Bloomberg says Paulson in drive to reform U.S. financial Regulations

Robert Schmidt of Bloomberg is reporting that Treasury Secretary Hank Paulson is leading a drive pushed by the business community to roll back the Sarbanes-Oxley Act ("Paulson Leads Drive to Ease Regulations of Sarbanes-Oxley Law").

Schmidt's article does a good job explaining Paulson's views and the pressure the Treasury Secretary would like to mount in a campaign to repeal Sarbanes-Oxley, but only touches on how limited Paulson's ability to maneuver is in this area. It also fails to mention that Paulson's objectives do not seem to be limited to just SOX but all U.S. financial regulation. This has several important implications.

First, while Paulson is indeed the most powerful Secretary of Treasury that the Bush Administration has had, the Treasury Department is still comparatively weak vis-a-vis the power the agency wielded during the Clinton years. Unlike many countries, the Securities and Exchange Commission (the country's securities market regulator) does not report to the Treasury Department (or, for that matter, to the president directly). With the exception of the Office of Comptroller of the Currency (OCC) , nor do the nation's banking or insurance regulators. With banks, the big daddy regulator is the Federal Reserve, with OCC and the Federal Deposit Insurance Corporation (FDIC) playing second fiddle. Insurance regulation in the United States is conducted at the state level.

What this means is that the Treasury Department, while it represents the United States at such international organizations as the Financial Stability Forum, the Organization for Economic Cooperation and Development and the Financial Action Task Force, really isn't the boss of anyone important. It collects taxes, protects the president, and heads the Financial Crimes Enforcement Network, but really doesn't set regulatory policy in any area except for taxation. So Paulson can use the weight of his (diminished) office to try to push through regulatory changes, but he's in a poor position to do it by himself.

The one thing that he can do, and which he apparently is considering, is streamlining banking regulation by moving the OCC under the Federal Reserve's authority. The OCC has been blamed by some for the mess that now is the Basel II Accord, which the Federal Reserve has since said applies only to large U.S. banks with international operations, and not small U.S. banks (a position that has caused some consernation among European financial regulators, who see this as giving smaller U.S. banks a competitive advantage). If Paulson does move the OCC under Federal Reserve authority, it will simplify U.S. banking regulation. But U.S. banking regulation isn't what has the U.S. Chamber of Commerce and its Committee on Capital Markets Regulation with their underwear in a wedgie.

In the end, however, Paulson may be able to claim victory for events underway before he took office. As I noted previously, the Public Company Accounting Oversight Board is in the process of drafting a new Audit Standard 5, which will take much of the pain out of Section 404 of the Sarbanes-Oxley Act. This new AS5 may well be out by December. That, combined with new SEC deregistration rules (which likely will be released at or before the new AS5 is) will make it difficult for foreign issuers to complain about the costs of Sarbanes-Oxley. The costs of implementing Section 404 (the provision on internal controls) will drop, and, if you don't like it, it will also be much easier to get out of the American market.

This will not solve the Sarbanes-Oxley issue for many foreign (and domestic) issuers. The PCAOB will still be policing audit firms, which will make it harder for companies to reward or punish auditors who don't go along with their interpretation of U.S. Generally Accepted Accounting Standards (US GAAP). CEOs and CFOs will still need to certify the accuracy of their companies' financial statements -- which, while not costly, is something CEOs and CFOs would rather not do, since it more clearly puts their butts on the line if someone is lying. And companies will still need to give a statement about the quality of their internal control systems. What will be different is that the steps the audit firm will use to check on the validity of this statement will be far less rigorous and costly.

Public companies will still complain about this last point, but the strength of these complaints will be far weaker. Right now, a company legally can announce (truthfully) that its internal control are weak and that it has no idea about how its money gets spent. And they will still be able to do this after implementation of Section 404 is "improved" (i.e., AS5). The problem with this, of course, is that no sane investor will pay much for the securities of a company making such an announcement, and companies know this. Hence, some issuers will continue to complain about the internal controls provision, arguing that it still requires them to adopt expensive new internal controls or else face a dramatic drop in stock price. But, frankly, that's a little like a used car dealer complaining that a law that mandates used cars be sold with accident and repair reports will lead to car buyers paying less for damaged cars. In other words, an argument that's a little harder to feel sympathy for.