Small Business Shielded From Sarbanes

The House Financial Service Committee today approved a measure seeking to stiffen fraud oversight by the Securities and Exchange Commission, so you might be surprised to hear that it watered down one antifraud measure in the process. The bill loosened Sarbanes-Oxley audit requirements for small business. Those regulatory changes were put into effect in 2002, as a response to the Enron and WorldCom debacles. Since then, business generally criticized the measure, saying it results in much higher auditor fees. You can debate whether the fraud protection Sarbanes-Oxley provides is worth the costs it imposes, but that those costs are too high for small business seems hard to dispute.

First, here's some detail, via Bloomberg:

The House Financial Services Committee voted 37-32 today to spare companies with market values of less than $75 million from audit requirements of the 2002 Sarbanes-Oxley Act. The permanent exemption was added to legislation that would boost funding for the U.S. Securities and Exchange Commission and impose stiffer rules on the brokerage industry.

The Obama administration pushed for the amendment, arguing investor-protection rules should be aimed at large companies rather than small businesses that may have difficulty complying with more rigorous audit standards. Democrats including House Financial Services Committee Chairman Barney Frank and U.S. Representative Paul Kanjorski, who heads a capital markets subcommittee, said the measure could harm investor confidence.

I'm going to have to side with the White House on this one. Back in my consulting days, during the years of 2003-2005, I did quite a lot of Sarbanes-Oxley advisory. My team generally chalked up fees exceeding $1000 per hour. The projects sometimes lasted weeks. If you do the math, you quickly realize that's a lot of money for smaller businesses to incur. And that doesn't even include the loss to productivity resulting from a company's workers spending time on regulatory paperwork and testing.

And what's the gain? Well, it may prevent some fraud. But the cost of fraud at larger businesses is obviously far greater. For example, let's say there's fraud in 1 in 100 firms at a cost of 10% of a firm's market cap. If those firms have an average size of $50 million, that's $5 million per 100 smaller firms. Raise that market cap to $1 billion, and suddenly the cost is $100 million per 100 larger firms. Given the economies of scale, however, the Sarbanes-Oxley audit costs aren't proportionally higher for the larger firms. So the sort of return-on-audit costs to prevent fraud is much greater for bigger companies.

Of course, the larger question is whether Sarbanes-Oxley does any good at all. Although we haven't seen much Enron-esque corporate fraud since 2002, we also hadn't seen much prior to it either. But even if it does turn out to help, from a purely economic standpoint, it makes total sense to relax those audit standards for small businesses, particularly at a time like now when so many are struggling to stay afloat. Let's hope the provision makes it into the final version of the bill that the President signs.