A Pox on SOX, It's Bad for Stocks
Sarbanes-Oxley promotes inequality by discouraging companies from going or remaining public.
With corporate tax reform in the rearview mirror, Congress and the Trump administration should pare back a misguided regulatory regime that imposes unnecessary costs on public companies, discourages initial public offerings, and skews the distribution of wealth toward the very rich.
The problem traces back to the bursting of the dot-com bubble in the spring of 2000. For two and a half years stock prices dropped precipitously, with the Nasdaq Composite Index losing more than 75% of its value. The collapse of audit firm Arthur Andersen and the bankruptcies of Enron and WorldCom sent the stock market into free fall in the second quarter of 2002. With midterm elections only five months away, members of Congress felt they had to do something to restore corporate accountability and public confidence in Wall Street.
The result was Sarbanes-Oxley, sometimes called SOX, a hastily drafted law that imposed one-size-fits-all regulations on American corporations. The law contained some beneficial reforms intended to prevent the next Enron or WorldCom by improving corporate governance. It established oversight of public accounting, increased penalties for fraud, provided protection for whistleblowers, required more transparency for insider stock sales and material events, and reduced conflicts of interest in corporate governance.
But these benefits came with enormous red tape. Section 404 of Sarbanes-Oxley imposed an intrusive audit regime on almost every aspect of a public company’s operation. This has proved to be one of the most costly and counterproductive regulations ever introduced, with compliance adding about $2 million in annual costs for the smallest public companies and far more for bigger companies.
Section 404 audits focus on minute operational details, not on detecting the kind of high-level accounting fraud that took WorldCom down. The costs Section 404 imposes have disproportionately affected small public companies and discouraged many promising venture-capital-backed enterprises from going public. Section 404 has also prompted some public companies to delist and revert to private ownership.
Combined with the impact of mergers, acquisitions and corporate failures, Sarbanes-Oxley has dramatically reduced the number of public company investment opportunities in the U.S. In 1996 there were 7,322 public companies listed on U.S. stock exchanges; today there are 3,671. With fewer initial public offerings, powerful incumbent firms have raised barriers to new entrepreneurship and made it harder for competing startups to raise funding, tamping down innovation.
Before Sarbanes-Oxley, young companies on the path to an IPO could remain entrepreneurial and nimble. But the law created massive disincentives to seeking capital from public markets. Instead of going public and accepting the huge costs of SOX compliance, young companies increasingly sought acquisition by other larger public or private businesses. Many startups chose to stay private in the portfolios of venture-capital and private-equity firms.
Wall Street and the capital markets also adjusted to the law. Investment banks redirected resources into originating, structuring and trading real-estate mortgage debt, which helped create the financial excesses that nearly sank the economy in 2007-08. Investment dollars increasingly fled from public markets, finding their way instead into private equity and venture capital firms.
By reducing investment opportunities for middle-class Americans, Sarbanes-Oxley had the unexpected consequence of exacerbating wealth inequality. The world of venture capital and private equity is an exclusive club for the rich, while the public markets cater to diverse investors — both affluent and of modest means. When companies went public earlier in their lifetimes, employees and average investors had more opportunities to build wealth.
The share of wealth owned by the top 1% of Americans has surged over the last generation in part because those not already at the top have been increasingly shut out of the wealth-creation process. To redress this growing wealth disparity and invigorate entrepreneurial dynamism in the U.S. economy and capital markets, Congress can take some fairly simple legislative action.
The 1930s provide a model to correct excessive or incomplete legislation. When the deficiencies of the Securities Act of 1933 — also passed after a market crash — revealed themselves, Congress went back and passed the Securities Exchange Act of 1934, which has proved both durable and effective. The current Congress can fix Section 404 by making its audit mandates on internal company controls voluntary, while keeping the bulk of Sarbanes-Oxley’s less costly regulations intact. Companies should be responsible for ensuring the integrity of their own operational, financial and accounting information, with full disclosure to the Securities and Exchange Commission in annual reports.
A scaled back Sarbanes-Oxley — SOX 2.0 — would serve as a complement to tax reform, reducing government involvement in decisions about how to allocate corporate resources and returning that function to shareholders and managers. It would help the American economy grow and U.S. companies become more competitive abroad. Perhaps most important, it would spur innovation from more startup IPOs, which would democratize capital markets and help restore a more equitable distribution of wealth.