Upcoming Supreme Court decision in Sarbanes-Oxley case
The Supreme Court is expected to hand down its decision soon in a major case involving the massive and costly Sarbanes-Oxley Act of 2002, Free Enterprise Fund v. Public Company Accounting Oversight Board. The Court could issue its ruling as early as this Thursday, and will definitely hand it down by the end of June when its session closes. The case, in which Competitive Enterprise Institute attorneys are service as co-counsel, mounts a constitutional challenge to the Public Company Accounting Oversight Board (PCAOB), the accounting regulatory body created by the law.
We argue that the way in which the PCAOB board members are appointed violates the Appointments Clause of the U.S. Constitution. Namely, that PCAOB officers, who wield a great deal of regulatory power over businesses and industry-wide accounting practices, are "principal officers of the United States" who must be appointed by the President, with advice and consent of the Senate or by an agency head, as required by the Appointments Clause.
This requirement was intended by the Framers to instill a high level of accountability for officials who wield such vast powers. Although the PCAOB is a striking constitutional anomaly - a case of an independent agency (Securities and Exchange Commission) appointing an equally powerful independent agency - it's a case that will also potentially change, for the better, how other government officials and regulatory bodies are answerable to the American people.
The immediate impact of this case, if our challenge is upheld, will be on U.S. entrepreneurs and investors who have been impacted negatively by this law. This memo sets forth three main points on the importance of this case.
1. Sarbanes-Oxley (Sarbox, SOX) has permanently reduced the number of companies going public, permanently increased the size of companies going public, and had a permanent negative effect on job creation and economic growth.?
Much of the early criticism of Sarbanes-Oxley -- hotly disputed by the law's defenders -- was that it was causing foreign firms to stop listing initial public offerings (IPOs) of their stock in the U.S., forcing them to go to London instead. A running joke attributed to London's socialist mayor Ken Livingstone and others is that London should build a statue of Senators Sarbanes and Oxley for bringing in so much business. The law's defenders insisted that this was the inevitable effect of foreign countries getting more competitive; however, this argument failed to answer the question as to why firms were choosing not to do dual listings in the U.S. and London, as they had in the past. Or why companies like British Airways and Air France were actually deregistering from U.S. exchanges. In fact, only one foreign airline, Ireland's Ryanair, is now listed in the U.S.
But more importantly, and often overlooked, is a fact not much in dispute: the absolute number of IPOs since Sarbox has decreased dramatically and never recovered.
According to a 2009 Renaissance Capital report, IPO issuance in 2008 and 2009 is lower than any period since the 1970s, when business creation struggled against inflation, high interest rates and the Vietnam War. Also, data compiled by Jay Ritter of the University of Florida show the number of U.S. IPOs were lower in every year after SOX was enacted in 2002 (2003 to present) than in every year of the decade from 1991 to 2000, including the early '90s recession years. For instance, in the post-SOX boom year of 2006, there were 162 U.S. IPOs. Yet in 1991, a year when the U.S. was mired in recession but did not have SOX, there were 295 U.S. IPOs
The sheer size of companies going public has also increased, in large part because a company needs to be pretty big to afford the accounting costs that have shot up fourfold as a result of SOX, according to a summary of research in the Sarbanes-Oxley Compliance Journal. According to Business Week, the median market cap (as measured by number of shares times share price) for a company doing an IPO was $52 million in the mid-'90s. Today, it has shot up $227 million. Google had a $1 billion market cap when it went public of 2004. And Facebook still hasn't gone public, despite having an estimated market cap of nearly $10 billion. By contrast, in 1981, Home Depot went public with just four stores. Home Depot co-founder Bernie Marcus told Investor's Business Daily that his firm could never have gone public and raised money for growth had SOX been in effect.
This illustrates the devastating effect of the law in holding back present and future economic growth. Budding Home Depots and Microsofts can no longer go public to raise money for growth. They must wait until they are as big a Google to go public to lock in their gains. But this lack of an ability to issue equity because of SOX means that firms are ever more dependent on financing through debt, especially difficult considering the current credit crunch.
No matter what kind of business an up-and-coming firm engages in -- whether it's oil drilling or "green tech" -- there are only two basic mechanisms they can use to raise capital to finance their growth: debt and equity. To expand their businesses with money they don't have, entrepreneurs can both borrow money from banks and issue bonds - debt transactions with contractual obligations to pay creditors a fixed amount on a certain date. Or they can issue shares of stock with no obligatory payouts but with an ownership interest in any future prosperity of the firm.
Recent studies have shown that debt and equity don't always move together, and can be substitutes, rather than compliments, as forms of financing. They also show that in some instances, equity issuance can even be countercyclical and increase during bad economic times. This fact gives hope that increased equity issuance could lessen the severity of a recession and get the economy back on its feet much sooner. But this will only happen if - and this is a crucial if -- there are not undue policy barriers to companies going public. Evidence suggests that we were able to recover more quickly from the early '90s recession because an actual increase in companies -- from Starbucks to Cisco -- issuing IPOs. But SOX forecloses that possibility and makes for a longer recovery.
2. By enforcing Sarbox's mandates, the PCAOB has focused on trivial risks, not only driving up costs for companies, but missing the bigger picture such as the Lehman Brothers off-balance sheet accounting.
The PCAOB has stretched Sarbox's requirement that auditors "attest" to a company's internal controls over financial reporting in the law's Section 404 to require a full-blown audit of trivial items that could remotely effect a financial statement. This has turned the law into the "Accountants Full Employment Act" and the reason the Big 4 accounting firms lobby so hard against even minor rollbacks in Congress, such as the exemption from Section 404 that passed in the House version of the financial regulation bill.
Under PCAOB Accounting Standard 2 (later revised as Accounting Standard 5), accountants had to scrupulously examine trivial items with little relevance to shareholders, such as who has the office keys and how many letters are in an employee passwords.
According to John Battelle's book The Search, considered a definitive history of Google Inc., Sarbox was "hell for a company like Google, which made its money literally pennies at a time, from millions upon millions of micro-transactions." Battelle reports that Sarbox compliance significantly delayed Google's IPO. "According to engineers involved in the work, Google had to significantly restructure its advertising report system from the ground up." If this was difficult for a company like Google, imagine what a burden it is to smaller companies.
The PCAOB's interpretations of Section 404 governing "internal controls" over auditing costs public companies $35 billion a year, according to the American Electronics Association. University of Rochester economist Ivy Zhang found that the law has cost the American economy $1.4 trillion in direct and indirect costs.
Almost as important is that Zhang and other researches have found that Sarbox has had no quantifiable benefits in fighting fraud. The PCAOB has done little or nothing about in telling accountants how to handle accounting for the off-balance sheet entities at issue in Enron that resurfaced with Lehman and other companies. Countrywide Financial, now charged by the SEC with accounting fraud, actually won an award for its Sarbox compliance from the Institute of Internal Auditors in 2007.
3. Despite widespread denunciation of phantom Bush-era deregulation, regulatory relief from Sarbox has widespread bipartisan support.
See the quotes from Nancy Pelosi, John Kerry, and others below. Also, 101 House Democrats voted for an amendment to the financial regulation bill to exempt smaller public companies from Sarbox internal control audits.
Ø Commentary on the Daily Caller: Sarbox reform would boost our economy, but even small reforms (such as small company exemptions) are being blocked by the powerful accounting lobby. http://dailycaller.com/2010/02/02/obama-can-aid-small-businesses-by-providing-regulatory-relief/
Ø CEI Capitol Hill conference, "Sarbanes-Oxley, the Supreme Court, and America's Economic Future." The conference featured Hans Bader, co-counsel to the the plaintiff; Mallory Factor, founder of plaintiff Free Enterprise Fund; and Reps. John Adler (D-N.J.) and Scott Garrett (R-N.J.). Adler and Garrett are bipartisan sponsors of the exemption from Sarbox's internal control auditing mandate. This legislation would be included in the financial regulation bill that would pass the House a couple weeks later. http://www.viddler.com/explore/ceivideo/videos/124/
Ø CEI study, "SOXing It To The Little Guy," detailing Sarbox's cost to Main Street entrepreneurs and investors. http://cei.org/gencon/004,05954.cfm
Ø CEI study, "The Public Company Accounting Oversight Board: An Unconstitutional Assault on Government Accountability" was the basis of the Appointment Clause arguments made in the courts. The study explains the connection between the PCAOB's lack of constitutional accountability and the bad policy outcome of its rules, such as the mandates for audits of internal controls. (Note: when you go to the following link, there is computer jargon on the Executive Summary page -- "&apos" when there are apostrophes -- which needs to be cleaned up) http://cei.org/gencon/025,04873.cfm Notable quotes on the overreach of the Sarbanes-Oxley Act
The Obama administration, expressing support for the provision of the House financial regulation bill by Scott Garrett (R-NJ) and John Adler (D-NJ) provision that would permanently exempt smaller companies from the Sarbox internal control mandates, has said, "Our focus must be on addressing the threats posed to investors and consumers by large, interconnected companies, rather than placing an undue burden on small businesses." (The Wall Street Journal, http://blogs.wsj.com/washwire/2009/11/03/sarbanes-oxley-critics-declare-a-victory-at-least-for-now/)
Democratic Leader Nancy Pelosi Oct. 24, 2006 on CNBC
"Everything that we do should be to encourage the markets not to discourage them. We've even gone on record on our innovation agenda revisiting Sarbanes-Oxley because, again, unintended consequences. There's a need for it. You need the transparency. You need the focus on it. But you don't need -- I don't think you need the whole package."
Sept. 14, 2006 Massachusetts Senator John Kerry called for a "task force" to "make it easier for small businesses to comply with the Sarbanes-Oxley by reducing their regulatory burden in the future." http://kerry.senate.gov/v3/cfm/record.cfm?id=264068
New York Sen. Charles Schumer, Nov. 1, 2006
"With the benefit of hindsight, the Sarbanes-Oxley Act of 2002, which imposed a new regulatory framework on all public companies doing business in the U.S., also needs to be re-examined. Since its passage, auditing expenses for companies doing business in the U.S. have grown far beyond anything Congress had anticipated."
New York Rep. Nydia Velazquez, June 5, 2007
"Small firms continue to be supportive of the intent of the Sarbanes-Oxley Act and many have benefited from the stronger corporate governance culture that it encouraged. However, what we have continued to hear is that these benefits - and particularly those associated with Section 404 - come at a very steep cost." http://www.house.gov/smbiz/test/hearings/opening-statements/statement-sox-06-05-07.html
Former Senate Majority Leader Tom Daschle, Oct. 3, 2005
"SOX has also had unintended consequences that generate complaints from small and mid-sized capitalization companies who say that their access to capital from publicly-traded stock markets has been made prohibitively expensive." http://online.wsj.com/article/SB112829439572458006.html?mod=opinion_main_commentaries (subscription required)
Jack Welch, General Electric CEO responsible for turnaround in 80s and 90s. "Small companies with all these financial controls that are in there now and the penalties that go on with small entrepreneurial companies, it's tough." Interview with Tavis Smiley.
Bernie Marcus, cofounder of Home Depot, when asked by Investor's Business Daily if Home Depot could have gone public when it did under SOX: "I don't honestly believe we could. We went public after opening our fourth store because we needed the capital to open more stores. Going public and entrepreneurship were the keys to our success. If you're a public company today, you have to be surrounded with lawyers and you can't make a decision without a lawyer on one side of you and accountants on the other side. Today, you just can't use your business judgment to take the risks that must be taken for a new company to succeed" Available at http://www.legalreforminthenews.com/Reports/IBD%20Bernie%20Marcus%20Interview%201-30-06.pdf
Carly Fiorina, former CEO of Hewlett-Packard and Republican candidate for U.S. Senator from California: "I think Sarbanes-Oxley is an example of the dangers of a rush to legislation in an emotional moment. . . . I absolutely believe that new businesses, smaller businesses shouldn't have to comply with the full scope of Sarbanes-Oxley, and I think there's no question that Sarbanes-Oxley has had a chilling effect on companies' decisions to list here as opposed to perhaps listing on other exchanges around the world" http://techcrunch.com/2010/01/31/interview-carly-fiorina-senate/
Charles Munger, Berkshire Hathaway vice-chairman (considered Buffet's "partner" in building the company), "Sarbanes-Oxley has raised our costs. I don't think it's done anything favorable for the quality [of our financial results], because there was quality to begin with."
Peter Thiel, venture capitalist and first outside investor in Facebook, "The IPO window is almost closed and I think in part, this is a response to Sarbanes-Oxley to the ways in which being the CEO of a public company is simply no fun anymore. They're subject to insane levels of scrutiny. You're not able to pursue any sort of multi-year corporate strategy and instead you are held to a quarter-by-quarter earnings schedule which is ultimately quite detrimental to long-term planning." http://bigthink.com/ideas/17716
Carl Schramm and Robert Litan, president and vice president of Kauffman Foundation, leading foundation on research in entrepreneurship: "Compliance with the Sarbanes-Oxley Act of 2002, in particular, has proven to be far more expensive for smaller companies than originally intended or forecasted. Since shareholders are the intended beneficiaries of Sarbox, why not let them vote on whether their company needs to comply with some or all of its provisions-the expensive requirement for auditing of internal controls, in particular. We suspect that many shareholders would choose some form of opt-out, and in so doing, would enable more growing companies to continue growing as independent firms, rather than being bought out by larger companies that can intentionally or unintentionally rob the firms of the entrepreneurial magic that made them successful in the first place." http://online.wsj.com/article/SB10001424052748704013004574517303668357682.html
Source: Competitive Enterprise Institute, 1899 L Street NW 12th Floor, Washington, DC 20036