Evidence on Sarbanes-Oxley Act

The US introduced the Sarbanes-Oxley Act (SOX) in 2002 in response to several well known corporate scandals. A recent working paper from the New Zealand Institute for the Study of Competition and Regulation reviews the last 5 years of empirical research on the effects of SOX. The paper, Sarbanes-Oxley and its Aftermath: A Review of the Evidence by Glenn Boyle and Eli Grace-Webb, opens by pointing out that no less than, a staggering, 528 studies of SOX can be found on the Social Science Research Network!

The SOX sought to change the manner by which a firm's directors, executives and auditors provide information to share-holders about firm's performance and financial well being and to give shareholders control over the all important incentive structures used for aligning the interests of management with those of the firm's owners. And there is evidence that owner and management incentives are not aligned. The book, Pay without Performance: The Unfulfilled Promise of Executive Compensation by Lucian Bebchuk and Jesse Fried offers evidence that the compensation process has been corrupted. The Bebchuk and Fried view is that the process has been captured by CEOs. They argue that executives use the power they have to pay themselves large amounts which are not related to performance. Some commentators, however, argue that SOX was a typical knee-jerk political reaction rather than a reasoned response to corporate problems.

SOX focused on four key areas, thought to be in need of reform: the accuracy and reliability of financial disclosures, corporate governance, fraud, and the accounting industry. Research on the effects of SOX can be placed in one of three categories.

First, the effect of SOX on firms - on their costs, their governance, their investment and risk-taking strategies, and so on. Second, its effect on the quality of information provided to investors by firms and auditors. Third, its effects on the efficiency of capital markets.

As far as a firm's costs are concerned, studies into the effects of SOX usually take one of two approaches: "either statistical studies of the reaction of securities prices to events affecting the implementation of SOX, or direct surveys of post-SOX changes in costs." The underlying idea for the market reaction studies is simply that a firm's stock price is the present value of future discounted earnings, so any SOX- attributable changes in this price represents an estimate of the net cost of SOX to the firm. Different studies reach different conclusions, some showing costs going up while others show them going down. Other results suggest that while SOX may have targeted the correct governance attributes, the mandatory imposition of these measures is called into question since the market was already rewarding firms who adopted these measures voluntarily. The results of some studies also suggest that the market perceived a benefit from the adoption of SOX for firms that had previously offered weak governance protection to their shareholders. Still other results tell us that small firms are particularly badly affected by higher SOX-imposed costs. Any benefits are offset by the additional costs imposed. Studies based on other capital markets conclude that debt markets reacted negatively to announcements that made the passage of the SOX more likely. But studies also show that SOX was successful in "creating a climate of investor confidence in financial information, and restoring normalcy in the financial markets particularly in the long term."

Another groups of studies attempted to identify actual cost increases. One study found that average audit fees climbed by US$2.32 million between 2003 and 2004. It can be argued that at least part of this increase can be attributed to SOX compliance costs. Other evidence indicates that smaller firms suffer more due to SOX-mandated increases in compliance costs.

SOX appears to have effected the governance of companies both via the composition of board and their behaviour. Boards have become larger and more independent with audit committee meetings becoming more frequent. Directors are less likely to be current executives and more likely to be lawyers, consultants, financial experts and retired executives.

One paper suggests that in the time after the introduction of SOX firms with shareholder protection greater than that mandated by SOX reduced their level of protection.

As one might expect executive compensation has been affected. The evidence tells us that the ratio of incentive to fixed salary compensation decreased post-SOX. There has also been a reduction in attempts by executives to influence the value of stock options (cf Bebchuk and Fried).

SOX has also had some unintended consequences.

Faced with more onerous regulations, economic agents inevitably react in ways that minimise the obligations thus imposed. SOX has been no exception to this general rule.

Incentives matter! Who would have guessed?

A number of studies suggest that there has been an increase in the frequency of firms reducing their shareholder numbers to below 300 in order to escape Securities and Exchange Commission overview. The market's reaction to "going dark" is strongly negative - the delisting move is seen as a indication of a weak financial situation. Also as public floats of less than US$75 million escape Securities and Exchange Commission scrutiny, in terms of Section 404 of SOX, there is an incentive to remain under this level. Evidence also points out that SOX has had a chilling effect on IPOs and US listings of foreign companies. SOX avoidance moves also include a move away from bond sales to the public towards bond sales to institutions on the private debt market - which do not have to be registered with the SEC. Other measures taken by some firms include a reduction in risk-taking and investments by management along with lower R&D and capital expenditures and an increase in cash holdings; relative to similar firms in the UK. There is also evidence that US firms have reduce their investment in risky projects and with this lower exposure to risk, firms seem to be more risk adverse.

With regard to the quality of information provided by firms to investors some of the available evidence tells us that investors are being provided with very reliable information post-SOX. Other studies suggest that managers now disclose less information even though the precision of supplied information has increased. As to information provided by the firm's auditors Boyle and Grace-Webb state,

Another objective of SOX was to increase investor confidence in the quality of audit reports. However, the evidence that is available to date suggests that the firms most in need of quality audits are now less likely to obtain the services of top-tier auditors.

The evidence also shows that after the passage of SOX, riskier firms have had a higher growth in audit fees and are more likely to see their auditors resign. Other papers show that there has been more detection of fraud by auditors. (Or are auditors just telling us about more of what they find?) But the evidence also notes that whistle-blower detected fraud fell post-SOX.

To the extent that more reliable information is being provided, capital markets would be expected to react more decisively to the release of new information and there is evidence to support this view. Also the market appears to find some, if not all, of the new information valuable. The evidence suggests that firms who are able to show effective internal controls have a lower costs of equity. On the other hand, there is less certainty as to the usefulness of CEO and CFO certification. Also it still appears that private information is a source of capital market profit. The evidence shows that post-SOX the exploitation of private information in the exercising of options has increased in profitability. Thus SOX has not prevented the continuation of this form management opportunistic behaviour.

In conclusion Boyle and Grace-Webb say

While apparently improving market liquidity and some aspects of corporate governance and information disclosure, SOX has also had a number of more deleterious effects: greater costs of auditing, governance and human capital, and compliance more generally; a mismatch between auditor quality and firm risk; more firms delisting or otherwise staying below the regulatory radar; less corporate investment and risk-taking; and ambiguous changes in the quality of investor information and capital market efficiency.

One thing that may be of importance for economies like New Zealand, should they wish to go down the SOX-type path, is the finding that the downsides of SOX are more extreme for small firms.

Boyle and Grace-Webb emphasise that the studies they have reviewed suffer from at least two problems in isolating the effects of SOX:

First, it is difficult to differentiate any impact of SOX from that of other post-scandal regulatory initiatives - Coates (2007) notes that SOX was enacted "amidst sharp financial, economic, and political changes". Second, it is also often difficult to distinguish the impact of SOX from that of the corporate scandals themselves.

Boyle and Grace-Webb end their paper by drawing the sobering conclusion that,

... the evidence to date is not particularly reassuring: commentators who argued that SOX would be a case of "legislate in haste, repent at leisure" look increasingly likely to be proved correct.