The Sarbanes-Oxley Act
Raising the Standards for Corporate Accountability
by Barry Koestler and Joseph Petrelli, Jr.
On Thursday, February 19, 2004, Barry Koestler and Joe Petrelli, Jr. represented Demotech, Inc. at a Columbus Society of Financial Analysts breakfast meeting at the Blackwell at The Ohio State University. At this meeting, Congressman Mike Oxley, Chairman of the House Committee on Financial Services, and Mr. Bill Gradison, Member of the Public Company Accounting Oversight Board, spoke regarding the development of the Sarbanes-Oxley Act, which established stronger protections for investors in response to corporate accounting scandals, and its impact on corporate responsibility and investor confidence.
Congressman Mike Oxley
Congressman Oxley represents Ohio's Fourth District in the United States House of Representatives. He is the Chairman of the House Committee on Financial Services and leads 70 members on the committee, the second largest in the House. The Committee on Financial Services oversees the insurance industry, Wall Street, banks, monetary policy, and housing, and was the first to hold hearings on the financial fraud at Enron, WorldCom, and some of the other companies currently undergoing accounting issues.
As the co-author of the landmark Sarbanes-Oxley Act, Congressman Oxley began his discussion by clarifying for the audience that his first name was in fact not Sarbanes, as many people have assumed. He then proceeded to briefly describe the scenario that led to the passage of the well-known Act.
The Beginning of the Sarbanes-Oxley Act
The Sarbanes-Oxley Act was a direct result of Enron and the accounting scandal that was unearthed. The first hearing took place in December of 2001, with the Securities and Exchange Commission, Arthur Andersen, and Enron. The abrupt failure of Enron and the financial deceit that was uncovered quickly brought corporate accountability to the public's attention. Enron was the first in a string of extremely large organizations that had major accounting scandals exposed publicly.
President Bush's Response and Ten-Point Plan
In March of 2002, in response to these scandals, President Bush outlined a plan to improve corporate responsibility and restore investor confidence.
President Bush's Ten-Point Plan:
Each investor should have quarterly access to the information needed to judge a firm's financial performance, condition, and risks
Each investor should have prompt access to critical information
CEOs should personally vouch for the veracity, timeliness, and fairness of their companies' public disclosures, including their financial statements
CEOs or other officers should not be allowed to profit from erroneous financial statements
CEOs or other officers who clearly abuse their power should lose their right to serve in any corporate leadership positions
Corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain
Investors should have complete confidence in the independence and integrity of companies' auditors
An independent regulatory board should ensure that the accounting profession is held to the highest ethical standards
The authors of accounting standards must be responsive to the needs of investors
Firms' accounting systems should be compared with best practices, not simply against minimum standards
In July of 2002, the President called on Congress to grant the Administration increased powers to enforce corporate responsibility and to improve oversight of corporate America. The President presented a mandate for a bill to be drafted prior to the August recess.
Due to the extremely aggressive time frame, the Committee was motivated to eliminate partisan political debate. The majority of the Act was drafted in 72 hours in what Mr. Oxley referred to as a truly bi-partisan effort and an under-rated story in American politics. On July 30, 2002, the President signed the Sarbanes-Oxley Act of 2002.
Congressman Oxley feels that "9 or 9 and a quarter" of the ten points were addressed. The Act serves to federalize the auditing profession with sweeping changes to corporate accountability and reporting. The Sarbanes-Oxley Act addressed issues regarding auditor independence, accountability of officers and directors, timeliness and quality of financial reports, and created the Public Company Accounting Oversight Board (PCAOB).
In October of 2002, Bill Gradison was appointed by the Securities and Exchange Commission to a two-year term as a founding Member of the PCAOB. Mr. Gradison held elective offices for over thirty years and was president of the Health Insurance Association of America for six years. During his eighteen years in Congress, Mr. Gradison was a ranking member of the House Budget Committee and the Health Subcommittee of the Committee on Ways and Means.
The Long-Term Impact of Sarbanes-Oxley
Mr. Gradison began his remarks by stating that he feels that Sarbanes-Oxley is a clear example of cross-party coordination focusing on public interest. Cutting to the heart of the Act, Mr. Gradison explained that the basic intent is the auditing of auditors.
The Public Company Accounting Oversight Board as an Extension of Sarbanes-Oxley
The PCAOB is a private-sector, non-profit corporation, created by the Sarbanes-Oxley Act of 2002, to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports. This oversight includes the registration of domestic auditors and the detailed inspection of those auditors who audit a large number of public companies. The inspections include viewing the home office from the top and also a look at individual engagements. Substantial violations that are uncovered are then passed on to the Justice Department or the Securities and Exchange Commission.
The Impact of Sarbanes-Oxley, Now and in the Future
Mr. Gradison spoke briefly as to the success this increased scrutiny has produced since the Act's passage. Mr. Gradison was forthright in admitting that the number of income restatements has increased in the short-term. However, these restatements have shown signs of decreasing in the long-run. Furthermore, the Act has influenced a number of markets beyond the U.S. and has influenced the adoption of similarly purposed rules and regulations in foreign markets. This is partially due to dual-listing on international stock exchanges.
Furthermore, Mr. Gradison feels that as auditing standards improve, non-public and not-for-profit companies may adopt the higher standards due to lender requirements and as the higher expectations become the standard. This passive requirement will improve the universal adoption of these standards even for organizations that are not currently legally required to comply.
The Audience's Reply
After Mr. Gradison finished his comments, questions were received from the audience.
Mutual Fund Fees
One of the first topics raised by the audience dealt with the public outcry for more transparency as to the fees and practices of mutual funds. Mr. Oxley acknowledged the importance of this topic to the 95% of Americans who own mutual funds. He responded that the House had already passed a bill and the Senate was assessing it, while the SEC was promulgating regulations. Both the SEC and the House were pushing for the transparency of fees and the examination of trading practices that might favor large institutions.
Sarbanes-Oxley and Not-For-Profit
The next question had to do with the extension of Sarbanes-Oxley to the not-for-profit sector. Congressman Oxley stated that there was currently no intention to push the Act in that direction, as problems did not seem to be as prevalent. He also reiterated that some voluntary adoption has begun occurring as the not-for-profit organizations do not want to be caught later having to comply and also due to the fact that many of the boards of these organizations are comprised of people subject to and familiar with Sarbanes-Oxley through other corporate experience.
Fees and Costs Associated with Sarbanes-Oxley
According to Ventana Research, an organization will incur an average cost of $700,000 on IT consulting and software for the first year of compliance with the Sarbanes-Oxley Act, section 404. AMR Research estimated that $2.5 million was spent on average by Fortune 1000 companies on Sarbanes-Oxley compliance tools in 2003. There is little doubt that compliance will be expensive and the final question of the session focused on this hot-button topic regarding fees associated with Sarbanes-Oxley compliance.
Congressman Oxley admitted that compliance will be costly. However, he believes that the initial expense should be largely one-time and that some validation of effort has already been reported. He also added that increased investor confidence should drive higher valuations and that the latest market growth should be more stable because of the strength of investor confidence, which underlies the growth. Furthermore, Congressman Oxley suggested that in the long-run, the financial figures that auditors rely on will be presented with greater accuracy and certainty, which reduces auditing costs to a degree.
This concluded the Columbus Society of Financial Analysts meeting.
Oxley-Baker Plan and the Insurance Industry
Congressman Oxley's name has been frequently highlighted recently in insurance publications in regards to the Oxley-Baker 'Standards' Plan. This Plan attempts to develop standards for federal involvement in insurance regulation. Mr. Oxley is proposing a federal-state advisory council made up equally of state commissioners and appointees of the Treasury, SEC, and Federal Reserve. He contends that this council will, "make all this work, and coordinate future discussions over insurance tax policy and federal-state uniformity issues." This coordination between federal and state reflects the experience states have with insurance regulation and if not coordinated properly, federal action could have unintended consequences.
The insurance industry has responded coldly to applying Sarbanes-Oxley requirements on the grounds that the already heavily regulated insurance industry should not be subjected to the costly restrictions imposed by the Act. Ultimately, the potential outcome for additional, federally imposed reporting requirements is unclear and the direction will be influenced by the impact of Sarbanes-Oxley, with results that are just beginning to be observed.
Barry J. Koestler II, CFA is a Senior Financial Analyst and Chief Ratings Officer at Demotech, Inc.
Joseph L. Petrelli, Jr. is a Senior Consultant at Demotech, Inc. Mr. Petrelli has earned a Masters of Business Administration from Duke University, the Fuqua School of Business.
For nearly 20 years Demotech, Inc., a Columbus, OH based financial analysis and actuarial consulting firm, has been serving clients throughout the insurance industry. Demotech offers a variety of services including actuarial opinions and pricing assistance, strategic market and product evaluations and analysis, state filings assistance, as well as financial valuations. Demotech was the first company to have its rating process formally reviewed and accepted by Fannie Mae, Freddie Mac, and HUD. Since 1989, Demotech's Financial Stability Ratings'® have provided an independent opinion on the financial stability of property and casualty insurers and title insurance underwriters.