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Tuesday, June 07, 2005

Did SOX Lower Companies' Values?

Here's a great article on market-based evidence of the costs of Sarbanes Oxley. It's evidence strongly suggests that stock market participants expected the costs of SOX to exceed its benefits. According to this working paper by Ivy Zhang (doctoral candidate from the University of Rochester) titled Economic Consequences of the Sarbanes Oxley Act of 2002, announcements of legislative events that indicated an increasig liklihood of passage of SOX were associated with significantly negative subsequent stock market reactions. Here's the abstract (emphasis mine):
This paper investigates the economic consequences of the Sarbanes-Oxley Act through a study of market reactions to legislative events related to the Act. I find that the cumulative abnormal return around all legislative events leading to the passage of the Act is significantly negative. The loss in total market value around the most significant rulemaking events amounts to $1.4 trillion. I then examine the private benefits and costs of major provisions of the Act by investigating the cross-sectional variation in market reactions to the rulemaking events. Regression results are consistent with the hypothesis that shareholders consider both the restriction of nonaudit services and the provisions to enhance corporate governance costly to business. The results also show that Section 404 of SOX, which mandates an internal control test, imposes significant costs on firms.
I've highlighted the most striking fact in the abstract - that there was a massive loss in firms' values due to the very negative perception of SOX (and particularly Section 404 which mandated tests of internal controls). The paper has a number of features to recommend it: it provides a very nice timeline of the events leading up to SOX, it's got a great survey of the literature, it breaks out the effects of various provisions of the law (like sections 404 and 401), and it looks at the effect of SOX on firms with weaker vs. stronger existing governance structures.

Zhang examines the market reactions to 17 different announcements surrounding the passage of SOX. She shows that the stock market lost approximately 20% in total value (after correcting for other factors) around these 17 announcements. Interestingly, the losses in firm value were greatest for firms with weaker governance, indicating that the expected costs of compliance for these firms outstripped the expected benefits.

All in all, a great paper, and a hat tip to Larry Ribstein at Ideoblog for the link.