approach to structure corporate boards, determine their duties and those of officers, and set standards and processes for internal controls. In so doing, Sarbox defies common sense and the American tradition of competition to promote innovation and best business practices.

Haven’t any benefits arisen?

Sarbanes-Oxley does introduce some beneficial reforms, such as establishing an oversight board for public accounting, increasing penalties for fraud, providing more protections for whistleblowers, requiring more transparency of insider stock sales and material events, and reducing conflicts of interest in corporate governance. But much of this good is outweighed by unexpected negative consequences of Section 404 of Sarbox, which regulates internal company controls. It is appropriate to ask, “who wins and who loses?” It is no secret that Sarbox greatly benefits lawyers and auditors.

Wait a minute. Weren’t they the ones that got us into this mess, by failing in fundamental due diligence regarding Enron’s capital structure and WorldCom’s financial statements? No matter that the Big Five accounting firms are now the Big Four. In a truly stunning reversal of fortune after being discredited and becoming the butt of numerous jokes, the external public auditing firms that previously let the public down are now riding a wave of unprecedented power—pushing around corporate officers and board directors and effectively regulating their companies’ IT operations. The time-consuming audit procedures of Sarbox 404 have become a windfall, with auditors’ fees being increased 100% or more in two years. And for what?

High-level fraud is still likely to go undetected because regulators are looking in the wrong places. Section 404 audits focus on such minutiae of operational details that they won’t detect or prevent high-level fraud, such as capitalizing instead of expensing the billions that took WorldCom down. The bottom line is that since the Act passed, public auditors’ revenues have doubled, but their role as a second line of defense against executive malfeasance and corporate crime is no better today than before.

Why hasn’t corporate America demanded an accounting?

Privately, many CEOs and CFOs acknowledge the massive waste and misdirection of resources, but some remain silent because 404 provides them a measure of protection against liability in the event that a system or human error requires a material restatement. One S & P 500 corporate executive taking early retirement acknowledged that 404 has less to do with controls such as ERP (enterprise resource planning), ORM (operational risk management), or BPM (business performance management), and everything to do with CYA (cover your ass).

Sarbox illustrates the madness of overregulation and the folly of Congress trying to legislate risk- and error-free business operations. This might be tolerable were it a one-time cost and if it did not interfere with management’s flexibility and ability to run the business. “But with Sarbox nobody has any bandwidth to think about innovative ideas or new models,” says a top project manager at Cingular, the nation’s largest cellular service provider. Jeffrey Garten, dean of Yale’s School of Management, predicts: “CEOs are going to become more risk-averse and big investments in risky projects will be held back.”

In practice, new initiatives have gone right out the door at many companies, with project after project postponed or canceled. William Zollars, CEO of Yellow Roadway, the largest trucker in the U.S., says, “it requires an army of people to do the paperwork.” In addition to diverting some 200 employees to work on Sarbox in Q4 of 2004, Zollars spent nearly $10 million on outside accountants and auditors, which was more than 3% of his firm’s annual profit. But Yellow Roadway may be getting off cheaply, as BusinessWeek puts the average large company compliance price tag at upwards of $35 million. Scott McNealy, CEO of Sun Microsystems, says that the billions spent nationally on Sarbanes-Oxley compliance weighs on the stock market and is like “throwing buckets of sand in the gears of a market economy.”

It gets worse. The greatest impact of Sarbox is on small public companies and venture capital start-ups, which generate more than 70% of new jobs in the U.S. As is the case with most regulation, compliance is more regressive with smaller companies because costs are spread over fewer heads and less revenue. As a result, not only are many start-ups hesitant to go ahead with IPOs, but approximately one-fifth of existing small public companies in the U.S. have considered going private because of the costs of Sarbox. The exodus also involves foreign-domiciled companies listed on one of the U.S. stock exchanges, who now want to delist and get out of Dodge to avoid the high cost and wastefulness of Sarbanes-Oxley.

The fundamental problem with Section 404 is that it punishes and rewards the wrong people. It is strangling the golden goose of innovation and productivity and making the US less competitive in the global economy. Little wonder that the U.S. stock market is in a funk and technology company valuations remain depressed. This is the first time in the history of the U.S. capital markets when so many companies are voting with their feet and taking active steps to delist or to go private. A mid-course correction to Sarbanes-Oxley is urgently needed.

So what can be done?

The SEC may exercise its prerogative, make exceptions and use its exemptive power to render optional the various regulatory provisions found excessive. But a better solution is in legislation recently introduced by Congressman Jeff Flake (R-AZ) that treats all companies equally and simply makes Section 404 of Sarbanes-Oxley voluntary. And there is political cover and precedent for Congress to get behind this. The Securities Act of 1933, which passed in a similar environment—after a market crash to correct excesses that was also accompanied by accounting irregularities, misrepresentation, and fraud—was found wanting. These deficiencies prompted Congress to go back and enact the Securities and Exchange Act of 1934, which has provided the main bulwark of securities regulation ever since.

By making Section 404 mandates on internal controls voluntary, while keeping the rest of Sarbanes-Oxley intact, Congress still can claim victory in being tough on corporate crime, improving corporate governance and boosting investor confidence. Firms can determine the appropriate level of controls by management discretion or by shareholder vote, with full disclosure to the SEC and in annual reports. Such a scaled-back Sarbanes-Oxley II would let shareholders and managers have more say than government in deciding how corporate resources are best spent. A solution along these lines would help keep the U.S. competitive in world markets, while it would restore balance at home and reaffirm the primacy of free market initiatives and innovation.

Heck, it might even be fun to go to work again.

Scott S. Powell, Ph.D., is a visiting fellow of the Hoover Institution of Stanford University and has been a Senior Vice President with UBS Financial Services and RBC Dain Rauscher specializing in serving corporate cash management needs. Prior to that, Powell was an executive with Kidder, Peabody & Co. He currently serves as a board member of BMG Seltec, Inc., and has consulted to the U.S. Government on a number of top political appointments. Articles regarding his views on the impact of Sarbanes-Oxley have been published by Barron’s, Hoover Digest, and other top business journals. Powell recently affiliated with OneAccord Consultants in Bellevue, Washington..