How Sarbanes-Oxley Hinders Technology Transfer
I grew up here in Kansas City, on the Kansas side, Johnson County. Ewing Kaufman left the Kaufman Foundation as his legacy, along with many other things, including Major League Baseball. Kauffman, of course, founded Marion Laboratories and turned it into a billion-dollar company that is now part of Sanofi-Aventis. He brought the Royals to Kansas City. I remember, I was in the long line of trick-or-treaters at his house, where they would have about 10 people at the gates giving away Royals memorabilia—baseball hats, and things like that. He really was a salesman to the end.
Ewing Kaufman’s is a classic American story. I know from watching him on TV and from talking to the people who knew him that he could sell a ketchup popsicle to a woman in white gloves. He wasn’t afraid to wear a loud suit. He started a pharmaceutical company out of his basement in 1950. He used the name Marion Laboratories, his middle name, so people wouldn’t think it was a one-person operation. This is a story about American entrepreneurs, salesmen, and inventors of the kind you often hear about—Alexander Graham Bell, Thomas Edison, the Wright Brothers—tinkering around their homes. Usually nothing comes of this experimenting and tinkering, but sometimes these entrepreneurs hit upon something really big and start their own companies. That’s the way it’s supposed to work.
One of the things the Competitive Enterprise Institute asks is, “Say, if Ewing Kaufman, Bill Gates, or Meg Whitman of eBay were starting out today, what barriers would they encounter? Could they do what they did?” Now, these are all extraordinary individuals, and you would like to think that no matter what, they could have achieved what they did. But laws and policies do matter, and even if they could have, it would have taken them longer—and we would have been poorer as a result. What would be the barriers to Ewing Kaufman or Bill Gates today? I believe that Sarbanes-Oxley is a significant barrier, particularly in the growing fields of biotech and nanotech.
Sarbanes-Oxley, and things associated with it, came about as an overkill regulatory reaction to the Enron debacle. Why is it important for technology transfer? Let’s look at what is always essential for the inventor to go from tinkering in the small lab to getting new technology out to the public. One of the things that is essential is tapping into the public capital market. It is important to ask, especially with network industries: How do you go? How do you get a computer on everyone’s desk?
One of the best examples of a technology transfer developed by small entrepreneurs and entrepreneurial firms is the transistor, which, of course, changed everything by enabling the miniaturization of everything. I have here, courtesy of my father, a vacuum tube. This is what computers, televisions, and radios used to run on.
When mainframe computers took up entire rooms, they’d have these babies inside them, and they, like light bulbs, would break easily. The microscopic transistors developed by Bell Labs were, of course, a huge innovation. But it was mostly smaller entrepreneurs who took it from there and got it into the market.
Let’s look back at one of these companies—Texas Instruments, which developed the silicon transistor, was a $27 million business is 1950, and now its business is around $9 billion. Wouldn’t you have liked to have gotten in on the Texas Instruments IPO? I think everybody would, but the thing is, you couldn’t have. Texas Instruments didn’t launch an IPO. It didn’t have the resources to list on the New York Stock Exchange. It wasn’t a big enough company.
Instead, Texas Instruments did what many smaller companies do today, a process now known as a reverse merger. It found this rubber company, Intercontinental Rubber, that basically wasn’t making anything, had come out of hard times, but had a listing on the New York Stock Exchange. Texas Instruments bought it, and because of that, was allowed to list on the New York Stock Exchange, then eventually changed its ticker symbol—and the rest is history.
You couldn’t do that on the NYSE now; most of the reverse mergers have recently been done over the counter and on the Pink Sheets—special small venues for low-priced, thinly traded stocks, known at “penny stocks”—and the SEC frowns on this type of transaction. But the biggest barrier by far now is the Sarbanes-Oxley Act.
There have been many estimates of Sarbanes-Oxley’s costs. It has rasied the overall cost of operating as a public company by 130 percent, according to the law firm Foley and Lardner. It has added 30,700 man-hours for each firm, according to the trade group Financial Executives International. Additional time that you have to spend complying with accounting is time that you can’t spend on developing your product. A Korn-Ferry survey found on average $5 million in costs devoted to this for Fortune 1000 firms. But those surveys, which I wrote about in National Review, have all been superseded by an academic economic study by Ivy Zhang of the Graduate School of Business at the University of Rochester. She found that there has been a $1.4 trillion market loss attributable to Sarbanes-Oxley.
This law passed Congress in a crisis mode. A gentleman here mentioned 9/11 and how Congress rushed through the USA PATRIOT Act right after that. This was a similar situation. Because Enron went bankrupt, then WorldCom, there was the rush to “do something.” And there are some interesting political dynamics, because the Democrats then controlled the Senate. Sen. Paul Sarbanes (D-Md.) had a bill, which the Republicans basically adopted. There’s plenty of blame to go around. There were only three brave Congressmen—whom I think should get a medal—who voted against this. Even after hearing a lot of complaints from their constituents, there’s still a little reluctance to change this “let the SEC handle this” attitude, even though there are parts of the statute that the Securities and Exchange Commission really can’t do anything about
The costliest part—which has received attention in the press—is Section 404, which deals with internal controls. Congress wrote that the CEO, in addition to certifying the financial statement, must sign a document certifying that the internal controls relating to the financial statement are accurate. This statement must be attested to by an auditor. Yet one of the main problems is that Congress did not define the term “internal control” in the bill. Instead, it created a quasi-private accounting regulatory agency to set auditing standards called the Public Company Accounting Oversight Board (PCAOB), which has issues of its own. This agency collects a compulsory fee from all public companies, and its chairman gets paid more than the President of the United States.
The PCAOB interpreted internal controls as broadly as possible—essentially as anything that could be relevant to a financial statement—and also said that an “attestation” in the law had to be a full-blown audit. This means that accountants are auditing things like what kind of software a company uses. If the auditors think that the software is outdated, that might constitute a bad internal control. Also, in things like employee passwords, accountants are actually looking at things like that and saying, “This is a bad internal control.” It’s driving some of the tech guys at public companies crazy.
This is hardest for a small firm, guys who start this in a garage, in a lab, and want a close-knit board to guide them. Many firms are voluntarily delisting from the stock market because of Sarbanes-Oxley, still trading with shares in venues such as the Pink Sheets, but in areas in which they are much less liquid and less information is available about them, which hurts shareholders as well. This is a crisis and is already affecting innovation.
Congress must revisit the mess it created when it acted in a panic. In the long term, we need to rethink the kind of risk we allow in society, and make sure our risk aversion doesn’t stop the engine of technology transfer. Then we can ensure that creative entrepreneurs can flourish and make society better, just as Ewing Kauffman did. Thank you so much.