Corporate Governance

The SEC and the Costs of SOX: A Section 404 Survey

By J. Robert Brown

SOX was adopted in the aftermath of Enron and Worldcom.  When the law came out, the knives were unsheathed and the criticism rampant.  Plenty of pundits and academics purported to quantify the costs of SOX and find that the costs more than outweighed the benefits.  Most of these purported attacks were at best premature and at worst wrong.  For an analysis of this critics, see Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance. 

There was no provision that received more vituperative criticism than Section 404(b).  Section 404(b) required the outside auditors to "attest" to the assessment by management (required by 404(a)) of the company's internal controls.  Section 404 essentially required outsiders to assess the system of internal controls implemented by management.  This did not make managers happy.  In addition, however, the provision conincided with an increase in auditor fees.  As a result, it was a relatively easy matter to quantify increases in fees and lay them at the doorstep of SOX. 

The attempts to attribute increases in auditor costs to Section 404(b) were way off the mark.  Auditor fees increased in part because of the changed enviornment after Enron and the heightened risk of liability.  In other words, some of the increase had nothing to do with SOX and would have happened anyway.  They also increased because auditing fees in a pre-SOX era were subsidized by consulting fees.  Once SOX essentially separated audting and consulting functions, the auditing fees increased to reflect the lost subsidy.  In that case, the increase may have been related to SOX but had nothing to do with Section 404.

Section 404 did increase costs.  It was an extra service that had to be paid for.  In addition, there was a concern that auditing firms took the opportunity to bulk up on hours (and fees) in performing the service, a matter of opportunity rather than necessity.  Nonetheless, those criticizing the Act rarely noted that Section 404(b) was at best responsible for only a portion of the increase.  

We don't hear much about Section 404(b) anymore.  The SEC took some of the pressure off by exempting for a time smaller companies (non-accelerated filers).  Moreover, accounting firms got better (and presumably more efficient) at performing the service.  Anecdotal evidence also suggests that software and other forms of increased efficiency have been utilized.  Mostly, though, with the current financial crisis taking place, critics have a much harder time taking the position that whatever the costs, they outweigh the benefits.  This crisis has emphasized that there is a need for greater oversight by gatekeepers, not less.

We give all of this background because we noted that the SEC is conducting a survey on the costs associated with Section 404.  The survey can be found here.  The survey notes that all "companies with experience in complying with 404 rules are invited to participate."  Perhaps the SEC would also like to hear from non-companies about the perceived benefits of the attestation.  In any event, whatever the costs, we have little doubt that under this Commission, the benefits of the provision will outweigh the costs.

Full post as published by The Race to the Bottom on March 06, 2009 (boomark / email).