On 30 July 2002 the Sarbanes-Oxley Act (Public Company Accounting Reform And Investor Protection Act of 2002 abbreviated as SOX) was approved by the US Congress by a vote of 423-3 and by the Senate 99-0. In signing it into law President George W. Bush stated that it included “the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt” (Bumiller 2002). The act contains 11 sections including provision on the following issues:
The direct costs are considerable. A survey of the 224 largest public firms in the USA by Financial Executives International with regard to the direct costs of complying with Section 404 of the Sarbanes-Oxley Act estimates that the average first-year cost is almost $3 million for 26,000 h of internal work and 5,000 h of external work, plus additional audit fees of $823,200, or an increase of 53% (Zhang 2005). Although the direct cost tend to decrease over time, compliance costs still average $3 million per company and amount to 2–3% of revenues for small companies (The Economist, 21 May 2005). 2–3% is comparable to profit rates in many companies.
These direct cost estimates do not include opportunity costs of time or behavioral effects, for example the uncertain effects of having managers sign off on their responsibilities down the organization or the opportunity costs of top management time spent on auditing and control issues. At the same time other regulatory changes – like corporate governance codes from both NYSE and NASDQ – have contributed with more regulation. Some commentators argue that the administrative costs of these initiatives have spurred de listing from American exchanges (cf. Block 2004; Engel et al. 2005; Marosi and Massoud 2007; Kamar et al. 2006; Leuz et al. 2008) and have led international companies to list elsewhere, e.g., in London. The report issued 30 November 2006 by the Committee on Capital Markets Regulation concluded that US capital markets are loosing competitiveness and that regulation costs play a leading role in this shift (Hubbard 2007; Hubbard and Thornton 2006a, 2006b Committee on Capital Markets Regulation 2006). The complexity of regulation is no doubt further increased by the new US enforcement regime, which delegates extensive power to the Securities and Exchange Commission (SEC) and the PCAOB to engage in a specific dialogue with companies which in the eyes of the regulator – do not to comply with the law.
In sum, Sarbanes-Oxley is a complex contribution to a field of practice which is already extensively regulated by company law and best practice codes.
Although Europe has not been subject to the rigors of Sarbanes-Oxley, she has also had her fill of regulation. There are new EU directives on transparency (2004), prospectuses (2003), transparency, market abuse (2003), takeovers (2004), financial instruments (2004). Moreover, all European countries have now adopted corporate governance codes on comply or explain basis.
Much of the new corporate governance regulation can be regarded as “second generation” in the sense that it deals not just with control of executives (1st generation regulation) but with control of control (which I will here define as 2nd generation): Auditors are to control internal control procedures which are designed to control the executives. The PCAOB and audit committees are to control the auditors who exercise control over the executive through the annual report. Boards that control the executives are to be more accountable to shareholders. Strangely, the same institutions which are believed to have failed in a number of instances auditors, boards, shareholders now assume an even greater role in corporate governance. When the control did not work or rather were claimed not to work the response was to control the controls and perhaps third generation controls are not a long way off. It seems inevitable, however, that such elaborate control systems will be more complex and that this will be costly.
As a result corporate decision makers are faced with the complexity of thousands of lines of interrelated codes applied to many different actors and enforced by several different government agencies. Moreover, it is highly likely that the intensity of regulation has increased over the past decade. This motivates the following discussion of regulation costs from the viewpoint of economics and psychology.
Following Adam Smith (writing on taxes), I identify the costs of regulation complexity with “vexation costs”, a subspecies of transaction costs:
By subjecting the people to the frequent visits and the odious examination of the tax gatherers, it may expose them to much unnecessary trouble, vexation, and oppression; and though vexation is not, strictly speaking, expense, it is certainly equivalent to the expense at which every man would be willing to redeem himself from it.
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