While Section 404 of the Sarbanes-Oxley Act has helped boost investor confidence in the U.S. capital markets, there could be improvements in disclosure and in the internal-controls assessment and reporting regime, panelists stated during the fourth panel at the Securities and Exchange Commission/Public Company Accounting Oversight Board roundtable on Section 404 of Sarbanes-Oxley.
A number of panelists suggested that the testing cycle of noncritical controls should be lengthened or rotated to avoid repeated annual testing of low-level controls. Speakers who supported that idea included Monte Redman, chief financial officer of Astoria Financial Corp.; Karen Hastie Williams, director of Chubb Corp. and SunTrust Bank; and Robert Pozen, chairman of MFS Investment Management.
The alternative system could entail an annual focus on entity-level controls over financial reporting and fraud issues while giving an auditor discretion when a company has demonstrated strong controls. Williams noted that the audit committees on which she serves receive information from internal auditors that helps discover any problems at an early stage, without adding another layer of review.
Improvements could be made in the disclosure of financial information and material weaknesses as well, panelists said. Gregory Jonas, managing director of the accounting specialists group at Moody’s Investors Service, believes the markets understand generally what a material weakness is; however, there could be specific improvements. “We need to turn up the noise on controls that prevent and detect fraudulent financial reporting,” he said. “This is the critical area [that] would give us more comfort to know folks are really working at these fraud-related controls.”
Second, disclosures have become backward-looking rather than forward-looking: major problems usually have occurred before a material weakness is reported. “We’re saying the patient had a heart attack and, by the way, had high blood pressure,” said Jonas. “I hope we can become increasingly focused on preventative controls.”
Moderators also questioned the impact of Section 404 on the competitiveness of the U.S. capital markets.
Noreen Culhane, executive vice president of the New York Stock Exchange Group’s global corporate client group, cited exchange listing activity at the Alternative Investment Market (AIM) of the London Stock Market as anecdotal evidence that companies are choosing not to comply with the U.S. regulatory system or face the litigious environment in the United States. “The real issue here is not within the U.S. markets but the U.S. markets as an entity,” said Culhane. “There are 1,500 companies listed on AIM; one-third that listed there in 2005 are non-U.K. companies.” (Editor’s note: Based on reporting following the roundtable, of the 519 companies that joined AIM last year, 120 were non-U.K. companies, according to AIM’s parent company, the London Stock Exchange.)
The globalization of capital is a change for the U.S. markets. “You want to see the signs and take action before the patient is dead,” said Culhane. While there are benefits to being a corporate issuer registered in the United States, including a significant valuation premium, “costs have to be better aligned to redirect that flow of money back to the U.S. capital markets,” she said.
Peter Lyons, a partner at Shearman & Sterling, stated that his clients did not favor the officers’ certification requirement of Sarbanes-Oxley, but “we didn’t see them vote with their feet until they saw the barrel of 404.”
Pozen noted that issuers in the United Kingdom also have financial reporting obligations, but many are guidelines. There might be an optimal mix of rules and guidelines for reporting obligations, he suggested.
The internal-controls provision has improved investor confidence since the accounting scandals and the Internet investment boom, panelists noted. The reduction in reported material weaknesses and the markets’ calm reaction to those events indicate that the provision has helped investor confidence, observed Culhane.
Investors know that management and auditors take Sarbanes-Oxley seriously, noted Williams. Going forward, investors will see that the legislation has become institutionalized within companies, she said.
Speaking from the investor perspective, Michael McConnell, managing director of Shamrock Capital Advisors, cited the preliminary benefits investors are witnessing, include enhanced transparency, improved corporate governance, and better business processes and financial statements. Those improvements can be noted in the higher market multiples compared with three years ago, which indicate a lowering cost of capital, said McConnell.