Congress enacted the measure last year in the wake of Enron’s collapse and during the associated scandals involving firms such as Arthur Anderson and WorldCom (now MCI).
And while the reform measure’s primary focus has been upon high-visibility corporations, Ott says smaller firms believe it will have a disproportionate impact upon them.
An article by Ott — who is a partner with Warner, Norcross and Judd — and one of his associates, Tashia L. Rivard, appears this week in a financial trade publication. The two discuss the impact of Sarbanes-Oxley upon private banks and thrifts, which also seem to be a special case.
Ott, who specializes in counseling public companies concerning federal and state securities laws, told the Business Journal that Sarbanes-Oxley seeks to achieve two primary goals.
“First, it wants to strengthen auditor independence,” he said. “And second, it sets out to foster good corporate governance practices.
“The idea is to make sure the folks at the top understand what’s going on and to keep the board informed.”
And as far as most smaller banks are concerned, he said, the most striking feature of Sarbanes-Oxley is its audit independence requirement.
“The two issues apply to even small banks that file financial reports with SEC. They have to comply with these rules.
“Many of these smaller public banks,” he elaborated, “have used an external auditing firm to also handle their internal audit functions because it just doesn’t make economic sense to hire their own internal auditor.
“The size of the organization just doesn’t justify that kind of expenditure, so they’ve been outsourcing the work on a flat fee basis to their external auditor.”
But under Sarbanes-Oxley, he explained, the Securities and Exchange Commission has decided that practice is no longer acceptable.
The SEC takes the position, Ott said, that independence of the external and internal audit functions requires two separate sets of eyes in public banks.
In large banks, he said, that’s perhaps not a major problem. Ott, who has been with Warner Norcross for 10 years, explained that large banks always employ an internal staff (the delineation between large and small banks is whether they have total assets exceeding or less than $500 million.)
Ott said most smaller banks with which he has become acquainted indicate they cannot justify such expenses.
But SEC regulations are SEC regulations, he said, so now such firms face unattractive alternatives: shouldering the cost burden either in the form of hiring internal auditors or of hiring a different audit firm to do the internal work.
“Either way,” he said, “for a smaller firm it dramatically increases the cost of compliance and reporting process with SEC.”
Ott told the Business Journal that all of the smaller banks with which he works have indicated this is a significant cost for them. “It is important,” he added, “and they are looking at ways of dealing with the cost.
He said that even though Sarbanes-Oxley became law last July, the act allowed a one-year phase-in transition for many of its requirements.
“The audit independence rule is just transitioning into place now,” Ott said, “and so people are just starting to grapple with it to see how it will affect their firms. They’re just now figuring out how much it’s going to cost.
“In fact one of the things you’re starting to hear people talk about in the banking industry right now — for the smaller organizations that are publicly traded right now — is undertaking what are called ‘going-private transactions’.
“This means they either buy out or some way reduce the number of shareholders they have below the threshold where they would no longer be required to comply with SEC reporting. They wouldn’t have to file reports with the SEC.”
Once below the threshold, Ott said, such firms no longer are required to file reports with the SEC and wouldn’t have to comply with these rules.
“They’ll save the money of those requirements,” he said.
“The magic number for that,” he said, “ is that they need to get below 300 shares and file a document with the SEC that terminates their reporting requirements.
“I haven’t seen anybody publicly say they were going to do this, but a lot of people are discussing the pros and the cons right now.”
Reducing the number of shareholders, he explained, implies buying back stock or finding some other way to reduce the number.
“ That, of course, means a capital outlay,” he said. Presumably such an expenditure might make such institutions more vulnerable to competitors.
In private banking, Ott said, “ the Federal Deposit Insurance Corporation has said they recommend private banks consider using separate or same auditing independence standards.
“But they have openly acknowledged,” he added, “that it may be appropriate to use one accounting firm to handle its external and internal auditing.”