I recently met with a CEO of a public real estate company to discuss the impact of the Sarbanes Oxley Act of 2002 on his firm. I explained certain provisions of the Act as it relates to internal controls over financial reporting and audit committees and the consequences of non-compliance. His response? I was overreacting and that there is no sense of urgency.
Guess what? Several weeks later, after his annual shareholders meeting, he contacted me. He realized that non-compliance with the Act — which could ultimately lead to civil and possibly criminal penalties — was a risk he was not willing to take. Today, management of public real estate companies and board members are being inundated by lawyers, accountants and other consultants to discuss Section 404 of the Act, which requires management to establish, maintain and evaluate their internal controls over financial reporting for the company.
In addition, Section 404 requires an independent auditor to annually certify and report on management's evaluation of these internal controls. Their reactions range from confusion and denial to acceptance and action.
What Does It All Mean?
The Act will require senior management of public real estate companies to assure the reliability of their financial reporting and related disclosures and improve their corporate governance. There is no doubt that the Securities and Exchange Commission (SEC) and the newly formed Public Accounting Oversight Board, which was created by the Act, will be aggressive in enforcing these new laws.
Arguably, Section 404 and other provisions of the Act will significantly increase the cost of being a public company, especially for smaller public real estate companies. However, the cost for companies who do not comply will be far greater. For instance, companies that do not comply with the provisions of the act run the risk of significant civil and criminal penalties and could be punished in the marketplace by investors.
The estimated incremental costs associated with being public, including compliance with the Act, could range from $500,000 to in excess of several million dollars per year. For example, audit and legal fees will increase substantially. Information technology costs and related consulting fees will increase for purchasing new software. And directors and officers insurance — liability insurance for the errors, omissions or other wrongful acts of directors and officers — will increase up to 100% or more, not to mention the increased compensation costs for the board of directors and audit committee members.
In order to alleviate the costs and burdens imposed on companies to comply with Section 404, the SEC extended the original compliance date. Under the final rules, most companies, other than non-accelerated filers including smaller companies and foreign private issuers, will have to comply by their fiscal year end on or after June 15, 2004. All other companies must comply by their year-end on or after April 15, 2005.
Private real estate companies looking to attract capital from public companies, pension funds and/or other institutional investors, or eventually planning to go public, will be well advised to adopt many, if not all, of the Section 404 mandates. Institutional investors making acquisitions or entering into joint ventures will incorporate in their due diligence process compliance with many provisions of the Act.
It also is likely that in the future, states and private and public institutional investors will adopt some or all of the Act's requirements. Most definitely, non-compliance with Section 404 can have a negative impact on the value of a company and may derail proposed transactions.
A Momentous Decision
The Act is the most significant legislation in the securities area since the 1930s. It will help regain investor confidence in public companies by providing more reliable financial information to the public, and strengthen corporate governance. Since compliance with the Act will be costly, many companies may consider going private, merge with a larger company or liquidate and distribute the proceeds to their investors.
However, the benefits of well-documented policies and an evaluation of internal control will result in increased productivity and efficiencies in operations, and reduce the likelihood of fraud.
Scott Farb is the principal-in-charge of the national real estate group at Rothstein, Kass & Co., one of the nation's largest accounting firms. For further information, visit www.RKCO.com.