Is Sarbanes-Oxley Working?

The Sarbanes-Oxley Act turns two this summer. So we thought it was time to ask: How's it going?

It depends, as usual, on whom you ask. "Everywhere I go, I hear from the bill's supporters and its detractors," House Financial Services Committee Chairman Michael Oxley, an Ohio Republican, said in a recent speech to the City Club of Cleveland.

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Sarbanes-Oxley imposed new responsibilities on corporate executives and boards, and greatly expanded the role of directors who sit on corporate audit committees. A five-member accounting oversight board was created with the power to examine audit firms and discipline wrongdoing. Under Section 404 of the law, corporate mangers must create tight controls over financial reporting, assess them regularly, and have independent, outside auditors attest to their effectiveness.

Judging by public opinion, the law is a hit: A Harris poll sponsored by Movaris, a provider of Sarbanes Oxley compliance software, earlier this year found 59% of investors believe the Sarbanes-Oxley Act will help safeguard their stock investments, and 57% say they would be very unlikely to invest in a company that didn't comply with the law. Supporters say investors are regaining their faith in markets, and view the Sarbanes-Oxley Act as a key factor in the process.

Despite complaints about the expense, Rep. Oxley says the cost of complying with the law appears to be "eminently reasonable." He cites a Financial Executives Institute study that pegs the first-year costs of compliance with the internal-controls requirements at less than 1% of a company's revenue.

Sen. Paul Sarbanes, a Democrat from Maryland, says the law has accomplished much, invigorating the Securities and Exchange Commission with new funding, establishing the Public Company Accounting Oversight Board and changing corporate-governance practices for the better. But in a recent speech, Sen. Sarbanes said that while he sees significant progress since President Bush signed the measure into law in 2002, "it is obvious that the job is not done."

One area of concern is the $7.5 trillion mutual-fund industry, which is exempt from the internal-controls requirements of Sarbanes-Oxley. Sen. Sarbanes noted that a litany of mutual-fund trading abuses have come to light since the law was passed, prompting numerous Senate hearings. For now, lawmakers are leaving the matter to the SEC, but that could change if the agency backs off action or if fresh fund-industry problems emerge.

How do other players see the law? What changes would they recommend? Here's what a wide range of experts say.

THE CEO

Janet Dolan
President and Chief Executive Officer, Tennant Co., a Minneapolis maker of industrial cleaning products

Ms. Dolan believes that Sarbanes- Oxley was "well-intentioned but it was a little bit of a rush to judgment.... They just threw something at corporate America and left it to us to figure out.... The legislation was broad on requirement and short on specificity."

As an example, she cites Section 404 of the law, which requires executives to conduct an annual assessment of internal controls on financial reporting. Deadlines to comply with the law were set before compliance requirements were issued, so "we were all aiming at a moving target."

The result, she says, is a lot more documentation, "creating a paper trail that documents what we were doing already.... We're seeing a significant amount of board time going into charter and governance-review processes, over and over again.... That time probably could have been better spent on reviewing company operations."

Ms. Dolan says that it's also making it harder to recruit board members. "The work of the audit committee is now very heavy," she says, and "many good candidates are saying, 'I already serve on one board.'" As a result, "we're all starting to look at corporate officers below CEO and COO." She says Tennant plans to raise fees paid to outside directors, given the added time they now spend preparing for and in board meetings.

Ms. Dolan complains that the law is especially burdensome for smaller-cap firms such as Tennant. "This has been pretty much a one-size-fits-all-approach," she says. "It's fallen much more heavily on small-cap companies in terms of the expense.... We're all having to do about the same thing, but it's less of a burden for General Electric than for us." Ms. Dolan says that "our out-of-pocket cost to comply with 404 is approaching $1 million," and that outside audit fees may double over 2003 as a result of complying with all the Sarbanes-Oxley requirements.

"These are all direct, financial impacts of the legislation," she says. "We all support good governance. The question is, at what price? If you keep adding expense, at some point it tips the scale." For many smaller firms, she says, "the cost of being public anymore is really starting to be questionable."

As for changing Sarbanes-Oxley, Ms. Dolan offers this advice: "Tinkering may improve it, but it's not going to recoup the time and money that was spent trying to adjust to a very unclear expectation.... I would welcome the legislative authors to listen, listen well, make it as practical as possible. And, bear in mind there is a cost for all this and ask: Is the cost worth it?"

The Enron Restructuring Officer

Stephen Cooper
Chairman, Kroll Zolfo Cooper LLC, New York, and interim Chief Executive Officer and Chief Restructuring Officer of Enron Corp.

Mr. Cooper says that while critics complain about Sarbanes-Oxley, "I really have not seen anybody that's looked at Sarbanes-Oxley and said this is an opportunity for us to...embrace all of the best practices and be at the leading edge of running a business instead of the trailing edge."

By contrast, he says, "at Enron, we're taking virtually all the steps we can to embrace best practices, including compliance with Sarbanes-Oxley. My view is, given where Enron was, to the extent practical, we ought to be a poster child for good corporate practices."

At Enron, Mr. Cooper says, Sarbanes-Oxley is a "very helpful" blueprint for reform. Requiring corporate managers to certify the firm's financial results, ensure it has appropriate internal controls and be answerable to independent directors "is a framework to create higher responsibility and accountability," he says.

Is it enough? "Corporate governance is really a state of mind," Mr. Cooper says. "Whether it be pre-Sarbanes, during Sarbanes, or post-Sarbanes, the fact of the mater is, without the right state of mind, what we're creating are just more hurdles for people who are committed to gaming the system to jump over. We're not fixing the system."

The Institutional Investor

Cynthia Richson
Corporate Governance Officer for the $60 billion Ohio Public Employees
Retirement System, and a member of the standing advisory group to the Public Company Accounting Oversight Board

Ms. Richson believes that Sarbanes-Oxley is "a step in the right direction." Coupled with new listing standards at the New York Stock Exchange and the Nasdaq Stock Market, she says, it achieves many goals sought by institutional investors for years.

But, she adds, "there are still some areas that need some work."

For instance, she believes that investors need better disclosure of executive compensation that now may come to light through unrelated litigation. General Electric Co. shareholders, for instance, learned the full extent of postretirement perks lavished on former CEO Jack Welch only during his divorce.

As a general matter, she says, "if use of the corporate jet is going to cost $2 million a year, then it ought to be disclosed.... Corporate reports ought to include a separate section for executive pension disclosure and other perks."

Such requirements, she says, may be best left to the SEC. "If it goes to Congress," Ms. Richson says, "it gets politicized."

Among other changes she'd like to see:

The Former SEC Chairman

Richard Breeden
Chairman, Richard C. Breeden & Co., a Greenwich, Conn., consulting firm, and former Chairman of the Securities and Exchange Commission. He is a director of BBVA, a Spanish bank, and the court-appointed monitor for WorldCom Inc., now MCI Corp.

Mr. Breeden says he applauds Sarbanes-Oxley as "one of the most important acts that's been passed in decades. But, he says, "when you have something of that magnitude, done in a relative hurry...there will be things Congress didn't get that deeply into."

In particular, he says the law forces "companies to pay more attention to internal controls. That is one of the great successes of the statute. But I'm very concerned that this will be turned into process rather than substance."

The problem, he says, is that the need to audit internal controls may "prove immensely costly without equally valuable increases in the effectiveness of controls. The way that the 404 process is unfolding is that accounting firms see themselves as having a license here to audit controls. That means every control has to have a written set of procedures, and then you have to go sample real-life corporate operations and test them against the procedures. I think there are many areas where that is a healthy exercise, but on the other hand, it can get carried to extremes. Is it beneficial to the economy to pay a ton to outside consultants to...make sure every procedure is followed? It risks putting day-to-day operations of the company into a bit of a bureaucratic straitjacket.... We can fill encyclopedias with how things are supposed to be done, and we can pay as much as we now pay to audit the books to audit control procedures, and we will still have control failures."

Mr. Breeden says he isn't urging that the law be repealed. Rather, he wonders "if we can keep a focus on the big risks, material concerns, things that can lead to harm to investors. Where are the reasonable cutoff points? My concern is that we're going to waste too much money by not targeting the requirements enough." Mr. Breeden thinks Congress should "hold some hearings and evaluate early in 2005 this whole process and be sure we've kept things in balance."

Mr. Breeden's biggest concern is over the role of accounting firms. Consolidation in the accounting industry has "put a lot of pressure on independence," he says, and with only four major accounting firms left, "maybe we should ask each of those firms to split themselves into three or four." Absent that, he says, "we can't allow the number of firms to shrink any further."

He adds: "I still see the area that is most broken is the audit profession, in its ability to detect fraud and abuse.... In some sense, we have our focus backwards, to the extent you lay all the pressure and responsibility on the audit committee. Three or four individuals, no matter how much talent and time they are willing to bring to the job, are not going to match the internal and external audit functions.

To deal with this, Mr. Breeden proposes "a requirement that accounting firms have outside boards of directors. We require that stock exchanges have public directors on their boards of directors, in recognition of the fact that they have a public function. I think it would be extraordinarily constructive if the four major accounting firms had to have a board of directors, and their own audit committees, focused on quality assurance. The profession has not done an adequate job in the past of actually delivering an independent audit that's done in an effective way."

Congress made the right decision to create the public accounting board, Mr. Breeden believes. "The question now is making sure the agency lives up to its promise, and makes the difference we need so that accounting firms put far greater stress on audit quality...because too many people rely on what they do."

The General Counsel

Logan Robinson
Vice President and General Counsel, Delphi Corp., an auto-parts supplier in Troy, Mich.

Mr. Robinson believes there's a "lot more right than wrong" with Sarbanes-Oxley. "Balzac said, 'Behind every great fortune is a crime,' [and] a lot of investors felt that way" amid the scandals that led to the law's adoption in 2002, says Mr. Robinson. The law "was an appropriate response to a real crisis," he says. "The core of the law is a good law that has defended our capital markets."

But he would like to see some changes. For instance, he says, "I don't know why we have to have two certifications" of corporate financial results, both sent to the SEC, covering criminal and civil liability. "Why not have one?"

In addition, with regard to a ban on executive loans contained in the bill, he says, "we could use some clarification.... It knocked out a lot of really common business practices. If someone relocates, can you give them an advance, or is it a loan?... I think there is a line you can draw between handing millions of dollars to a CEO and giving someone an advance."

Sarbanes-Oxley required the SEC to set minimum professional standards for lawyers; it adopted a rule that lawyers report potential wrongdoing up the corporate ladder, going to top management, the board or a legal compliance committee, if need be. But the SEC has yet to act on a controversial plan to publicize instances when companies fail to act after being informed of a potential fraud.

"Reporting up works pretty well," Mr. Robinson says. "Delphi has established a qualified legal compliance committee," composed of its audit-committee members. "We have not yet had to call a meeting of it, but I take comfort from knowing it's there." But "reporting out is more of a problem.... If you turn all the lawyers in the world into enforcement agents who are compelled to run to the SEC, there's going to be a huge problem in getting people to tell their lawyers anything."

A limited waiver of privilege would help, he says. Companies are reluctant to turn over confidential information to regulators for fear it may wind up in the hands of third parties, such as class-action plaintiffs. With a limited waiver, "you could give the government what it wants" without waiving a company's right to assert attorney-client privilege elsewhere.

Mr. Robinson says that the law hasn't made it harder to recruit board members, although, he adds, "their level of anxiety is high. Our audit committee is meeting twice or three times as long as it used to.... We had one meeting start at five in the morning to allow enough time."

The Watchdog

Nell Minow
Editor of the Corporate Library, a Portland, Maine, research firm specializing in corporate governance

Ms. Minow says she wouldn't make any "substantive changes" to Sarbanes-Oxley, although she does believe it can use some "fine-tuning."

She agrees with Mr. Robinson's point about modifying the rule on executive loans. Also, she says, since corporate governance traditionally is left to states, Congress dealt with it in Sarbanes-Oxley only indirectly. "I would certainly think about granting more authority to the federal government for corporate governance," Ms. Minow says, "because until we do that, we're going to have this lopsided approach" in which shareholders are outmatched by corporations at the state level.

If Congress were to become more involved, she suggests it clarify that directors must be actively engaged in oversight, "rather than defer to management's judgment." In addition, she says, "I would put proxy access in as a federal law," scrapping an SEC proposal aimed at making it easier for shareholders to nominate candidates to corporate boards.

A federal requirement that public companies allow shareholders to nominate their own candidates to boards, using corporate proxy ballots, if more than 50% of votes for a director are withheld in the prior year's election, would be a simpler approach, she says.

Ms. Minow also recommends that regulators and investors "stop relying on independence as a proxy for anything and instead rely on strengthening the system for nominating directors so we get the best directors on the board." Similarly, she says, mandating that the role of chairman be separate from the chief executive is "meaningless." She says a better approach might to be to let shareholders vote on who should chair the company's board.

The Chief Financial Officer

Dan Hale
Vice President and Chief Financial Officer of Allstate Corp., based in Northbrook, Ill.

Mr. Hale's main gripe about Sarbanes-Oxley is that "there's a need for a more consistent standard of compliance" with regard to the internal-controls provisions. Outside auditors, he says, must flag any significant deficiencies or material weaknesses they detect in corporate internal controls, yet regulators haven't offered a precise definition of what constitutes a significant deficiency or a material weakness. "It makes it difficult for companies to know how to comply with the requirements," Mr. Hale says.

Another problem: Without precise definitions, different auditors may reach different conclusions, even in similar situations.

To fix that problem, Mr. Hale says, the Public Company Accounting Oversight Board should give clearer definitions.

He also recommends that Congress do a "reasonable cost-benefit analysis. Are there ways to do this and get the same kind of benefit? Some would argue maybe the pendulum went too far.... We're now adding another layer of compliance, and the cost of that is unfortunate."

The Chief Accounting Officer

Arnie Hanish
Chief Accounting Officer, Eli Lilly & Co., Indianapolis, and a member of the Public Company Accounting Oversight Board's standing advisory group and Vice Chairman of the Financial Executives Institute committee on corporate reporting

Mr. Hanish says that initially, "I don't believe that any of us in the private sector really welcomed the government intervening in the accounting sector." But now, he says, "as much as I was upset when it first came out, I don't think it's been all that onerous, at least for us.... I think that Sarbanes-Oxley is working pretty well."

The law, he says, triggered a comprehensive review of how Eli Lilly documents corporate controls, and the discipline of that "has been tremendous." The review uncovered some redundancies, allowing the firm to eliminate some steps it was taking needlessly. "We added some controls as well." In all, "it was time and money well spent."

How much time and money is the new law costing Eli Lilly?

"It has certainly taken a lot more time than any of us anticipated," Mr. Hanish says. "The dollars have been significant." Five new hires will work full time on fulfilling the requirements of Sarbanes-Oxley, and outside auditors have to do much more testing and review work than in the past. "I think we have yet to see the full brunt of those costs," he says.

If he could change Sarbanes-Oxley, Mr. Hanish says, he would loosen requirements on how quickly corporations must file reports to the Securities and Exchange Commission. Sarbanes-Oxley requires companies to disclose important changes in financial condition quickly; under rules that take effect in August, firms generally must alert investors within four business days. A separate SEC initiative requires firms to file quarterly and annual reports sooner. When it is fully in effect, firms will file annual reports in two months, rather than three, and supply quarterly results within 35 days, slicing 10 days off the previous pace.

"I think the SEC went too far in accelerating the timing of the filing" of these reports, Mr. Hanish says. Greater speed is questionable for firms that detail earnings results in press releases before filing reports to the SEC, says Mr. Hanish, and the faster pace puts a significant burden on executives who often serve on other boards. He said subjecting them to a faster pace "could lead to reviews that would be less than optimal."

Although faster filing of quarterly and annual reports wasn't required under the Sarbanes-Oxley Act, it has made the SEC's filing requirements difficult because Sarbanes-Oxley has meant that corporate executives and boards meet more often and for longer periods, Mr. Hanish says.

Ms. Burns is a reporter for Dow Jones Newswires in Washington.

Write to Judith Burns at judith.burns@dowjones.com