The High Cost of Being a Public Company Under the Sarbanes-Oxley Act

In January of 2003, Foley began an annual study of the corporate governance compliance costs associated with the Sarbanes-Oxley Act (Act), a then-new phenomenon in the business world that has since become a household name. While our methodology evolved over the years as we learned how best to gather and analyze our data, one element remained constant: Corporate governance reform comes with a heavy financial burden for today’s public companies.

Even now, more than five years after the Sarbanes-Oxley Act’s initial implementation, costs associated with corporate governance compliance continue to rise. The question “corporate governance at what cost?” remains as relevant as ever.

Cost of Being Public
What we have found in the fifth year of our study is that companies are still paying millions of dollars to comply with the Act and related governance reforms. Specifically, the 2007 edition of our study, “The Cost of Being Public In the Era of Sarbanes-Oxley,” determined that the average cost of compliance for companies with under $1 billion in annual revenue has increased more than $1.7 million to approximately $2.8 million since the enactment of the Act. This represents a 171 percent overall increase between fiscal years 2001 and 2006.

Notwithstanding the large cumulative increase since 2001, this year’s study found only a slight increase in overall corporate governance compliance costs (one percent) in fiscal year 2006. This slight increase followed a 19 percent decrease in fiscal year 2005.

The 2005 decrease resulted primarily from a 46 percent decrease in lost productivity reported in fiscal year 2005. Lost productivity decreased another 48 percent in fiscal year 2006. Other studies have concluded that the realization of efficiencies after the initial phase-in of Section 404 in fiscal year 2004 have driven down costs, and the reductions we have seen in lost productivity in 2005 and 2006 are consistent with that conclusion. Nevertheless, these decreases in lost productivity in 2005 and 2006 have not reversed the extraordinary increases in lost productivity seen in 2002 (102 percent increase), 2003 (72 percent increase), and 2004 (556 percent increase), and lost productivity in fiscal year 2006 was $290,000, a 530 percent increase from $46,000 in fiscal year 2001.

While overall costs associated with Act compliance have “plateaued,” the out-of-pocket costs facing public companies have increased between fiscal years 2005 and 2006. Out-of-pocket costs associated with Act compliance were up 13 percent in fiscal year 2006 from fiscal year 2005 for public companies with annual revenue of under $1 billion, and they were up 12 percent over the same period for public companies with annual revenues over $1 billion. The increased cost of audit fees, board compensation, and legal fees has driven these out-of-pocket increases.

Quality Directors in Short Supply
This year’s study also confirms that it continues to be increasingly expensive for companies of all sizes to attract and retain qualified directors. Annual director fees increased steadily and consistently for each category of company analyzed. Overall, annual director fees have increased an average of 70 percent for small-cap companies, 98 percent for mid-cap companies, and 93 percent for S&P 500 companies between fiscal years 2001 and 2006. We believe changes in the accounting rules requiring the expensing of stock options contributed to this trend, as many corporations reduced their grants of stock options to directors and increased cash compensation after these rules phased-in in 2006.

Going Private
This year’s study found nearly one in four survey respondents, or 23 percent, are considering going-private transactions as a result of the corporate governance and public disclosure reforms, which is consistent with respondents from previous years. Additionally, respondents to our 2007 survey continued to consider other options, including selling the company (16 percent) and merging with another company (14 percent). It is no surprise that respondents, who are asked to check all options that apply for this question, are increasingly seeking alternatives to going private. We believe this is driven by increased awareness among the business community of the attractive prices being paid in 2006 and early 2007 by private equity funds in the mergers and acquisitions market.

Study Methodology
In 2007, Foley worked with national research firm, KRC Research, to conduct its fifth annual study designed to gauge the true financial impact of corporate governance reform on public companies. Due to the complexities of current reforms and the myriad of governance issues facing companies today, a multi-tiered approach was used to gather the necessary data. The study consisted of a survey designed to measure attitudes toward current reform among top executives and a comprehensive review of a database compiled by Standard and Poor’s Investment Services Custom Business Unit from proxy statements filed in 2007 for certain S&P Small-Cap, S&P Mid-Cap, and S&P 500 companies. A copy of the study, including a more thorough description of the study methodology, can be found online at www.foley.com/files/tbl_s31Publications/FileUpload137/3736/Foley2007SOXstudy.pdf.

Thomas E. Hartman has served as director of Foley’s annual study: “The Cost of Being Public in the Era of Sarbanes-Oxley” since 2003. The rapidly changing legislative, reimbursement, regulatory, and technology landscapes, coupled with increasing civil and criminal liability, have posed significant challenges and offered tremendous opportunities for medical device manufacturers.

This article is a part of the October 2007 edition of The Pulse, a newsletter for leaders in the Medical Device Industry.