A tremendously costly law: Sarbanes-Oxley, three years after its unfortunate passage.

Early this year, an unusual full-page ad appeared in the Wall Street Journal and other financial newspapers. The ad attempted to refute claims from businessmen about the costs imposed by the mandates of the Sarbanes-Oxley Act, the "corporate reform" law Congress passed in 2002 after accounting scandals hit Enron, Worldcom, and other companies. Yes, procedures stemming from that law "are neither simple nor inexpensive," the ad said, but the costs are well worth it if the result is restored investor confidence. "The [law's] greater goal and promise," the ad proclaimed, "is that the rigorous demands of compliance can lay the groundwork for improved and more reliable financial reporting, leading to a higher level of public trust."

The ad's message itself was not unusual; it mirrored the standard response the law's defenders give to complaints about cost. A Washington Post editorial intoned, "The nation's corporate chieftains ... complain about the cost of this new regulation, not pausing to mention the cost of Enron-type scandals." But what this newspaper ad shows is that not all corporate chieftains oppose this law. The expensive ad was not paid for by a pension fund or another group representing the investors the law was intended to serve: Its sponsor was, rather, PricewaterhouseCoopers, the multibillion-dollar accounting firm making a bundle in fees for doing all the audits the law has ended up requiring of business. By creating so many hurdles for public companies, the law has birthed a golden goose for those who audit them. And ironically, despite the media and legislative clamor to "get" the big accounting firms after Enron imploded, it's the Big Four accounting firms that have turned out to be the big winners from Sarbanes-Oxley.

THE BIG FOUR VS. AMERICA

"Auditors who lost their jobs when Arthur Andersen folded in the wake of the Enron scandal now find themselves up to their ears in work ... auditing local businesses that are racing to meet Sarbanes-Oxley regulations," the San Jose Mercury News reported in December. According to Business Week, PricewaterhouseCoopers has hired more than 1,600 new auditors and 400 temps from English-speaking lands to perform the extensive audits of businesses. The Big Four are hiring big-time, and have stepped up their recruiting efforts on college campuses: BusinessWeek says KPMG has upped its college recruitment by 40 percent in the last two years. Accounting is now a hot major. A headline in the magazine Practical Accountant summed up the accounting frenzy: "Cash in on Sarbanes-Oxley; reform unleashed a plethora of new and varied engagement opportunities."

But what's good for the Big Four isn't necessarily good for America. Other businesses, and ultimately the economy as a whole, are footing the bill for this regulation-driven auditing boom. Mounting evidence shows that the accounting-industry growth generated by Sarbanes-Oxley is coming at the expense of productivity, new jobs, and innovation in the general business world. A survey by Korn/Ferry International found that the law cost Fortune 1000 companies an average of $5.1 million in compliance expenses last year. For middle-market public companies, the law firm Foley & Lardner found that the act has increased the "cost of being public"--everything from audit fees to director insurance--by 130 percent. Substantial man-hours have also been diverted to Sarbanes-Oxley from other, more productive tasks. The industry group Financial Executives International found that the average firm was spending at least 30,700 man-hours a year on compliance with this law. As a result, a number of small U.S. and big foreign firms are rushing to deregister from U.S. stock exchanges--a blow to the U.S. capital markets, and, in turn, to the smaller U.S. companies that depend on these capital markets for financing.

Still, despite business complaints, the administration and the congressional majority--who have other critics, ones accusing them of wanting to repeal the New Deal--show no signs of willingness to scale back what has been called the greatest expansion of federal corporate law since FDR. Congress passed Sarbanes-Oxley less than a month after Worldcom announced it was in serious trouble; it was also six months after Enron's bankruptcy, and three months before the 2002 midterm elections. The Senate, then under Democratic control, had crafted a sweeping corporate overhaul bill by Sen. Paul Sarbanes, Democrat of Maryland. The House had passed a more modest bill by House Financial Services Committee chairman Mike Oxley, Republican of Ohio. When Worldcom announced the earnings restatement that would lead to its bankruptcy, the Bush administration and congressional Republicans went into crisis mode and approved Sarbanes's bill with very minor changes; about the only thing the House Republicans added to the final bill was a provision increasing the jail terms for those convicted of corporate wrongdoing. The bill passed the Senate 99-0, and the House approved it with only three members voting no.

The final product, the Sarbanes-Oxley Act, goes against a 30-year trend of general economic deregulation under Republican and Democratic presidents. It undermines federalism, by going where the federal government has never gone before in areas of corporation law that had long been provinces of the states; UCLA law professor Stephen Bainbridge wrote in Regulation magazine that the act has ushered in "the creeping federalization of corporate law." It regulates the structure and functions of boards of directors, and prescribes the duties of specific employees and board members. Intentionally or unintentionally, the law takes a significant step toward the longtime goal of Ralph Nader and other leftists: federal chartering of corporations. Environmental and labor activists are looking at ways to use the law to launch "shareholder complaints" to force companies to bend to their agenda. As William Greider Mr. Berlau is the Warren T. Brookes journalism fellow at the Competitive Enterprise Institute, noted approvingly in a recent cover article in The Nation, this new leftist "reform impulse is different because it seeks to change the system from within, using workers' capital as the driving wedge."

Oxley and the administration are standing firmly behind the law and seem opposed to significant changes in it. When I recently asked Oxley's office for his current views on the law, I was referred to remarks he made early last year at an event with Sarbanes at Washington's National Press Club, in which he said that "the objective ways that you measure this seems to me on the positive side," and that the market had gotten better since the law was passed. As for compliance costs, he said, they "pale in comparison to the costs of corporate fraud that could have occurred without this legislation." Treasury secretary John Snow in a recent Business Week interview praised Sarbanes-Oxley as "critically important legislation" and said Congress didn't need to modify the law.

Meanwhile, the law is fulfilling its promise to create, in President Bush's words at the signing ceremony, "the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt." Indeed, one section of the law threatens to become the most extensive day-to-day regulation of American business since FDR's National Industrial Recovery Act, the price-and-output regulatory scheme struck down by a unanimous Supreme Court in 1935. Just as the NIRA created industry boards that had to approve prices and output, Sarbanes-Oxley's Section 404 and its regulatory extensions mandate that the most minute bookkeeping practices have to be okayed by auditors.

PEEKABOO, WE SEE YOU

Section 404 requires that a business's executives sign off on the "internal controls" over financial statements and that the company's outside auditors "attest to" the soundness of these controls. The law also created the quasi-private Public Company Accounting Oversight Board to regulate accountants and set auditing standards. Although the Big Four initially opposed the tougher regulation this body would entail as well as the law's bans on consulting services that can be sold to an audit client, they quickly decided that having the board define "internal controls" as broadly as possible would likely more than make up for their losses. "We love the PCAOB and we love Section 404, especially given the other regulations in the law that affect us," says a staffer in the Washington, D.C., office of a Big Four firm.

The PCAOB, non-affectionately referred to as "Peekaboo" by many in the companies that are under its thumb, gave the accountants what they wanted: Last March, it defined internal controls as "controls over all relevant financial statement assertions related to all significant accounts and disclosures in the financial statements." It also defined the law's phrase "attestation" as a full-blown audit of each of these controls, just as the company's numbers have traditionaily been audited. In practice, this means that such things as the technology used to derive accounting numbers must be audited every year by the accountants. The board states that "the nature and characteristics of a company's use of information technology in its information system affect the company's internal control over financial reporting." This passage alarms public-company tech employees, because no technology is perfect, and even knowledgeable techies disagree about which is the best software. One public company's chief financial officer says this could mean that an auditor could label a computer with Windows 97, rather than an updated version, a bad internal control.

Daniel Goelzer, a member of the PCAOB, says this isn't likely: "I can't offhand think of a way that using an old version of Windows would make it more likely that your financial statements would be inaccurate." But he adds, "Maybe if there's something about the way that your Windows 95 interacted with the rest of the accounting software at a particular company, maybe it's conceivable." It's really up to the judgment of the individual auditor to decide whether a control passes muster, he says. "We have definitions, but I would certainly say to you that applying those definitions to a particular company requires judgment. That's why auditing's a profession, not a trade."

Yet it's a profession that the law is turning into a mini-regulator. And it's troubling when auditors have the power to second-guess management's best judgment on matters like technology, particularly when this power is combined with other parts of the law requiring "material weaknesses" discovered by auditors to be disclosed to shareholders and establishing criminal penalties for "willfully" disregarding proper accounting procedures. If management, which presumably knows the company better than anyone, has to go against its judgment of what's best to please an auditor, shareholders could lose out as well. And with every new business venture, there's a whole new set of internal controls. This could lead to a slowdown in business investment.

As if all this weren't enough for businesses to cope with, a whole bunch of interest groups now have their own definitions of "internal controls" they want to have imposed. The Oakland-based Rose Foundation for Communities and the Environment has called on the PCAOB to mandate that "independent auditors include reviewing the financial impacts of environmental conditions and environmental liabilities as part of their scope."

Many companies are hurrying to escape Sarbanes-Oxley by leaving the stock exchanges: According to a Wharton study, 198 American companies deregistered from exchanges in 2003, the year after the law was passed--nearly triple the number that deregistered in 2002. Prominent European firms, such as Siemens, are also considering pulling their U.S. listing because of the law. In 2004, the New York Stock Exchange had only ten new foreign listings.

This is clearly a threat to overall economic vitality. Alfred C. Eckert III, CEO of the GSC Partners investment firm, also worries that both Section 404 and the law's mandates for boards of directors will lead to the "bureaucratization" of large American firms: "We're going to have people who are much more bureaucratic ... and who are frightened and will react in always the most conservative course and will rely on process dictated by lawyers rather than good business judgment." Eckert warns that if Bush and Congress ignore these effects of Sarbanes-Oxley, Bush's planned tax and Social Security reforms will not come to full fruition. "[Sarbanes-Oxley] will make capital more expensive and lower the rate of growth of America. It's very simple."