magglassThe Sarbanes Oxley Act was enacted nearly twelve years ago in the midst of profusion of corporate scandals. Despite the passage of time, the Act has remained controversial. In order to evaluate the Act’s impact, Harvard Law Professor John C. Coates and Harvard Business School Professor Suraj Srinivasan undertook to review over 120 studies of the Act, focusing on research in accounting law and finance. They compiled their findings in a January 12, 2014 paper entitled “SOX After Ten Years: A Multidisciplinary Review” (here), which finds that though the Act has not had many of the dire consequences that its critics predicted, it is also analytically difficult to make the case that the Act overall has been beneficial.


In certain circles, the enactment of SOX is still highly controversial – it is, as noted in a March 10, 2014 Forbes article about the authors’ paper (here), still viewed by many as “a politically motivated over-correction” that threatens to “lead to a loss of risk-taking and competitiveness.” The authors themselves noted a “puzzle” about the public debate regarding SOX – that is that while the Act “continues to be fiercely and relentlessly attacked in the U.S., particularly in political election battles and during legislative debates,” survey evidence suggests that “informed observers, including corporate officers and investors, do not believe that the Act – as implemented…has been a significant problem and may well have produced net benefits, and the law has been copied at least in part by other countries.”


While the debate has continued, one thing is clear: Despite the criticisms, the Act and its institutions have survived almost unchanged. The PCAOB remains a durable and significant part of the regulatory landscape. The relation between audit firms and issuers continues to be defined by SOX. Internal control mechanisms, as modified by subsequent legislation that eliminates the provisions application to smaller companies, remain in force.


At the time of its implementation, the Act’s most vehement critics predicted it would lead to the federalization of corporate law, and argued that the law was excessively “mandatory,” in contrast to the traditional disclosure-oriented approach of the U.S. securities laws. The authors reviewed the results of research to date and concluded that “SOX had little impact on the federal/state balance of legal authority over corporations, has functioned to force disclosure, which in turn has combined with market forces to induce significant changes in control systems, and has been partly but not completely coped by other countries.”


The Act’s critics also have contended that the Act would “increase the marginal cost of being a U.S.-registered public company more than the benefits of the status,” which in turn, it was predicted, would lead to more companies going private or going dark, fewer companies going public, and loss of listings to exchanges outside of the U.S. However, the authors found that the research to date showed that “while smaller, less liquid and more fraud-prone firms did indeed exit U.S. stock markets after SOX,” the evidence that SOX reduced the number of IPOs is “weak at best, and is offset by evidence that IPO pricing improved.” The firms that have gone private or gone dark typically are very small, with market capitalizations generally under $30 million, and in fact going private trends in the U.K. “were similar to those in the U.S. after SOX.”


Though there are fewer non-U.S. companies with cross listings in the U.S., the firms that “defect to London” are “smaller, less profitable, less likely to have a Big-4/5 auditor, and are more likely to be based in a developed country” (the later point indicating that the benefits of a U.S. listing may be smaller for firms from developed countries than for companies in developing countries). The fact that there are fewer cross-listings obscures the fact that “the firms that choose to list in the U.S. post-SOX are larger, more profitable companies from less developed countries.” In market cap terms, “these larger cross-listing firms more that make up for the loss in listings in small firms, resulting in a net gain in market capitalization from foreign listings into the U.S. post-SOX.”


The authors also found that the results of various surveys about SOX stand in interesting contrast to the frequent criticisms of the Act. The authors found after a review of various surveys of corporate officials and investors that “contrary to the vehement criticisms of SOX,” the views of SOX among those most affected by its provisions “has been far more nuanced, even receptive,” producing among other things a higher level of confidence in companies’ financial reporting.


The authors suggest that the continuing criticisms of the Act may be due to the fact that “the Act has had clear, non-trivial and quantifiable direct costs,” while the “tasks of estimating either the benefits or the indirect costs of the Act are at least an order of magnitude more difficult than the task of estimating the direct costs,” and indeed the tasks of estimating the benefits and indirect costs “are possibly beyond the present capacity of researchers to achieve with much precision.”


Readers of this blog may be particularly interested in the authors’ analysis of the SOX-related costs of litigation. Many of the Act’s critics had predicted that SOX would lead to an “explosion of litigation,” with particularly dire predictions about the liabilities of independent directors. The authors found that while securities litigation incidence did rise immediately after SOX, it dropped to pre-SOX levels soon thereafter, and that while litigation risk for independent directors spiked in 2002, it reverted to pre-SOX levels after that. The authors noted the same pattern with D&O insurance premiums, where the premiums spike in the period 2002 to 2004, but declined in the years that followed. The authors noted that the pattern was “more consistent with large costs arising from the fundamental corporate misconduct that gave rise to SOX, followed by a reduction in that misconduct.”


Of particular note with respect to SOX’s litigation impact is the authors’ review of the impact of SOX on state court litigation. The Act’s critics has suggested that SOX might lead to changes in state law as a result of shareholders suing under state law but using SOX’s requirements as a basis for doing so. A comprehensive review of all Delaware court decisions between 2002 and 2012 showed only fifteen references in any way to SOX, and of these not one imposed liability on directors for failing to adhere to standards or live up to obligations created by SOX.


In the end, the authors conclude that “the state of research is such that – even after ten years – no conclusions can be drawn about the net costs and benefits of the Act, its effects on net shareholder wealth, or other research relevant to its assessment.” For policy makers, the challenges are how to better design future regulatory interventions so as to “permit more reliable inferences about their effects” in order to “improve the quality of information about whether they have led to net benefits” and to “reduce the risk that pure politics, untethered by fact or reason, will continue to generate unnecessarily costly oscillation in systemically important laws.”


Break in the Action: Over the next several days I will be traveling on business and there will a brief interruption in The D&O Diary’s publication schedule while I am away. Normal publication operations will resume upon my return.