A pox on Sarbox: the unintended and rotten consequences of the Sarbanes-Oxley law

National Review, May 14, 2007 by Jim Manzi

AS a very young teenager on my first unsupervised afternoon in New York City, I promptly lost $10 playing three-card monte. Afterwards, I vowed that I'd never get pulled into this kind of rigged game again. I had learned an important lesson: Ignore what the dealer is saying and keep your eye on the money card. This can be a good strategy in other areas of life, too. Take, for example, the Sarbanes-Oxley law ("Sarbox")--a measure that claims to make the stock market safer, but actually has the effect of taking money from small investors and giving it to multimillionaires.

In 2002, on the heels of business scandals at Enron and WorldCom, Congress passed Sarbox to restore investor confidence in the integrity of U.S. public markets. Sarbox imposed a grab-bag of requirements on public companies--everything from criminal penalties for executives who willfully misreport financial results to restrictions on insider trading. Much of the energy behind this legislation was generated by the market meltdown that had eliminated about 50 percent of the value of the S&P 500 stock-market index in the 28 months leading up to the passage of the law. Asset bubbles are almost always followed by stricter regulation of markets. Human nature being what it is, bubbles in their later stages typically invite an abnormally high amount of fraud, and the resulting regulations are often excessively focused on preventing whatever particular flavors of malfeasance were most recently prevalent. Targeting wrongdoing is easy to understand, plays to our need to believe that somebody must be to blame for our sudden loss of wealth, and allows politicians to be seen doing something. Such regulations are usually produced very quickly, and often have effects that the authors never anticipated. The drafting and implementation of Sarbox is an excellent example of this dynamic.

NOT QUITE AS PLANNED

The most consequential component of Sarbox has turned out to be something that was not the subject of deep inquiry at the time: the "Section 404" requirement that companies specify, execute, and externally certify procedures for tracking and reporting financial results. The impact of this blandly written 168-word requirement, as subsequently interpreted by regulatory agencies and the accounting profession, is a classic example of the law of unintended consequences. According to the independent, bipartisan Committee on Capital Markets Regulation, Section 404 has driven the first-year cost of implementing Sarbox to about $15 to $20 billion, or more than 35 times what was estimated when the law was passed.

What are we getting for all that money? All else equal, more reliable financial reporting should lead to greater investor confidence and tend to increase stock values; on the other hand, all else equal, higher costs and the partial loss of management attention should tend to depress profits and therefore reduce values. Estimating the net effect is extremely difficult since it implicitly requires us to be able to know how investors would have valued companies in the absence of Sarbox. Partisans on both sides of the issue point to studies that purport to quantify the overall impact of the law, often with risible levels of asserted precision. Sarbox opponents often cite a University of Rochester study that estimates Sarbox has reduced total market capitalization by about $1.4 trillion due to net negative investor reaction. To put it in context, this is close to 10 percent of total U.S. GDP, which is pretty hard to imagine. Sarbox supporters cite an MIT study indicating that complying with Sarbox can reduce cost of capital by about a full percentage point. The author of this study, Ryan LaFond, was honest enough to admit: "I'm very comfortable saying there are some benefits, and they are economically meaningful. Whether they exceed the costs, I have no idea."

The root problem with all of these studies is that there is no objective, scientific way to know what stock prices should be. That's why we spend huge sums of money running stock markets. Of course, if you just ignore all of the complexities of real capital markets, Sarbox can be seen as a straightforward regulation that guarantees that "a dollar of net income is a dollar of net income." In this view, the argument that we should let the market sort out what is the right level of spending on internal controls and audits is like arguing that we should not prosecute a business that sells 15 rancid ounces of meat as a pound, and instead just let consumers decide which butchers they want to patronize.

It is true that there is a practical role in many spheres of life for regulations that reduce the costs that consumers bear to find what they want. Generally they are most appropriate for quantities, like weights, that can be defined unambiguously and assessed relatively cheaply, and for matters on which the result of misinformation can be catastrophic to health or physical safety. But this is nothing like the case with the evaluation of corporate performance. The appropriate measures for this are constantly debated; they are difficult and expensive; and they vary widely from one industry, time period, and company to another. In many of the most innovative sectors of the economy, the very accounting values, such as Net Income, that Sarbox is focused on validating are so useless that managers and owners simply ignore them when operating and valuing companies.