Corporate governance reform continues to impose a substantial and still growing burden on U.S. public companies, according to Foley & Lardner LLP’s recently released study, the fifth annual The Cost of Being Public in the Era of Sarbanes-Oxley.
In the five years since SOX was adopted, the Foley study found that the average annual cost of compliance for companies with under $1 billion in annual revenue is $2.8 million an increase of more than $1.7 million.
During that time, companies of all sizes have experienced dramatic increases in outside audit fees, averaging 189 percent for S&P 500 companies, 251 percent for S&P mid-cap companies and a mind-boggling 311% for S&P small-caps.
Overall compliance costs leveled off in 2006, registering just a slight 1 percent increase in overall costs over 2005, following a 19 percent decrease in 2005 compared to 2004. However, a closer look behind those numbers suggests that the last two years may only represent a brief pause in the upward expense trend.
Consider the following:

While overall costs may have reached a plateau, the out-of-pocket costs incurred by public companies increased between 2005 and 2006, including increases in audit fees, board compensation expense and legal fees.

Audit fees for all S&P companies increased by 4-6% in 2006 compared to 2005.

Companies are finding it increasingly difficult to attract and retain qualified directors, resulting in substantial increases in annual director fees in the five years since SOX was enacted, with average increases of 70 percent for small cap companies, 98 percent for mid-cap companies, and 93 percent for S&P 500 companies.

Most of the 19 percent decrease in 2005, and the offset to increasing out-of-pocket costs in 2006, were improvements in internal efficiency realized by companies that reduced their lost productivity costs following the initial implementation of Section 404.

Given the continuing increase in out-of-pocket costs, it is reasonable to think that by this year at the latest, most public companies will have realized the maximum internal efficiencies possible, and that overall costs will again begin to rise, albeit more modestly than in the initial years following the adoption of SOX.

Other options

Given this sizeable and growing financial burden, what are U.S. public companies to do? Nearly 25 percent of the companies responding to a survey that was part of the Foley & Lardner study reported they are considering “going private” transactions, while approximately 15 percent report were considering the sale of the company or a merger with another company. In addition, privately-held companies are increasingly exploring listings on non-U.S. stock markets such as the London Stock Exchange’s Alternative Investment Market, or AIM.
Are these long-term solutions? Probably not.
More likely, they represent a market’s typical reaction to a sea change from “business as usual” such as that represented by SOX and other corporate governance reforms. In the face of rising waves, captains seek to steer their ships to safer ports to wait out the storm, while capable ships’ engineers devise better ways to stabilize their vessels in stormy waters. Once those repairs and improvements have been made, the ships once again set sail on the open waters.
Private equity firms that take companies private in the current market represent such a safe harbor. Out of the spotlight, such businesses can pause, regroup, streamline their internal procedures, and emerge again for public scrutiny better equipped to deal with corporate governance reforms and their long-term impact on public markets.
This is consistent with the investment philosophy of private equity firms, which typically have a 3-5 year time horizon to realize value on their investments. Does anyone really think that Chrysler will be a private equity portfolio company for the next 15 years? Las Vegas odds makers would probably put the over/under at about 2011.
Similarly, AIM and other foreign markets represent a theoretically attractive alternative for U.S. companies. These markets tout somewhat lesser corporate governance requirements and a more informal regulatory scheme.
But as most companies who have listed on AIM it is a highly illiquid market dominated by a few institutional traders.

Still a preference for U.S. markets

These markets offer little liquidity and few of the traditional advantages of being a publicly-traded company in the U.S. – attractive equity compensation plans for employees, currency for acquisitions, and the ability to raise substantial additional growth capital.
Think of it like players who escape to the Canadian Football League: The pay is decent, the games are exciting, the fans are engaged – but wouldn’t they rather be playing in the NFL? The U.S. capital markets are still the most liquid and attractive alternatives for public companies, and despite the increased costs imposed by SOX, that doesn’t appear to be destined to change anytime soon.
The message of the five annual studies completed by Foley & Lardner since the adoption of SOX is that increased corporate governance costs are here to stay. For better or for worse – and the incremental value of each layer of governance requirements continues to be debated – such expenses have become a necessary component of every public company’s cost structure.
The cost of entry has increased, but in the long run don’t expect companies to shy away from the U.S. markets. The advantages over other markets, and the need to provide an exit strategy for all of the private equity investors who are buying companies today, suggest that U.S. equity markets will see continued sailings of new and recycled vessels, even if the waters are occasionally choppy.
Paul Broude is a partner in Foley & Lardner LLP, where he is a member of the firm’s transactional & securities and private equity & venture capital practices, and vice chair of the emerging technologies industry team. He regularly represents companies in public offerings and M&A transactions, and advises both public and private companies on corporate governance issues.