Getting a Better Understanding of How SOX Affects Small Firms
In response to the highly publicized corporate scandals at companies such as Enron, WorldCom, and Arthur Anderson that shook public confidence in the public securities markets, Congress passed the Sarbanes-Oxley Act of 2002. The act (which, along with its implementation, is commonly referred to as “SOX”) made a number of significant changes in the governance, accounting, auditing, and reporting environment of firms traded in U.S. securities markets.
While it is clear why Congress passed the legislation, it is less clear what the ultimate effects have been. Those who favor SOX argue that it reduces investor concerns by improving the transparency and accuracy of financial reports. Those who oppose SOX contend that compliance imposes too great a burden on publicly traded firms, particularly on small firms, which will face higher average costs and derive lower average benefits as a result of new regulations.
RAND Corporation researchers in the Kauffman-RAND Institute for Entrepreneurship Public Policy have taken a closer look at what others who have studied SOX have found and have conducted some research of their own on the impact of SOX on small firms.
Looking at Measurable SOX Effects
Since the passage of SOX in 2002, a slew of research has emerged in three areas that figure heavily in empirical measurements of the effects of SOX: (1) relative compliance costs for small firms compared to those of large firms, (2) stock-price reactions, and (3) changes in the propensity of firms (particularly, small firms) to leave the public capital market.
In reviewing studies in these three areas, RAND researchers concluded that SOX has had a mix of negative and positive effects on small firms, but it is unknown which effects will prove most significant in the future. More specifically, they concluded that the evidence should be interpreted with caution for at least three reasons. First, the effects found in the studies could be explained in a number of ways. Second, the studies suggested that increased compliance costs may have had certain beneficial effects. And third, in general, the reviewed studies did not distinguished between the early post-SOX period and the later post-SOX period, meaning that it is important to learn whether the initial outcomes represented one-time effects or recurring ones.
Does SOX Drive Small Firms Out of the Public Capital Market?
One of the three areas focused on how much SOX has pushed firms—particularly, small ones—out of the public capital market because of the high costs of compliance. Previous studies looking at this issue have had difficulty controlling for unobserved factors that can conflate exit decisions and effects of the enactment of SOX.
A RAND study worked to get around this difficulty by comparing the probability of a public firm being bought by a private acquirer over time in two populations: a “treatment” group subject to SOX (U.S. firms) and a “control” group that is not (foreign firms). The difference between the two populations is the change that can be attributed to SOX.
When the researchers used this approach and examined acquisitions as a whole, they found no relative increase in the rate of acquisition by private acquirers (going private) among U.S. firms. However, when they differentiated between acquisitions based on firm size, they found a relative increase in the rate of going private by small U.S. firms.
Moreover, when they differentiated between acquisitions based on how close they were to the enactment of SOX, they found a relative increase in the rate of going private by U.S. firms in the first year after the enactment. Finally, when they differentiated between acquisitions based on both firm size and the proximity of the acquisition to the enactment of SOX, they found that the increase in the rate of going private by small U.S. firms is concentrated in the first year after the enactment.
To be sure, the findings do not answer all the questions that need to be answered for evaluating SOX. First, the exodus of small firms from the public capital market would be a blessing if the departing firms were prone to the type of financial fraud that SOX seeks to limit. Second, even if SOX burdened small firms with no connection to the integrity of their financial statements, it could benefit firms that remained public enough to justify this cost. Finally, the experience that market participants have continued to develop in complying with SOX and the steps that regulators have taken to clarify SOX's requirements may have lowered the costs below where they were when the study took place.
BRIEFING TODAY You are invited to attend a briefing by Dr. Pinar Karaca-Mandic on How Does Sarbanes-Oxley Affect Firms' Decisions to Stay in the Public Market or Go Private? TODAY at 1 pm in 304 Cannon House Office Building.
MARK YOUR CALENDAR Dr. Susan Gates and Dr. Christine Eibner will brief on issues surrounding employer-provided insurance in small businesses. The briefing will be held the morning of April 4, 2008. Exact time and location TBA. Visit http://www.rand.org/congress/ under “Upcoming Events” closer to April 4th for more information.
Pinar Karaca-Mandic, Ph.D., is an adjunct economist at RAND and an assistant professor at the University of Minnesota School of Public Health, Division of Health Policy and Management. She is involved in projects at RAND that focus on the impact of various legislations and reforms on small businesses, such as the Sarbanes-Oxley Act of 2002, state small group health insurance reforms, and the Medicare Prescription Drug Improvement and Modernization Act of 2003. Dr. Karaca-Mandic earned her Ph.D. in Economics from University of California at Berkeley in 2004.
Read more work by Dr. Karaca-Mandic
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