Unintended consequences: it was meant to help, but Sarbox is wreaking havoc on the bottom line. Will CEOs take it laying down--or push back?

To the architects of the Sarbanes-Oxley Act, the sweeping reform was a quick cure-all for what was ailing Corporate America's moral structure. But as public companies struggled to get their hands around compliance, and particularly onerous Section 404 requirements by the December deadline, they've shelled out millions of dollars to auditors, accountants and consultants. There seems little argument that the pendulum has swung too far.

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With chief executives now personally accountable for every uncrossed "t", they've been challenged to design new ways of managing their companies information flows so that they have a private window into all that goes on. That might be a good thing--assuming it's possible. But while legislation that forces companies to pay more attention to potential malfeasance is certainly positive, most CEOs view Sarbox as a hastily written, poorly conceived law that will have years, if not decades, of unintended consequences for U.S. companies.

The overhaul has proved particularly painful for those CEOs who believe they already had sufficient checks and balances in place, and are now finding that the everyday added compliance demands are draining corporate coffers and CEOs' time, causing U.S. companies to hunker down in defensive, risk-averse mode at the worst possible time. In other words, CEOs agreed at a roundtable, reform is good--but the very legislation that aimed to protect shareholders now stands to harm them. "We're out of balance," said Pat Russo, CEO of Lucent Technologies, "and there is an ultimate price we'll pay for staying out of balance."

Part of that will be the literal price tag--the enormous cost of compliance, which is taking a huge bite out of companies' bottom lines. Eugene McGrath, CEO of New York utility Con Edison, said Sarbox cost $2 million to $3 million to the bottom line "just to pay the extra accountants and all the attorneys to watch over everything we did." He added that, on a more positive note, the company's stakeholders will have assurance that the company is run ethically.

But will that justify the 1 to 2 percent off the bottom line for the investor? Not necessarily. "The costs so far outweigh the benefits. It's unreal," said Robert Ashe, CEO of business intelligence solutions company Cognos, which sponsored the roundtable. "The things that the auditors are doing are just unbelievable."

In the new world of hyper-regulation, it will be auditors, not shareholders, who profit most--and auditors are fully aware of their advantage. "They are gouging," said Al Fasola, director at cable company RCN. "They're getting higher returns from every individual in the firm at a time when they're risk-managing their way out of the accounts that may cause them legal briefs in the future. They're reaping a huge windfall."

Meanwhile, as expenses mount, companies are losing productivity to the compliance grind. "There's the lost opportunity of spending time on doing a deal with a customer so I can generate value versus spending time on internal, process-oriented issues," said Russo, who calculates that she spends at least half a day at each quarter's end with finance specialists, lawyers and binders full of certifications. And that's not counting the unexpected time-draining events, such as one long, drawn out tug-of-war Russo recalled having with Lucent's accounting firm about a matter that should never have been on her calendar. "It was a month's worth of time," she said.

For Con Edison, the focus on compliance is such a strain, it could put future growth at risk. "Prior to Sarbanes-Oxley, our people were working 80 or 100 hours a week," said McGrath. "So Sarbanes-Oxley comes along and I think the big management issue for us is, How do we manage Sarbanes-Oxley and not take our eye off the ball and get into real trouble with the business?"

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That is a challenge on multiple fronts. First, the new obsession with rules and regulations is creating a culture more of avoidance and fear than of entrepreneurial ingenuity. "The reason the United States industry has been successful is we've been aggressive," said Donald Nigbor, chief executive of Benchmark Electronics, a service provider and electronics manufacturer. "We've taken risks; we've gone out and promoted new technologies; we've done all these things over the years, and now we're pulling back." That hunker-down mentality, he added, is taking root at the board level, filtering down through the organization, and it will inevitably harm U.S. competitiveness on a global level. "There's a particular danger right now, because the offshore competition American companies are facing is building to a crescendo, a peak, just when we're becoming more timid," Nigbor said. "Sarbanes-Oxley is making every U.S. company more timid, less aggressive."

Sarbox Could Harm Job Growth

Boards in the U.S., in particular, have become risk-averse, in part because of the influence of regulators. "There's an intimidation going on," said Walter LeCroy, chairman of LeCroy Corp., a manufacturer of electronic wave-shape analysis tools. "The boards are being intimidated by the accounting firms, and you just need to attend some of their sessions," he said. "I'll be honest with you, after I attended, I wasn't sure I wanted to be on my own board. They scare the hell out of people."

Wary of doing anything to rouse the ire of an Eliot Spitzer, boards are clamping down on growth moves such as acquisitions. Job growth overall will suffer as a result. "People aren't hiring as many people. They are being more cautious about everything they do," said Nigbor. "So how do you measure that? How do you go in there and ask, 'How many jobs are lost because of Sarbanes-Oxley?'"

And how, for that matter, do you measure the impact on the existing work force? Harold Yoh, CEO of diversified managed services firm Day & Zimmermann, suggested that intense dissatisfaction will plague employees at public companies. "And when you have a frustrated employee, you have one who is not going to be as motivated or as freethinking to come up with a better solution," said Yoh, noting that his private company has been affected because public company customers have stalled projects. "That frustration or de-motivation," he added, "leads to not being in the game as much. If you're frustrated, you're not in the game."

Those frustrated employees may not want to stick around when and if the job market improves. "All of our employees are kind of ready to leave after four years of being frozen, doing extra work and being asked to do more," said Barry Siegel, president of Recruitment Enhancement Services. "Now, all of a sudden, Big Brother is watching them, and they're going to think it's greener on the other side of the street. They're going to look for other positions where they think they won't be watched as much. They can certainly go into the private sector."

Dreaming of Going Private

Rather than wade knee-deep in Sarbox paperwork or languish on the open market, many small or midsize companies already have gone private since the new regulation went into effect. And that's just a taste of what's to come, assuming the current regulations stay in effect, CEOs agreed. "You're just going to see an awful lot of smaller public companies that are going private, point blank and simple," said Maurice Taylor, CEO of wheel-maker Titan International.

Even big companies are fantasizing about the shelter of private life. "I've talked with a number of CFOs from companies listed on the [NYSE] who have said to me, 'If I could easily figure out how to de-list and get off, I'd get off in a heartbeat,'" said Lucent's Russo. "Those are big, reputable companies we want listed on the exchanges in this country."

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For those opting to stay in the public market--and a mass exodus seems unlikely--the toll will continue to mount. Some CEOs will attempt to gain a business advantage or a return from the investment so that all is not wasted. For example, Cognos' Ashe noted, one way to leverage more control in terms of management oversight will be to implement more sophisticated tools, such as workflow-based software, document planning systems and transaction controls; those tools will greatly improve CEO visibility into the organization for a number of other purposes.

John Joyce, senior vice president of IBM Global Services and formerly CFO of the computing giant, explained that the company's investment in standardized systems prior to Sarbanes-Oxley made it much easier to comply. "It was painful, as it was for all of us, with 404, but it was not as bad as we thought because we had so many standardized processes," he said. "So now that we've done 404, and we have this information, it's, 'Can we glean business insight from the information that's flowing?' We're obviously going to know more of the details of what's going on at the end of the supply chain. We now have this information, and the question is now, what can we do with it to help run the company better?"

That's a bit rosy for some corporate leaders who feel that in the current climate, CEOs resigning themselves to making lemonade would be a deadly passive move. Even obeying the rules won't keep a CEO out of trouble, they argued. "You get an Eliot Spitzer, and a well-run company, and if the timing is right, the company is just in trouble and becomes a target," said LeCroy. "So I believe that if business just says, 'Well, we've been dealt a tough hand, but we're going to make the best of it'--if that's our whole reaction to this thing, we're in trouble. I think we need to find some way to push back and convey the message that this is not fair; it's not good for the country."

The question remains, How do we get that message across? "How do we collect this experience--what's good about it, what's bad about it, agree on what's bad about it, get into the political process in a way that they understand why correcting it is in their interest," posed McGrath. "If we don't do all of those things, we're going to be sitting here next year and talking about it too."

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Some CEOs, like Ashe, believe that with the 404 compliance date having only just passed, it was still too soon to tally the costs and benefits, or to sort out the impact. "There's a lot of learning we're going to accumulate in the next 90 to 120 days, as we find out what the compliance level is," said Ashe, adding that Ernst & Young has estimated a possible 50 percent noncompliance rate for 404. "If it is 50 percent noncompliance, nobody's going to care about 404. If it's 10 percent noncompliance, people are going to care, because those companies are going to be called out."

Regardless of 404 compliance, what shareholders will be crying about is the diminishing rate of return, predicted Patrick Murray, chairman of Dresser. "When people look at the annual reports this year, and the amount of cost that's been loaded into these businesses," he said, "I think it's going to be sooner rather than later that there's a backlash."

One final devilish twist from 404: Auditors have to issue their opinion of a company's internal controls and whether they can anticipate future misdeeds. If the auditors issue a "qualified opinion," meaning they have some concerns about a company's controls, those companies could get pounded in the stock markets or have banks withdraw lines of credit. Depending on how many companies receive qualified opinions, it could be large enough to act as a damper on the overall financial markets.

Add it all up and it's not a reassuring picture: CEOs will take fewer risks and create fewer jobs at the very moment that global competitors are gearing up. They may postpone projects and their share prices could suffer, all while they are reducing their bottom lines to spend on compliance. When the full enormity of the costs of Sarbox sink in, the pendulum may well swing back--if CEOs are willing to give it a good, firm push.

RELATED ARTICLE: The Hidden Cost of Sarbox

* CEO time is wasted. Forced to spend days on compliance, they spend far less time with customers and looking ahead.

* Boards are scared. Good directors are afraid to serve; those who do are much less likely to approve strategic risk-taking by the CEO.

* Risk-taking is out. Just when companies around the world are becoming more aggressive, U.S. firms are hunkering down. Our timidity is their gain.

* Lower return to stakeholders. As more and more money is poured into compliance, less of it will make it to the bottom line--and even less into shareholder pockets.

* More companies will go private. Even private companies will be hurt by their public company customers' reluctance to engage.

* Bad decisions abound. To avoid auditor scrutiny, managers will take the path of least resistance, and make poor judgment calls in the process.