WASHINGTON — Critics of the legislative process say laws that pass without meaningful opposition are often the ones that spawn troublesome unintended consequences. Community bankers offer the Sarbanes-Oxley Act as an example.
The corporate reform law passed the Senate in July 2002 on a 97-0 vote. It was not until executives began trying to comply with section 404, the internal controls provision, that concerns turned into complaints. Community bankers say the addition to an already daunting compliance burden will force them to deregister their stock or sell to larger companies better equipped to handle the new requirements.
When Robert McCormack became its CEO, the $1 billion-asset Sun Bancorp Inc. of Selinsgrove, Pa., was laboring under a huge chunk of high-rate Federal Home Loan bank debt. Prepayment was not a viable option, however; the debt carried a $30 million prepayment penalty, and Sun made $2.7 million in the first six months of this year.
That debt was the main reason Sun agreed on Oct. 1 to sell itself to Omega Financial Corp. in nearby State College, Pa.
But Sarbanes-Oxley was also a factor, Mr. McCormack said.
“When you started looking at the combination of the FHLB debt and the amount of earnings we were going to have, and then throw SOX expenses on top of it — it certainly played a role in our decision,” Mr. McCormack said. “I think there is the potential that there will be more sales because of Sarbanes-Oxley.”
Others agree.
For a bank that is thinking about selling itself, section 404 is another reason to do so, said Steven Hovde, the chief executive of Hovde Financial Inc., an investment bank that deals solely with financial institutions.
Section 404 requires public companies to include a review of their internal controls in their 2004 annual report, approved by their independent auditor, filed with the Securities and Exchange Commission.
The control structures ensure that companies handle their assets and liabilities appropriately and that financial statements reflect them accurately.
There are internal controls for cash management, accounts payable and receivable, payroll, and financial and tax reporting, to name a few. They dictate the procedures banks must follow in things as complicated as their processing systems and as mundane as which employee should accompany a customer to the safe-deposit box.
Access to the general ledger is a basic example, said Sydney Garmong, a technical communications executive with Crowe, Chizek & Co. LLC.
“The systems are integrated, and there is a lot of automated processing, but sometimes posting doesn’t go as expected and you have to do a manual entry,” she said. “If there are not good internal controls over that process, you could have someone writing bogus entries — maybe even to put cash into their accounts.”
The controls are not difficult individually, but there are a lot of them, and banks must document them, test them, and then get their auditors to agree that they work.
“Smaller financial institutions are finding compliance with Sarbanes-Oxley 404 to be incredibly expensive,” said David Downs, an investment banker with BankAtlantic Bancorp’s Ryan, Beck & Co. Inc. in Livingston, N.J. “The amount of work that they have to go through to document all their internal controls is just time consuming and expensive, and you’re typically hiring either a consultant or another accounting firm to help you.”
That is because conflicts of interest prevent the attesting auditor from helping the bank get its controls up to speed.
“Community bankers are telling us that their audit fees are doubling or more,” said Karen Thomas, the chief operating officer at the Independent Community Bankers of America. “It fosters consolidation, because smaller banks have a smaller asset base over which to spread all their fixed costs, and Sarbanes-Oxley is yet another very costly regulatory burden.”
Increasing costs are “a bottom-line statement that you can’t refute,” said Rick Ueltschy, the chairman of the financial institutions audit group at Crowe, Chizek. “You need to apply resources to it in some way. You may hire people, you may use outside contractors, but there is a need to import arms and legs and intellect.”
Though bankers and their accountants acknowledge that costs are likely to be highest in the first year, the costs won’t disappear in subsequent years.
Mr. Ueltschy said the first year’s costs include building a framework and infrastructure. Then there is “the cost of the annual assessment” and the “annual cost of maintaining that documentation and process that you built.”
The result is a tremendous strain on community banks’ relatively limited resources.
“For a small company that is really lucky to have one very good CPA as their controller or CFO, they simply don’t have internally someone with the requisite background to digest all this internal control auditing and manage the company through it,” Mr. Ueltschy said. It is not clear that community bankers will pony up the costs without exploring alternatives, and given ongoing consolidation, selling is always an alternative.
Community banks typically have “three or four senior guys and then a board that meets once a month with the capacity to absorb only so much regulation,” said Kip Weissman, a lawyer with Luse Gorman Pomerenk & Schick PC. “They will sell when it just becomes too difficult to manage their assets and their regulatory responsibilities. A few will make the transition to a larger institution and hire more people and bring in a second generation of board members. But often they go until they run out of steam — and if you put more pressure on them through additional regulation, they will sell sooner.”
Community banks and their investment bankers are suggesting that the section 404 requirements have been a big factor in moving that tipping point.
“At some point smaller community banks will hit a threshold … where they have to decide: Is now the time to review strategic options or to make a significant investment in infrastructure?” said Robert Rout, the chief financial officer at S&T Bancorp Inc. in Indiana, Pa. “I believe Sarbanes-Oxley requirements will accelerate the consolidation in the banking industry, especially for smaller banks and thrifts.”
Joseph Thompson, an investment banker with SunTrust Robinson Humphrey, said many of his clients have decided that going private is the best answer.
A number of them “are literally leveraging their balance sheets so they can get some of the small shareholders off their books so they don’t trip any of the requirements,” Mr. Thompson said. “It’s always of note when government regulation forces changes in capital formation.” But going private was not the solution that lawmakers or the SEC envisioned.
Companies that go private “still have shareholders,” said Mr. Downs of Ryan Beck, “and what we end up doing is reducing the amount of information about these companies that is in the public arena.”
“We end up with investors being less knowledgeable about their investments.”
Buyers have also noted the effect of Sarbanes-Oxley, because they must attest to the internal controls of acquired companies. The SEC has given acquirers a one-year waiver, but public companies may not be eager to rely on it. Not being able to vouch for a recently acquired company is a message not likely to sit well with investors.
Mr. Downs and other investment bankers say few deals or none will close at yearend this year.
“If you close a deal on Dec. 31, are you going to be in a position to attest to the adequacy of the internal controls of an organization that you’ve owned for one day?” he asked. “You are going to be much more inclined to want that deal to close in January, which gives you basically an entire year to get comfortable with and document their controls.”
