Sarbanes-Oxley Rules Get Reprieve in Subprime Mess

By Reuters -  |  Posted 2008-03-29

WASHINGTON (Reuters) - The Sarbanes-Oxley corporate reform law passed after the collapse of Enron Corp has been called every nasty name in Big Business's book: costly, burdensome, a bane to U.S. capital markets.

But now that investor confidence has again been shaken by market turmoil, calls to ease Sarbanes-Oxley have quieted as the regulatory pendulum swings again to reform.

Even at the U.S. Chamber of Commerce's annual conference on capital markets this week, there was a marked shift in tone from last year, when Sarbanes-Oxley was blamed for making U.S. markets less attractive to overseas investors.

"An increasing appreciation for the internal controls is emerging," Jim Turley, chief executive of accounting firm Ernst & Young ERNY.UL, said at the Chamber conference, where many of the pro-business speakers said there may be a need for more regulation.

"There's a global debate about what management should be saying about its controls."

The 2002 Sarbanes-Oxley law -- particularly its Section 404 -- was designed to beef up companies' internal controls over financial reporting and to make sure top executives are in the know on financial data. It also requires auditors to report on management's assessment and on the controls themselves.

In fact, the Sarbanes-Oxley disclosure requirements should have helped clarify one of the fundamental questions in the credit market meltdown: When did executives know the value of subprime mortgage-backed securities were actually much lower than what appeared on their companies' books?

"Many of these companies knew or should have known that housing prices don't just go up and up and up forever," said Larry Rittenberg, an accounting professor at the University of Wisconsin-Madison. "The companies did not have any financial controls in place to systematically test the values of these securities."

The lack of controls to test the values of subprime-linked securities was not a failure of Sarbanes-Oxley, he said, but a failure of companies to follow the spirit of the law.

While experts say it's tough to quantify the benefits of Sarbanes-Oxley in the current subprime mess, there's little doubt the market turmoil will lead to more regulation.

"There had been some ongoing talk that small companies may be exempted entirely from (Section) 404," said UCLA law professor Stephen Bainbridge. "Unfortunately, the mood on Capitol Hill in light of the subprime mortgage crisis is not going to be very deregulatory."

Senators John Kerry, a Democrat from Massachusetts, and Olympia Snowe, a Republican from Maine, have sought for some time to ease Section 404 requirements for small companies. They did not respond to requests for comment.


Many of Wall Street's previous complaints about Sarbanes-Oxley were rooted in the idea that it was "crisis legislation," said University of Tennessee law professor Joan Heminway, and did not get a thorough cost-benefit analysis.

Congress passed the corporate reform law followed a wave of book-cooking scandals capped by the 2001 collapse of former energy trader Enron. Lawmakers believed stricter disclosures would help restore investor confidence in the markets.

Company costs to comply with Sarbanes-Oxley were expected by lawmakers to drop significantly after the first year or two. But during the third year the law was in force for large companies, the average cost of complying with Section 404 was $2.9 million, according to Financial Executives International.

Business groups have repeatedly attacked Section 404 as costly, invasive and offering few tangible improvements to financial statements.

The U.S. Securities and Exchange Commission conceded this point to some extent. In July, the SEC relaxed the provision, saying companies and auditors could take a narrower approach to comply with Section 404 by focusing only on the riskiest internal controls.

In February, the SEC also proposed to delay for the fifth time the deadline for small companies to comply.

In light of the current suspicion that some banks, mortgage lenders and other companies failed to properly manage subprime-linked valuations on their books, there is little likelihood that Sarbanes-Oxley will be weakened.

"The typical political answer is to ratchet up regulation," Bainbridge said.

SEC enforcement director Linda Thomsen said heightened regulatory responses after market crises have had positive effects, namely increased corporate governance.

"There has been an accumulation of events, including Sarbanes-Oxley, that have led us to a place where boards are pretty well engaged," Thomsen said on the sidelines of the Chamber event.

(Reporting by Karey Wutkowski, editing by Gerald E. McCormick)