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Sarbanes-Oxley regulation effective without harming investor value

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The Sarbanes-Oxley Act of 2002 had teeth, but did not bite investors.

That’s the verdict of a new study on the efficacy and impact of the controversial government regulation enacted in response to accounting scandals at Enron, WorldCom and others. Legislators intended Sarbanes-Oxley (or “SOX” to the finance world) to dissuade opportunistic behavior by managers without imposing net losses on investors.

To gauge their success at achieving both goals, researchers from the University of Washington Foster School of Business and Rice University investigated two key provisions of the act: the prohibition of self-dealing (specifically firms extending sweetheart loans to executives), and the increase in executive liability for the firm’s financial reporting.

Foreign firm effect of Sarbanes-Oxley
Did SOX work? Considering foreign firms that listed on either New York or London exchanges in addition to their home markets between 1990 and 2006, the researchers found that those firms were six percent less likely to choose New York over London after Sarbanes-Oxley was implemented. This suggests that foreign executives, accustomed to laxer regulatory environments at home, were convinced that the act’s deterrents against self-dealing and fraudulent accounting were serious, according to co-author Stephan Siegel, an assistant professor of finance at the Foster School of Business.

Did SOX hurt the value of firms? The researchers studied investor activity in foreign firms on the day that they announced listing on a New York exchange. The prices of those stocks, on aggregate, climbed two percent higher in the years after Sarbanes-Oxley than they did after the same announcement before Sarbanes-Oxley. Siegel says this indicates that investors believed SOX would also benefit the bottom line.

Sarbanes-Oxley impact on US businesses
To measure investor response in the US, the researchers applied this empirical data to a provocative what-if scenario. Had Sarbanes-Oxley been implemented as a complete surprise to the market—rather than fomenting for months in response to the accounting scandals—the researchers estimate that a medium-sized US firm listed on the NYSE, NASDAQ or AMEX would have experienced a price increase of between 5.7 and 14.5 percent.

According to Siegel, investors believed that Sarbanes-Oxley was good for their companies, despite—or perhaps because of—the pain it would impose upon management.

“We conclude that managers didn’t like SOX because they were constrained, which was the idea,” Siegel says. “But that’s easy. You can always enact regulations that people don’t like. The more important—and somewhat surprising—finding is that shareholders seemed to like it.”

Effective, but optimal?
Few two-word phrases can incite such heated debate across this grand experiment in capitalism that is the United States of America than “government regulation,” whether you’re talking the auto industry or health care, baseball or banking.

“Most financial economists, myself included, would generally argue that it’s very difficult for the government to introduce a regulation—even with the best intentions—that gets it right and proves beneficial to the economy and society,” says Siegel.

He credits the widely-held notion in finance of an efficient, omniscient market that is far better equipped to regulate itself than any government could be.

Free market vs. government regulation
“We’re not suggesting that SOX was the best way to address this crisis, necessarily. Some would argue that if we had deregulated the markets, kept government rules out of the game and given shareholders more direct power to control management, we might have achieved a better outcome,” Siegel says.

“But from this study, we can say that what the US government did with Sarbanes-Oxley was not a disaster. It had the impact on managers that regulators intended. And shareholders did not feel it destroyed the value of their company. This suggests that, as an empirical matter, regulatory interventions can improve upon private outcomes in some instances.”

“The impact of the Sarbanes-Oxley Act on shareholders and managers” is the work of Stephan Siegel, assistant professor of finance at the Foster School of Business; Lance Young, assistant professor of finance and Neal and Jam Dempsey Faculty Fellow at the Foster School; Jefferson Duarte, associate professor of real estate finance at Rice University; and Katie Kong, a doctoral student at the Foster School.