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Reader Profile
Are the costs of compliance reasonable or unreasonable relative to the benefits of implementing the new governance requirements? In the 1970s, I served for nearly seven years as one of the original commissioners of the US Consumer Product Safety Commission. At that time, the concept of cost-benefit analysis was rather new and agencies across the government struggled with it. The identification of benefits and costs of a proposed regulation is relatively straightforward; the hard part lies in attaching dollar estimates and determining probabilities. And quite often, unintended consequences are never factored in at all. At the Commission, we found that one of the most difficult things to quantify was the value of a human life. No matter what set of estimates we used, the outcomes always seemed unfair as one age group or class of adults was valued over another. Similarly, it is a challenge to quantify the benefits and costs of governance with such diverse constituents as shareholders, employees, customers, communities, regulators, the media, and the public. What I found most useful at the end of the day was the discipline of using a cost-benefit approach as a framework for decision-making. The simple exercise of making two columns – benefits and costs—is illuminating, and I continue to use it. If we apply this approach to implementing SOX, the stock exchange requirements, and the new SEC regulations, here is what it looks like. Key Benefits: * Improved checks and balances and a healthier working relationship between boards and management brought about by higher standards for director independence and the requirement for the members of three committees – audit, compensation, and nominating – to be independent * More candid discussion and useful feedback to management through required executive sessions of non-management directors * Enhanced investor and public trust in financial statements, because their accuracy must now be certified quarterly by the CEO and CFO * Greater attention to financial results as audit committees provide more vigilant oversight and as the outside auditors are hired by audit committees * More diverse and independent boards, as nominating committees are more active in identifying potential directors, making the newcomers less beholden to the CEO * Increased rationality in executive pay as compensation committees dig more deeply into compensation plans and turn to their own consultants for advice * Heightened emphasis on a culture of honesty, stemming from a more rigorous code of ethics and new mechanisms for whistle blowing Key Costs: * Higher implementation costs, in particular for legal and accounting functions and the creation of a whistle-blowing mechanism * Higher fees paid to outside auditors * Higher costs for compliance with the standard on internal control implementing SOX 404 * Loss in productivity as strategic focus and human resources are diverted to implement requirements * Continuance of some costs into the future, not entirely predictable, e.g. SOX 404 costs * Potential loss of investor confidence if qualified 404 opinions cause firm’s opinion on the financial statements also to be qualified, or if malfeasance is found after all governance reforms have been implemented * Disadvantages for smaller companies which lack the resources to comply readily with one-size-fits all regulations There are unknowns on both sides. We believe that better governance leads to better financial performance, but there is little empirical evidence to document that. Still, it is our belief and our hope. One key area where the jury is out as regards the costs-benefits calculus, is the 404 standard governing internal control. Many people already think compliance is too costly. After this first year of implementation, this standard should be carefully reviewed and changed if necessary. There is also an ongoing legitimate concern about the impact of the new rules on smaller companies. A Foley & Lardner survey estimated that costs for companies with annual revenue under $1 billion increased 130% between 2001 and 2003 as a result. Will the new rules discourage the creation of new firms? Will new companies be limited in their ability to raise capital because it is more difficult to go public? Will all of this have a dampening impact on our system of entrepreneurial capitalism? This is not something regulators should allow to happen. There was an urgent need to restore trust in financial reporting, accounting firms, and corporate leadership that warranted the new rule regime. Trust has not been completely restored, but we are on the right path. From that perspective, the benefits outweigh the costs, especially in light of the costs to those who lost most because of the scandals. What legislators and regulators should strive for is a balancing of interests – to make decisions that serve the public interest while being fair to all concerned. That’s where cost-benefit thinking comes in. Barbara Hackman Franklin Barbara Hackman
Franklin is President and Chief Executive Officer of Barbara Franklin
Enterprises, an international consulting and investment firm
headquartered in Washington, D.C., which provides advice and counsel to
American companies operating in foreign markets, notably China. |
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