Sarbanes - Oxley

Time to move on to a subject that is consuming the professional life of myself and others like me. The Feb. 10 edition of the Wall Street Journal ran an article that the head of the SEC, William Donaldson, was starting to moderate his position on certain reforms for public companies including the new internal control rules that evolved from the Sarbanes-Oxley Act. The article then went on to hardly mention this area, which points at two problems. As we near the first annual filing date for our largest corporations we are about to find out just how much trouble they are having meeting these rules, and secondly the Commission really does not know how to set these rules in terms of their cost and reward.

This problem may become the problem of all of us who invest heavily in stocks for our retirements. While the SEC has been making cheerleading statements for the past 6+ months on the state of these efforts raising investor expectations, the fact is that almost 700 companies have reported finding major weaknesses in their control systems through the end of the year. Is this the tip of the iceberg? As the these Annual Reports on Form 10-K, with their auditor and management reports on internal control, start to flow out in late March and through April we should focus our attention on the smaller companies involved in this reporting cycle. When we look at the reports of the accelerated filers ( greater than $75MM market capitalization), what I expect we will find is that as we get closer to the bottem end of the company size range the percentage of companies with reportable weakness will go up dramatically.

The truth is that we probably should not be that concerned. We cannot legislate away criminal behavior completely. Bad people will find ways to do bad things, and people under extreme financial pressure will sometimes turn to fraud and stealing in an effort to resolve their problems. The fact that the cookie jar is being watched through internal auditing will deter a certain percentage of those who might commit embezzelment and fraud, but the most commited and innovative will still find a way.

The second truth is that the internal contol efforts of Sarbanes-Oxley are more likely to focus in and deter the smaller frauds and embezzelments. In the major Enron and Worldcom type frauds, there was much colusion amoung officers and this is nearly impossible to stop. Much of the money defrauded came from investors outside the company and was the product of inflated stock prices. These types of massive stock frauds can only be perpetrated at the largest of companies. The smaller the company, the smaller the reward and economic damage.

The current average cost for compliance now exceeds $2,000,000 per company. If an experienced executive was deciciding the value of this insurance premium in relation to the potential for fraud, these amounts would probably never be paid. As we start to look at the results we have produce in our first efforts, it is time for Mr. Donaldson and the SEC to step up and show some leadership. It is time to slow this train down and evaluate what we have received for our time and money.