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March 1, 2006

Those Sarbanes-Oxley Blues

My audit costs are rising
My D&O is due
My bottom line's falling more behind
I got the Sarbanes-Oxley blues

Board of directors resigning
My auditor's front page news
My CFO's calling in from Rio
I got the Sarbanes-Oxley blues

Thus go the first two stanzas of “The Sarbanes-Oxley Blues,” a hilarious “festive audio” holiday musical lament from Headwaters MB, the Denver merchant bank for middle-market players. Like every good spoof, this one is grounded in truth. Many companies, both public and private, have got the blues.

The Sarbanes-Oxley Act of 2002 (SOX) set high standards for corporate accountability and financial reporting. Among other things, all financial reports for publicly owned companies must include a separate report on internal controls. This shows that the numbers are accurate and that the company has confidence in the reports because necessary and rigorously proven controls are in place.

That was the idea, anyway, and with CEOs and CFOs now required to certify their financial statements, tremendous care and caution have become the rule. So much so, that SOX and especially its controls provision, Section 404, have become something of a nightmare.

Like just about everyone else, I agree that significant change was necessary to bolster the integrity of financial reporting by publicly owned companies and bring a stronger sense of security back to our financial markets. What concerns me now, however, is that the pendulum has swung so far in the direction of Puritanical rigidity that real damage is being done to the structure of U.S. corporate governance.

Many observers of SOX cite the out-of-pocket cost of compliance as a major issue. That's because the extensive and often redundant reporting and verification procedures have added an average of $4.3 million to internal costs and auditors' fees for a broad range of public companies, or so the U.S. Chamber of Commerce computes.

But to me, the far more damaging aspects of SOX are on people and the kinds of normal, legal and beneficial business relationships that make business better. We now live in an era where hugely compensated independent auditors refuse to offer accounting advice and counsel because of concern about their own liability under SOX, and because the very act of asking the question might be taken as proof that the company lacks sufficient internal financial reporting firepower.

We now live in an era where companies, paralyzed by the potential for SOX-related complications, are rendered wholly risk-averse and postpone or even abandon needed business decisions. Some companies have gone private rather than continue to live with SOX. Excellent corporate officers and directors have resigned because they find SOX-related requirements onerous and because the tone and tenor of SOX-related accounting presumes wrongdoing, as if management is guilty until proven innocent. It has become far too difficult to recruit talented individuals to be directors because of SOX.

This surely was not the intent of Congress in passing the Sarbanes-Oxley Act.

MSCI applauds the many moves afoot to bring a sense of balance and sanity back to sound corporate governance and financial reporting. Standards need to be clarified, and the chilling effect on reasonable discourse between companies and their auditors must be removed.

Huge scandals made it necessary for the government to act, but the unanticipated consequences of its actions led to the Sarbanes-Oxley Blues. It's time to compose a new song that all of us, harmoniously, can sing.