Going Private - Sarbanes-Oxley

The SOX Appeal of Going Private

As the cost of compliance mounts, it's only reasonable to assume that many outfits, especially the smaller ones, will avoid it altogether

Is the Sarbanes-Oxley Act of 2002 one of the reasons why an increasing number of companies are opting to go private? When Georgia Pacific (GP ; S&P investment rank, 3 STARS; recent price, $47) CEO Pete Corell attributed his willingness to sell to a private company in part because of what he viewed as onerous regulations like those contained within Sarbanes-Oxley (popularly known as SOX), the news set off market speculation about whether other public companies would follow suit.

How real is this threat? And what does it mean for investors? Standard & Poor's Chief Economist David Wyss believes SOX is a factor in the recent wave of privatizations, but a relatively minor one. He does, however, think the legislation makes it even harder to be a public company, which creates another incentive for outfits to stay or go private. "Most of the issue is, I think, transitional. Once companies learn to operate in the new environment, it should stabilize," Wyss says.

SOX came about as a result of the large corporate financial scandals involving Enron, WorldCom, Global Crossing, Arthur Andersen, and others. Under the law, all publicly traded companies are required to submit an annual report on the effectiveness of their internal-accounting controls to the Securities & Exchange Commission.

SMALL-BIZ BURDEN. A study by law firm Foley & Lardner found that all the costs associated with being a big public company (i.e., annual revenues of $1 billion or more) averaged $14.3 million in 2004, up 45% from the year before, due largely to the requirements of SOX. The study also found that fees paid to outside auditors have continued to increase by double-digit percentages year over year since the enactment of SOX in 2002, with a dramatic increase experienced in 2004. Foley & Lardner attribute this increase to substantial costs associated with the financial control audits required under Section 404 of SOX.

A.R.C. Morgan, a consultant and advisory-services firm which focuses on SOX regulatory compliance, released its own study, which found that smaller companies are incurring higher SOX-related costs, as a percentage of sales, than larger companies. For example, the study found that companies with annual sales of less than $250 million incurred $1.56 million in external resource costs simply to comply with one SOX provision (the internal controls required by section 404). In contrast, companies with annual sales of $1 billion to 2 billion incurred an average of $2.4 million in such costs.

As a result, SOX compliance appears to weigh disproportionately on small public corporations. For many of these concerns, operating on thin margins, the additional cost is a significant percentage of their annual revenues. Not surprisingly, these are precisely the companies that some investors believe are most likely to go private rather than incur SOX costs.

NO PATTERN DETECTED. At the same time that some companies may be looking to go private to avoid regulation,