June 2007
Is Sarbanes-Oxley Impairing Corporate Risk-Taking?
Most of the controversy surrounding Sarbanes-Oxley has focused on its direct, tangible costs, especially the cost of creating, installing, and auditing internal controls under section 404. But there are many intangible ways in which this legislation could be even more harmful to the U.S. economy. In this conference, Kenneth Lehn, Leonce Bargeron, and Chad Zutter of the University of Pittsburgh presented a paper on whether Sarbanes-Oxley is impairing corporate risk-taking. Charles W. Calomiris of AEI and Columbia University, Allen Ferrell of Harvard Law School, and Kate Litvak of the University of Texas at Austin School of Law discussed the paper's findings.
Peter J. Wallison
AEI
Since the enactment of the Sarbanes-Oxley Act (SOX), commentators have focused mainly on the tangible auditing costs associated with the legislation. SOX has had several unintended consequences that are not as easy to quantify, however, such as the migration of financial transactions and securities offerings overseas and disincentives for U.S. firms to list or remain listed on U.S. public securities exchanges. Recently, Kenneth Lehn and colleagues at the University of Pittsburgh examined another potential unintended consequence of SOX--a decline in risk-taking by firms subject to SOX. Although Lehn and colleagues do not assert a direct causal relationship between SOX and the decline in corporate risk-taking--since empirical observations do not translate directly into explanations of why something occurs--they have at least demonstrated a correlation between the two phenomena. It is likely that the relationship between SOX and less risk-taking has to do with the makeup of corporate boards. The requirement that boards have a majority of independent directors has changed the character of the relationship between management and the board. Independent directors have come to believe that they have a role in the company's operations, despite their lack of knowledge, and their incentives in general--particularly concern about losses and litigation--make them more conservative than management about risk-taking decisions.
Kenneth M. Lehn
University of Pittsburgh, Katz Graduate School of Business
The paper presented at this conference, "Sarbanes-Oxley and Corporate Risk-Taking," considered the proposition, put forth by many policymakers and corporate executives, that SOX has led to less risk-taking by U.S. corporations. To evaluate this hypothesis, the authors conducted empirical research on three questions: Have U.S. corporations reduced investments in risky projects, such as capital expenditures and research and development (R&D), since SOX? Have the stock prices of U.S. companies become less volatile since SOX? Are firms, especially high-risk firms, less willing to go public in the United States since SOX? To address the first question, the authors compared a sample of 4,239 U.S. firms with a sample of 989 UK firms over three three-year periods: 1995-1997 and 1998-2000 (pre-SOX) and 2003-2005 (post-SOX). The authors answered the second question by regressing the daily returns of the companies of the former sample on the corresponding returns of the Morgan Stanley Capital Index (MSCI) world index. The data to answer the final question consisted of records of 1,882 UK initial public offerings (IPOs) and 7,380 U.S. IPOs, which came from the SDC Global New Issues Database.
As to the first question, the authors found that before SOX, the U.S. firms on average devoted more resources to R&D and capital expenditures than the UK firms, but that after SOX--while the U.S. firms still devoted a greater portion of its resources to these areas than the UK firms--the gap narrowed significantly. Also, while the U.S. firms had held more assets in cash than the UK firms prior to SOX, the gap widened even more after SOX. Regarding the second question, the standard deviation of the volatility in the prices of U.S. equities declined compared to that of the UK firms. Finally, with respect to the third question, the probability that an IPO was conducted in the United Kingdom as opposed to the United States increased in the years after SOX, and this was not due to a general increase in IPOs occurring in the United Kingdom, but rather due to an overall decrease in the number of IPOs on U.S. exchanges. Taken together, the results support the view that SOX has had a chilling effect on risk-taking by publicly traded U.S. corporations.
Charles W. Calomiris
AEI and Columbia University
The paper by Lehn and his colleagues is a significant contribution to the literature on the effects of SOX, and it is hard to disagree with most of the authors' data and analysis. There are, however, some potential problems with the authors' methodology and other factors they might take into account. For example, while the gap between the R&D and investment expenditures of U.S. and UK firms has narrowed, this might have resulted from the UK firms catching up to their U.S. counterparts, not from U.S. firms' being hampered by SOX. Also, in analyzing investment levels, the authors might look at whether the closing of the gap is happening in residual investment decisions to see if companies are making investment decisions in response to changes in the business cycle or other factors. They might also examine the investment and R&D decisions of private firms between the pre- and post-SOX periods. With respect to the decrease in stock price volatility, the authors might consider the influence of globalization. Furthermore, the authors could strengthen their analysis of IPO decisions in the United States versus the United Kingdom by specifying not just where the IPOs take place, but the firms' country of origin as well, since this would likely have an effect on the number of IPOs that take place in a given country (U.S. firms, presumably, are more inclined to list in the United States, and vice versa).
Allen Ferrell
Harvard Law School
The paper by Lehn and his colleagues offers several metrics of how U.S. firms have been less prone to risk-taking since SOX. It is important to consider, however, how these metrics actually measure risk-taking. With respect to R&D, for example, it is possible to imagine situations in which a firm increases R&D in order to have less risk by investing in a number of diverse research projects. Likewise, the composition of a firm's capital expenditures is important to examine, since certain types of investment entail more risk than others. A public utility company--which is guaranteed a profit by cost-plus regulation--investing in a new plant is taking on much less risk than a biotech firm investing in cutting-edge research. Regarding the volatility in stock prices, there are other ways to measure firm volatility than the MSCI world index. Moreover, studies have shown that volatility can decline as a result of earlier disclosure of information. Finally, it is important to consider whether a reduction in risk-taking by public companies is necessarily harmful, and whether the level of risk-taking by public companies is the result of an agency problem. For example, if a firm uses stock options for compensation, then management has an incentive for a volatile stock price.
Kate Litvak
University of Texas at Austin School of Law
Lehn and his colleagues' good paper contains rich data, but they should analyze it in more detail. In their measurement of risk-taking by U.S. versus UK public firms, the authors need to control for various firm characteristics, such as firm size, industry, profitability, leverage, and sales growth. More regression analysis would be helpful. In addition, the authors should take macroeconomic factors into account in order to bolster their hypothesis that SOX is a major contributor to a decline in risk-taking. Regarding their analysis of the recent decline in IPOs in the United States relative to the United Kingdom, they should also consider firm characteristics as a possible explanation. A recent working paper by Doidge, Karolyi, and Stulz argues that during the boom years of the late 1990s, all firms that could go public through an IPO did, and that the private firms that still have not gone public in the United States were in some way unusual. Doidge et al. also find that the United Kingdom may be attracting more firms--especially to the Alternative Investment Market (AIM) of the London Stock Exchange--but that these firms are typically smaller, newer, seek lighter regulation, and might not be good for U.S. exchanges in the first place. Thus, to show that SOX contributed to the choice of London over New York, one needs to look at characteristics of firms that choose London over New York today and firms that did so before SOX.
AEI research assistant Daniel Geary prepared this summary.
