The Long Petard: The New York Times and Sarbox

Having dug itself into a hole with inept handling of the ad and its aftermath, the New York Times Company may soon find itself unable to put down its shovel. Few ironies approach the richness of the mess the firm may face with the regulatory requirements of the Sarbanes-Oxley Act (Sarbox).

The Times has been among the strongest public advocates of Sarbox and has criticized attempts to reform its costly demands. Sarbox was rushed through Congress in 2002 following the Enron and WorldCom scandals. Since then even Nancy Pelosi and Charles Schumer have voiced concerns about its heavy burden on business.


Now the New York Times Company, its management, and its directors all may face some awkward questions and possible legal and financial liabilities, if the information contained in Public Editor Clark Hoyt’s column of September 23, 2007 is credited as true.

Regarding the discount given to MoveOn’s now-infamous ad, Hoyt wrote

The group should have paid $142,083. The Times had maintained for a week that the standby rate was appropriate, but a company spokeswoman told me late Thursday afternoon that an advertising sales representative made a mistake.

This appears on the face of it to indicate that the management control system of the company does not provide timely information to management regarding pricing and discounts of newspaper advertising in its dominant property, one of the principal revenue sources of the New York Times Company. At minimum, this is a major and disturbing problem. Unless the company was lying to Hoyt and the public, it didn’t know for three-plus days what kind of discounts its sales force were handing out, and could not verify compliance with basic policy.

This admission of internal chaos is startling.

But Sarbox could make it much worse. The control system problem arguably could qualify as a "material weakness" in the arcane jargon of the Sarbox-generated regulatory apparatus. If judged so, The New York Times Company was required to disclose it and could face severe consequences for not doing so. The harsh responsibilities imposed by Sarbox could end up biting the hand of friendship offered all these years by the Times.

Section 404

The heart of the matter is found in one of the most onerous and dangerous features of Sarbox: Section 404. It consists of two short paragraphs with the requirement that annual reports signed by the CEO must contain

"an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting."

To keep management honest

"each registered public accounting firm that prepares or issues the audit report for the issuer shall attest to, and report on, the assessment made by the management of the issuer."

Section 404 mandates, in other words, that CEOs and accountants certify not just a company’s numbers, but vaguely defined "internal controls" over the processes used to derive the numbers.

The American Electronics Association has estimated that this section alone cost $35 billion a year for all public companies and Financial Executives International estimates an average of 30,000 manhours for a single firm! It is one of the reasons why accounting is such a popular major at college and accounting firms are going on a hiring spree. It’s sometimes called the Accountants Full-Employment Act.

It’s also one of the reasons for the boom in private equity and small firms delisting from markets. The costs have also deterred companies from going public until they are extremely well-capitalized. Google was almost a billion-dollar company when it went public. By contrast, Home Depot went public after having just four stores in 1981. Home Depot co-founder Bernie Marcus told Investor’s Business Daily that the firm could not have gone public when it did had Sarbox been in place.

The law gives no definition of "internal control." So the SEC and the Public Company Accounting Oversight Board (PCAOB[1] (known in the trade as "peek-a-boo" — the quasi-private regulatory body set up by Sarbox) — have defined "internal control" as

"controls over all relevant financial statement assertions related to all significant accounts and disclosures in the financial statements."

They also defined the law’s phrase "attestation" as a full-blown audit of each of these controls, just as the company’s numbers have traditionally been audited. (See John Berlau’s National Review article).

The Sarbox regulations by the PCAOB and SEC state that any problem with the the internal control structure in which

"more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected [is a] material weakness."

Material weaknesses must be publicly reported in an annual report. If there is a material weakness, the CEO and an auditor cannot certify the company is in compliance with Section 404. If they do, they are subject to SEC investigation, likely civil fines, and possibly even criminal penalties that can be up to 20 years in prison.

The Times admits a "material weakness"

In its 2007 annual report, the New York Times Company disclosed a material weakness in its control system. Its new auditors, Deloitte and Touche, wrote:

"The Company did not design control procedures to appropriately consider the multi-employer versus single-employer status of collectively-bargained pension and benefit plans, leading to inappropriate accounting for certain plan liabilities in accordance with generally accepted accounting principles. Such material weakness resulted in material adjustments to certain plan liabilities within the current and prior period financial statements. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2006, of the Company and this report does not affect our report on such financial statements and financial statement schedule."

Deloitte & Touche concurred with management’s admission of a material weakness, using the tortured syntax and jargon of accounting-speak:

"… our report dated March 1, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of a material weakness."

The Times was on notice that its internal controls had this flaw. But what about other possible flaws which, if existing, it would be required to disclose?

Was the admitted level of management cluelessness about the Times’ advertising practice a "material weakness"? Did CEO Janet Robinson violate Sarbox by not finding and disclosing this weakness? If an affirmative determination is ever rendered, the consequences would be extremely unpleasant.

Truth or Consequences: The CEO’s Blood Oath

Not disclosing a "material weakness" can be construed as corporate fraud under the law’s broad reach. Maybe not wise policy, but the Times supported the law.

And under the law, it’s not enough for a CEO to say "I didn’t know." Specifically the certifications say "based on my knowledge" not the far more forgiving "to the best of my knowledge." It’s often referred to as "a CEO’s blood oath."

There are several provisions of the law using the term "willful," meaning executives have a duty to be aware of malfeasance.

In court, directors (which would include Chairman Sulzberger) have also been found to be liable if they should have known something, and had to pay defendant judgments out of personal wealth, not just directors’ insurance when shareholders sued. This potential civil and criminal liability of officer and directors is one of the things that has greatly accelerated buyouts, de-listings, and foreign-only listings.

The Times has strongly supported this editorially. It wrote just 10 months ago:

"It seems almost unbelievable, then, that corporate America would pick this moment to beg for relaxed regulation." [….]

"The rationale is that the high cost of complying with the corporate governance law, the Sarbanes-Oxley Act, along with runaway lawsuits have scared foreign companies away from American stock exchanges. The timing is particularly odd given that the compliance costs associated with the much-reviled Section 404 of Sarbanes-Oxley – which requires audits of companies’ internal financial controls – fell last year, as did the number of investor lawsuits, for the second year in a row. What has actually happened is that opponents of regulation believe that the coast is clear." [….]

"… over all, the system is working. It may need tweaks, but it does not need a revamping."

Shareholder class action lawsuit king William Learch may be heading to jail, but angry shareholders and hungry lawyers could still take the company’s management to court if they willfully violated Sarbox.

All in all, it might be time for the New York Times to reconsider its fondness for Sarbanes-Oxley. Come to think of, it’s probably already too late.