TO: Friends of CEI
FROM: John Berlau, Director of CEI’s Center for Entrepreneurs and Investors
DATE: June 21, 2010
SUBJECT: Upcoming Supreme Court decision in Sarbanes-Oxley case
The Supreme Court is expected to hand down its decision soon in a major
case involving the massive and costly Sarbanes-Oxley Act of 2002, Free Enterprise Fund v. Public Company Accounting Oversight Board.
The Court could issue its ruling as early as this Thursday, and will
definitely hand it down by the end of June when its session closes.
The case, in which Competitive Enterprise Institute attorneys serve as
co-counsel, mounts a constitutional challenge to the Public Company
Accounting Oversight Board (PCAOB), the accounting regulatory body
created by the law. We argue that the way in which the PCAOB board
members are appointed violates the Appointments Clause of the U.S.
Constitution. Namely, that PCAOB officers, who wield a great deal of
regulatory power over businesses and industry-wide accounting
practices, are “principal officers of the United States” who must be
appointed by the President, with advice and consent of the Senate or by
an agency head, as required by the Appointments Clause.
This requirement was intended by the Framers to instill a high level of
accountability for officials who wield such vast powers. Although the
PCAOB is a striking constitutional anomaly – a case of an independent
agency (Securities and Exchange Commission) appointing an equally
powerful independent agency – it’s a case that will also potentially
change, for the better, how other government officials and regulatory
bodies are answerable to the American people.
The immediate impact of this case, if our challenge is upheld, will be
on U.S. entrepreneurs and investors who have been impacted negatively
by this law. This memo sets forth three main points on the importance
of this case.
I. Sarbanes-Oxley (Sarbox, SOX) has permanently reduced the
number of companies going public, permanently increased the size of
companies going public, and had a permanent negative effect on job
creation and economic growth.
Much of the early criticism of Sarbanes-Oxley — hotly disputed by the
law’s defenders — was that it was causing foreign firms to stop
listing initial public offerings (IPOs) of their stock in the U.S.,
forcing them to go to London instead. A running joke attributed to
London’s socialist mayor Ken Livingstone and others is that London
should build a statue of Senators Sarbanes and Oxley for bringing in so
much business. The law’s defenders insisted that this was the
inevitable effect of foreign countries getting more competitive;
however, this argument failed to answer the question as to why firms
were choosing not to do dual listings in the U.S. and London, as they
had in the past. Or why companies like British Airways and Air France
were actually deregistering from U.S. exchanges. In fact, only one
foreign airline, Ireland’s Ryanair, is now listed in the U.S.
But more importantly, and often overlooked, is a fact not much in
dispute: the absolute number of IPOs since Sarbox has decreased
dramatically and never recovered.
According to a 2009 Renaissance Capital report, IPO issuance in 2008
and 2009 is lower than any period since the 1970s, when business
creation struggled against inflation, high interest rates and the
Vietnam War. Also, data compiled by Jay Ritter of the University of
Florida show the number of U.S. IPOs was lower in every year after SOX
was enacted in 2002 (2003 to present) than in every year of the decade
from 1991 to 2000, including the early ’90s recession years. For
instance, in the post-SOX boom year of 2006, there were 162 U.S. IPOs.
Yet in 1991, a year when the U.S. was mired in recession but did not
have SOX, there were 295 U.S. IPOs.
The sheer size of companies going public has also increased, in large
part because a company needs to be pretty big to afford the accounting
costs that have shot up fourfold as a result of SOX, according to a
summary of research in the Sarbanes-Oxley Compliance Journal. According
to Business Week, the median market cap (as measured by number of
shares times share price) for a company doing an IPO was $52 million in
the mid-‘90s. Today, it has shot up $227 million. Google had a $1
billion market cap when it went public in 2004. And Facebook still
hasn’t gone public, despite having an estimated market cap of nearly
$10 billion. By contrast, in 1981, Home Depot went public with just
four stores. Home Depot co-founder Bernie Marcus told Investor’s
Business Daily that his firm could never have gone public and raised
money for growth had SOX been in effect.
This illustrates the devastating effect of the law in holding back
present and future economic growth. Budding Home Depots and Microsofts
can no longer go public to raise money for growth. They must wait until
they are as big as Google to go public to lock in their gains. But this
lack of an ability to issue equity because of SOX means that firms are
ever more dependent on financing through debt, especially difficult
considering the current credit crunch.
No matter what kind of business an up-and-coming firm engages in —
whether it’s oil drilling or “green tech” — there are only two basic
mechanisms they can use to raise capital to finance their growth: debt
and equity. To expand their businesses with money they don’t have,
entrepreneurs can both borrow money from banks and issue bonds – debt
transactions with contractual obligations to pay creditors a fixed
amount on a certain date. Or they can issue shares of stock with no
obligatory payouts but with an ownership interest in any future
prosperity of the firm.
Recent studies have shown that debt and equity don’t always move
together, and can be substitutes, rather than compliments, as forms of
financing. They also show that in some instances, equity issuance can
even be countercyclical and increase during bad economic times. This
fact gives hope that increased equity issuance could lessen the
severity of a recession and get the economy back on its feet much
sooner. But this will only happen if – and this is a crucial if —
there are not undue policy barriers to companies going public. Evidence
suggests that we were able to recover more quickly from the early ‘90s
recession because of an actual increase in companies — from Starbucks
to Cisco — issuing IPOs. But SOX forecloses that possibility and makes
for a longer recovery.
2. By enforcing Sarbox’s mandates, the PCAOB has focused on
trivial risks, not only driving up costs for companies, but missing the
bigger picture such as the Lehman Brothers off-balance sheet
The PCAOB has stretched Sarbox’s requirement that auditors “attest” to
a company’s internal controls over financial reporting in the law’s
Section 404 to require a full-blown audit of trivial items that could
only remotely effect a financial statement. This has turned the law
into the “Accountants Full Employment Act” and the reason the Big 4
accounting firms lobby so hard against even minor rollbacks in
Congress, such as the exemption from Section 404 that passed in the
House version of the financial regulation bill.
Under PCAOB Accounting Standard 2 (later revised as Accounting Standard
5), accountants had to scrupulously examine trivial items with little
relevance to shareholders, such as who has the office keys and how many
letters are in an employee passwords.
According to John Battelle’s book The Search, considered a
definitive history of Google Inc., Sarbox was “hell for a company like
Google, which made its money literally pennies at a time, from millions
upon millions of micro-transactions.” Battelle reports that Sarbox
compliance significantly delayed Google’s IPO. “According to engineers
involved in the work, Google had to significantly restructure its
advertising report system from the ground up.” If this was difficult
for a company like Google, imagine what a burden it is to smaller
The PCAOB’s interpretations of Section 404 governing “internal
controls” over auditing costs public companies $35 billion a year,
according to the American Electronics Association. University of
Rochester economist Ivy Zhang found that the law has cost the American
economy $1.4 trillion in direct and indirect costs.
Almost as important is that Zhang and other researchers have found that
Sarbox has had no quantifiable benefits in fighting fraud. The PCAOB
has done little or nothing about telling accountants how to handle
accounting for the off-balance sheet entities at issue in Enron that
resurfaced with Lehman and other companies. Countrywide Financial, now
charged by the SEC with accounting fraud, actually won an award for its
Sarbox compliance from the Institute of Internal Auditors in 2007.
3. Despite widespread denunciation of phantom Bush-era deregulation,
regulatory relief from Sarbox has widespread bipartisan support.
See the quotes from Nancy Pelosi, John Kerry, and others below.
Also, 101 House Democrats voted for an amendment to the financial
regulation bill to exempt smaller public companies from Sarbox internal
- Commentary on the Daily Caller: Sarbox reform would boost
our economy, but even small reforms (such as small company exemptions)
are being blocked by the powerful accounting lobby.
- CEI Capitol Hill conference, "Sarbanes-Oxley, the Supreme
Court, and America’s Economic Future." The conference featured Hans
Bader, co-counsel to the the plaintiff; Mallory Factor, founder of
plaintiff Free Enterprise Fund; and Reps. John Adler (D-N.J.) and Scott
Garrett (R-N.J.). Adler and Garrett are bipartisan sponsors of the
exemption from Sarbox’s internal control auditing mandate. This
legislation would be included in the financial regulation bill that
would pass the House a couple weeks later.
- CEI study, "SOXing It To The Little Guy," detailing Sarbox’s
cost to Main Street entrepreneurs and investors.
- CEI study, "The Public Company Accounting Oversight Board:
An Unconstitutional Assault on Government Accountability" was the basis
of the Appointment Clause arguments made in the courts. The study
explains the connection between the PCAOB’s lack of constitutional
accountability and the bad policy outcome of its rules, such as the
mandates for audits of internal controls.
Notable quotes on the overreach of the Sarbanes-Oxley Act
- The Obama administration, expressing support for the
provision of the House financial regulation bill by Scott Garrett
(R-NJ) and John Adler (D-NJ) that would permanently exempt smaller
companies from the Sarbox internal control mandates, has said, "Our
focus must be on addressing the threats posed to investors and
consumers by large, interconnected companies, rather than placing an
undue burden on small businesses.” (The Wall Street Journal,
- Democratic Leader Nancy Pelosi Oct. 24, 2006 on CNBC
"Everything that we do should be to encourage the markets not to
discourage them. We`ve even gone on record on our innovation agenda
revisiting Sarbanes-Oxley because, again, unintended consequences.
There`s a need for it. You need the transparency. You need the focus on
it. But you don`t need — I don`t think you need the whole package."
- Sept. 14, 2006 Massachusetts Senator John Kerry called for
a "task force" to "make it easier for small businesses to comply with
the Sarbanes-Oxley by reducing their regulatory burden in the future.”
- New York Sen. Charles Schumer, Nov. 1, 2006
"With the benefit of hindsight, the Sarbanes-Oxley Act of 2002, which
imposed a new regulatory framework on all public companies doing
business in the U.S., also needs to be re-examined. Since its passage,
auditing expenses for companies doing business in the U.S. have grown
far beyond anything Congress had anticipated."
- New York Rep. Nydia Velazquez, June 5, 2007
"Small firms continue to be supportive of the intent of the
Sarbanes-Oxley Act and many have benefited from the stronger corporate
governance culture that it encouraged. However, what we have continued
to hear is that these benefits – and particularly those associated with
Section 404 – come at a very steep cost."
- Former Senate Majority Leader Tom Daschle, Oct. 3, 2005
“SOX has also had unintended consequences that generate complaints from
small and mid-sized capitalization companies who say that their access
to capital from publicly-traded stock markets has been made
- Jack Welch, General Electric CEO responsible for turnaround
in 80s and 90s. "Small companies with all these financial controls that
are in there now and the penalties that go on with small
entrepreneurial companies, it’s tough." Interview with Tavis Smiley.
- Bernie Marcus, cofounder of Home Depot, when asked by
Investor’s Business Daily if Home Depot could have gone public when it
did under SOX: "I don’t honestly believe we could. We went public after
opening our fourth store because we needed the capital to open more
stores. Going public and entrepreneurship were the keys to our success.
If you’re a public company today, you have to be surrounded with
lawyers and you can’t make a decision without a lawyer on one side of
you and accountants on the other side. Today, you just can’t use your
business judgment to take the risks that must be taken for a new
company to succeed" Available at
- Carly Fiorina, former CEO of Hewlett-Packard and Republican
candidate for U.S. Senator from California: "I think Sarbanes-Oxley is
an example of the dangers of a rush to legislation in an emotional
moment. . . . I absolutely believe that new businesses, smaller
businesses shouldn’t have to comply with the full scope of
Sarbanes-Oxley, and I think there’s no question that Sarbanes-Oxley has
had a chilling effect on companies’ decisions to list here as opposed
to perhaps listing on other exchanges around the world"
- Charles Munger, Berkshire Hathaway vice-chairman (considered
Buffet’s "partner" in building the company), "Sarbanes-Oxley has raised
our costs. I don’t think it’s done anything favorable for the quality
[of our financial results], because there was quality to begin with."
- Peter Thiel, venture capitalist and first outside investor
in Facebook, "The IPO window is almost closed and I think in part, this
is a response to Sarbanes-Oxley to the ways in which being the CEO of a
public company is simply no fun anymore. They’re subject to insane
levels of scrutiny. You’re not able to pursue any sort of multi-year
corporate strategy and instead you are held to a quarter-by-quarter
earnings schedule which is ultimately quite detrimental to long-term
- Carl Schramm and Robert Litan, president and vice president
of Kauffman Foundation, leading foundation on research in
entrepreneurship: "Compliance with the Sarbanes-Oxley Act of 2002, in
particular, has proven to be far more expensive for smaller companies
than originally intended or forecasted. Since shareholders are the
intended beneficiaries of Sarbox, why not let them vote on whether
their company needs to comply with some or all of its provisions—the
expensive requirement for auditing of internal controls, in particular.
We suspect that many shareholders would choose some form of opt-out,
and in so doing, would enable more growing companies to continue
growing as independent firms, rather than being bought out by larger
companies that can intentionally or unintentionally rob the firms of
the entrepreneurial magic that made them successful in the first