Like hundreds of other companies, Manhattan Associates ( MANH) restated its earnings last year. Between 1999 and 2004, the supply-chain software maker overstated its net profit by $7 million, or more than $1 million a year, because of how it accounted for a tax credit.

You might think that's another piece of evidence that Sarbanes-Oxley, the corporate compliance and financial transparency act passed nearly four years ago, is doing its job. But Manhattan Associates CEO Pete Sinisgalli says you'd be wrong: The restatement surfaced through internal controls the company had already set up, independent of Sarbanes-Oxley.

For Sinisgalli and others, the situation illustrates what is misguided about Sarbanes-Oxley. The law may have restored investor confidence, but Section 404 -- the controversial provision requiring reports on and testing of internal controls -- "adds a duplicate step to what you've already done," says Sinisgalli, who joined Manhattan Associates as CEO in 2004.

"We're just re-documenting and re-testing what we had in place," he says. "The redundancy is not just unnecessary, it's costing real money," noting that the $1 million Manhattan Associates spent on 404 compliance could have benefited investors. "In our case, that money frankly would have gone to increased earnings per share."

The Securities and Exchange Commission has started to take complaints like Sinisgalli's to heart -- at least enough to appoint a small business advisory panel to look into Section 404's impact on start-ups. That panel, largely comprising executives at companies like Bluefly ( BFLY), Tennant ( TNC) and MidSouth Bancorp ( MSL), as well as financial and law firms that are often their clients, issued their recommendation last month: Roll back Section 404 for companies with market caps below $787 million. Following a comment period, the final report is expected on April 23.

In describing Section 404, people often compare it to using a meat cleaver when a scalpel will do. The thrust of the recommendations is that the SEC should put aside the cleaver until the right scalpel can be found. "Regulators and members of Congress never anticipated many of the challenges that Section 404 compliance has presented," the panel's report said.

Notably, Congress didn't want auditor evaluations to increase charges or fees. But they have, disproportionately so for small companies. The report cites data from the American Electronics Association that compliance costs totaled nearly 3% of revenue for companies with market values below $100 million, with larger companies spending less than half a percent of revenue.

Until the framework for assessing internal controls can be better tailored to small companies, the panel said, the SEC should exempt them from the costs of an outside auditor mandated by Section 404. But in exchange for that relief, companies need to make auditors answer to the audit committee, not management.

"Given the landslide of legislative and regulatory changes, let's step back and ask the question: Have we struck the balance right? I think we've gotten it mostly right, but not with the implementation of 404," says Steven Bochner, a partner at Wilson Sonsini Goodrich &Rosati and a member of the advisory panel.

Not surprisingly, there is almost as much debate over the panel's central recommendation of exempting small companies from outside auditors as there is over Section 404 itself. Critics point out that the law will exempt nearly 80% of all public companies. Proponents say that it will only affect a mere 6% of the U.S. stock market capitalization. Both points, equally compelling taken on their own, are also equally valid.

And here's what the disagreement comes down to: Annual reviews from outside auditors are usually worth the cost for large companies, but not for small ones. Sarbanes-Oxley took a compliance template from big firms and made it apply to big and small alike.

The question now is, can the law be tailored for small companies without rolling it back?

Or as Bochner puts it, "Do you fix an airplane in the air or do you ground it? Some people are saying, let's work it out. But I'm saying that this is so far off the mark we've got to ground the airplane."

"I don't think the airplane is in that much danger, to use his metaphor," says Kurt Schacht, executive director for the CFA Centre for Financial Market Integrity and one of the three out of 21 panel members to dissent from the 404 exemption recommendation. Schacht points to studies showing small companies misstate and restate earnings almost twice as often as large ones.

"There were early implementation problems, but everyone acknowledges that the process is starting to settle in," Schacht says. "Over the course of a few years, this will be ironed out as auditors have a better sense of the usually less-complex circumstance of small companies. Hopefully, the costs will come down."

In the end, though, the panel's recommendations may well be for naught. Two sources close to the SEC said that the commission may not act on the recommended exemption, if only because it can't. It seems the commission isn't empowered to roll back Section 404 for small companies -- no matter how much it may or may not want to.

The SEC has the power to exempt provisions of the Securities Exchange Act of 1934. New securities laws are normally amended to that act, the grandfather of modern securities law enacted in the wake of another scourge of financial scandals. But a few portions of Sarbanes-Oxley, including Section 404, were deliberately not amended to the 1934 act -- ensuring that only Congress could repeal or alter them.

The SEC recently received a letter from Rep. Michael Oxley (R-Ohio) saying the commission does in fact have authority to relieve companies from compliance costs. But this week, the act's other sponsor, Sen. Paul Sarbanes (D-Maryland) delivered a speech arguing the contrary. Citing the opinion of dozens of legal scholars, Sarbanes said "there is no statutory basis for the proposed exemption."

So, it's looking more and more likely that any relief from Section 404 and its costs may be caught up in political squabbling and legal battles for another couple of years, time when the compliance costs are sure to come down anyway. That would be bad news for CEOs like Sinisgalli who are eager for relief.

"If you don't resolve that legal uncertainty, you risk bottling this recommendation in litigation for another two years, while nothing happens in 404 reform," says Schacht. "In our dissent, one of the points we made was, 'you better be sure the SEC can do what you're recommending. Otherwise, it seems to be a pretty futile exercise.'"

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