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About a two years ago I made my first foray into the blogging world by way of few comments on Roger McNamee’s blog: The New Normal. At the time, Mr. McNamee was promoting his new book and writing regularly on the site. His observations and his reputation, led to some ongoing discussions that included the thoughts of a wide range of people, including some high-tech executives like Marc Andreeson and Jeremy Allaire (founder of Brightcove, which was just beginning).

I was intrigued and as a passing experiment wrote a reply to two of Roger’s posts, one on Sarbane Oxley where Roger’s speculated the law was influencing corporate earnings guidance, and the other a post of Roger’s about the direction Internet video. With just a toe-in-the-water of blogging, I wrote both pieces anonymously using only an email address (lookingglass@gmail.com) to identify myself.

My replies were an experiment, but after recently seeing what I wrote in some old files, for the sake of nostalgia, and to own what I originally wrote, I decided to reprint my posts as well as links to the original discussion here on Metue today and tomorrow.

Today, Sarbanes-Oxley issues from February 2005(tomorrow net video):

Roger’s original discussion can be found here.

Excerpting it, and not including the logic for his argument (which can be read in his full post) Roger wrote the following:

Earnings reports from tech companies have generally been strong during the current reporting season.  In most cases, however, the guidance has been disappointing, causing a broad sell off on Wall Street.  It’s no surprise that investors react strongly when a CEO says the coming year will be below the recent trend line . . . but that doesn’t mean 2005 will actually be a bad year.

Thanks to Sarbanes-Oxley, I believe companies are sandbagging their 2005 guidance to Wall Street.

I replied twice in the ongoing discussion his essay provoked. Here is my two replies (with a few typos corrected):

Reply 1: It’s a cheap play on words but Sar-box might be the Bo-tox of the public company world.  A little injection of it here and there may help things look good on the surface, and it may provide real benefit for other ailments, but if used excessively, or without discipline, it’s toxic. 

I think, noting the variations in incentives throughout the fiscal year for reporting guidance and forecasting spotlights only part of the issue of guidance in a the post Sar-box.  In addition to the disequilibrium that exists, in the post-Sar-Box organization the balance of power has shifted a little.  Now, accounting and legal counsel (be it internal or external) can influence business decisions with a level of conservatism that, at times, can border on the irrational. Additionally, the administrative process, or procurement process, for going from term sheet to closed transaction can be bureaucratic and complex. These changes can impact sales cycles or influence the timing of transactions.  That in turn, can make it more difficult for seasoned (or non-sandbagging) executives to have a clear view on their projected returns… Unless they are in a business sector for which a significant portion of product or services are pre-ordered, or revenue from prior quarters is contractually recurring. 

There is a line somewhere where reasonable and appropriate due diligence and fiscal discipline morphs into something excessive and counterproductive.  Taking qualified risks is a part of the business proposition.  The question to me is – what is too much qualification? And are some enterprises having problems with that at the expense of opportunity, innovation… and guidance?

Geo-political macro issues not withstanding, the present climate, and the nature of Sar-box remind me a bit of a playground seesaw.  When one end of a spectrum reaches its peak, ensuing backlash causes the opposite pole to reach the top.  The questionable fiscal discipline, both with regard to the Bubble of buzz-word-bingo fame, and within spheres of traditional corporate America, that was experienced a few years ago, seems to have pushed the seesaw to the other extreme, and now, it must slowly find it’s balance and equilibrium.  Today’s climate is possibly not that different from the legal changes following Black Tuesday in 1929.  The conservatism that followed that boom and bust cycle led to the Securities and Exchange Acts of ‘33 and ‘34.  It took time and amendments/revisions before a balance was struck but once it was, there was reasonable success:  those laws still govern our markets today.

Conflicting incentives, motivations to sandbag, crystal balls with clocks that keep getting out of sync, toothier penalties for failure… It’s not an easy time to be at the helm of a public company.  And as an investor in them, seems it’s a good time to either look further into the future using conservatively computed longer-term financial targets as a filter, (along with sound business analysis), or alternatively, to jump into the trading pits with option and hedge strategies that turn the short term volatility into an advantage.

My Second Reply (in response to Roger’s and other’s comments):

This is moving toward a more general discussion of Sox then your original post but I agree; the problem is not an issue of intent, or necessarily even the regulations themselves. I’m not sure I’d say it’s inflexible though.  I think the code, to some extent, can be flexible, but the problem is in its interpretation and application. 

Every major securities law active for more than a few years is trailed by a litany of opinion letters and exemptions that act as an appendix to the original code.  Call it a factor of the horse-trading nature of the legislative process, or the complexities of the issues being addressed, but the regulatory process rarely seems to resolve things on the first pass. SOX is still a baby.  There has not yet been enough time for its various ambiguities to be hashed out. 

Document retention policy is one of many examples that illustrate the problems.  In the code, only document record retention requirements for public accounting firms are explicitly defined.  For the Corporation, references to what a company must keep available, or for how long, are ambiguous.  Other examples:

• Auditors are required to certify their client companies’ maintain “adequate” records to support financial transactions. But what is “adequate?” Can adequate differ depending on the size of a company?
• SOX requires that documents relevant to an audit or investigation must be available on demand and cannot be destroyed.  There are severe penalties in place for anyone who “knowingly” violates the requirement.  But do regularly document retention cycles provide a justifiable exception for documents not being available?  What happens if a company has a policy to delete documents every three years, but in the fourth year – an investigation requires prior documents? 
• Does a company really need to keep documents for 7 years (a standard taken from the explicit requirements for public accounting firm’s work paper retention)? Or is that excessive?

Absent judicial and legislative interpretation, the task of answering these questions, and others, seems to be falling to the conservative judgments of accounting firms, attorneys, and executives who are fearful of personal liability for non-compliance.  Their butts are on the line, and they are therefore, not flexible at all.  Better to err, they seem to argue, on the side of caution.  Maybe they’re right, but we don’t know yet.

There’s no question that SOX presents more of a burden to companies with fewer resources.  Wishful thinking is to say the laws will be challenged and interpreted soon. Pragmatism suggests we have little choice but to be patient and vocally push for middle ground.