effects of sarbanes-oxley on small large u.s. firms a
TRANSCRIPT
EFFECTS OF SARBANES-OXLEY ON SMALL & LARGE U.S. FIRMS
A THESIS
Presented to
The Faculty of the Department of Economics
The Colorado College
In Partial Fulfillment
of the Requirements for the Degree
Bachelor of Arts
By
Megan Fox
April 2007
EFFECTS OF SARBANES-OXLEY ON SMALL & LARGE U.S. FIRMS
Megan Fox
April, 2007
Economics
Abstract
The Sarbanes-Oxley Act of 2002 is controversial in the business world because of its costly and stringent provisions. U.S. firms of all sizes and various industries have difficulty complying with the law yet certain industries and small to mid-sized firms are hardest hit. This study hypothesizes that, due to the proportionately higher economic costs imposed, small to mid-sized firms as well as firms in the most vulnerable of industries are privatizing due to the costs of SOX and will continue to do so without reform of the act.
Keywords: SARBANES-OXLEY, PRIVATIZATION, AGENCY
ON MY HONOR, I HAVE NEITHER GIVEN NOR RECEIVED UNAUTHORIZED AID ON THIS THESIS.
TABLE OF CONTENTS
Chapter Page
I. INTRODUCTION ................................................................. .
II. THEORy..................................................................................................... 5
III. LITERATURE REVIEW. . . . . .. . .. . .. . . . . .. . .. . . . . .. . .. . .. . .. . ... .. . .. . .. . .. . .... 18
IV. DATA AND METHODOLOGy................................................ 29
V. RESULTS, ANALYSIS AND DISCUSSION .................................. 42
VI. CONCLUSION..................................................................... 54
SOURCES CONSULTED............................................................. 57
LIST OF TABLES AND FIGURES
4.1 Going private frequency of finns per quarter......................................... 35
4.2 Distribution of Privatization Transactions among Industries............ 36-37
5.1 Descriptive Statistics with respect to Finn Size........................... 43
5.1 Area Graph of Finn Size Distribution............................. ......... 44
5.2 Total Frequency of Small, Medium and Large Finns within the Sample 46
5.3 10 Most Frequent Industries represented in the Sample. . .. . .. . .. . .. . ..... 47
5.4 Annual Frequency of Going Private Transactions: 2004-2007.......... 49
5.5 Quarterly Frequency of Going Private Transactions: 2004-2007....... 50
CHAPTER I
INTRODUCTION
American corporate giants such as Enron, World Corn, Tyco and Xerox all have
several things in common. Among their similarities are their indiscretions in the U.S.
financial disclosure system. All were allegedly charged with some form of fraudulent
activity by the Securities and Exchange Commission (SEC) and found guilty. According
to the Forbes corporate scandal sheet the claims brought against them included falsifying
disclosed financial information, using audit companies for non-audit services, and
overstating profits.' These firms were just the beginning of a string of corporate
scandals, and eventually, they were all directly or indirectly associated with the
establishment of the Sarbanes-Oxley Act of 2002 (SOX).
Enron is perhaps the most directly related incident to SOx. In fact, general
opinion is that SOX was modeled point for point after Enron's infractions. Enron was at
one time America's largest energy company based in Houston, Texas, bringing in an
estimated $111 billion dollars in 2000. In 2001 they were found guilty of insider trading
and accounting fraud. Enron did not report much of its debts and losses, and much of its
reported profits were made by deals with limited partnerships it controlled. When Enron
was forced to declare bankruptcy, it was a financial disaster. After legal proceedings
began and it was revealed that Enron had been scamming its shareholders, the framework
began for Sarbanes Oxley. SOX's key components-the establishment of the Public
I Penelope Patsuris, "The Corporate Scandal Sheet," Forbes.com (2002): 1-5.
2
Company Accounting Oversight Board (PCAOB), increased disclosure requirements, and
heightened responsibility of corporate executives-are expected to reduce the chance of
further accounting scandals. Deakin and Konzelman explain that "Enron's fall was
brought about by conflicts of interest on the part of its senior managers and by a lack of
oversight on the part of its board and advisers.,,2 Enron's agency problem will be
addressed and explained in the next chapter. The fall of Enron was not alone in the
creation of SOX; WorldCom, now known as MCI, was another scandal that increased
pressure on the government for greater regulation.
W orldCom, the American telecommunications, company was found guilty of
accounting fraud by underreporting line costs and inflating revenues with fake accounting
entries. 3 In addition, Xerox, an American document management company, was accused
of false reporting and altering its accounts to present significantly higher revenues than
the company was actually earning. Tyco International experienced a different form of
accounting fraud when charges of embezzlement were brought against both the chief
executive officer and chief financial officer of the company.
SOX was formed not long after each of these incidents. It was created to address
each of the issues that the Securities and Exchange Commission (SEC) had faced with
publicly traded firms. However, SOX has not been without its own problems. Its
stringent disclosure policies, vague provisions and astronomical compliance costs are
among the greatest concerns. Phil Blank, a vice president of the ProBusiness division of
a firm called ADP, is concerned with how specific SOX regulations are. He says "With
2 Simon Deakin and Suzanne 1. Konzelman, "Learning from Enron," ESRC Centre for Business Research, Cambridge, Working Paper No 274, Sept. 2003.
3 "MCI, Inc.", http://en.wikipedia.org/wikilWorldCom#Accounting_scandals, 19 October 2006.
[SOX], the regulators want to know who was in what system, what they did, why they
were there, [and] whether they were authorized to be there ... from my perspective,
without a role-based access control system or an identity management system,
compliance is going to be a Herculean task.,,4 Blank's concern about the stringency of
compliance is becoming more and more common among U.S. firms.
3
SOX was created to better regulate companies such as Enron, Tyco, Xerox and
WorldCom, but the issue now is whether it fits all American publicly traded companies.
Bernie Donnelly of the Philadelphia Stock Exchange looks at SOX compliance from an
economic perspective noting "There's no return on your investment in this. It doesn't
generate anything other than more paper, more storage, more auditors and more
lawyers."s The act it seems is overly burdensome for firms that were already on the right
path. Like Donnelly says, the excessive amount of money that is put annually into SOX
compliance is likely to never return to the firms. Studies show that it is becoming
increasingly difficult for small to mid-size firms to keep up with the costs of compliance
of Sox. The fact that small to mid-size firms are struggling with these costs has another
consequence; it is challenging for them to compete with the larger firms that can
financially fulfill SOX requirements. This is creating a barrier to entry for U.S. firms,
which will no doubt affect the overall economy by keeping firms from entering the
market. The current thesis hypothesizes that compliance with the Sarbanes-Oxley Act of
2002 has become more difficult and expensive for firms, resulting in a privatization trend
that is just as prevalent in 2007 as it was immediately following the passage of the Act.
4 Ann Bednarz, "Thinking outside the Sarbox," NetworkWorld. 2005: 35.
5 Ibid: 36.
In addition, it investigates the potentially varying impacts on companies in different
industries.
This paper will first introduce the theory behind the problems with SOx.
4
Agency, corporate governance, reliability, disclosure and transparency, market regulation
and barriers to entry are discussed and analyzed in detail as to their relationship to SOX
and the economic implications in store for u.S. firms. Next, the review ofliterature
presents information from the extensive collection of publications regarding SOx. The
significant literature behind the study includes the history and initial intentions of SOX,
direct effects on large businesses, small business reactions to SOX, and finally, the
potential economic effects of SOX on firms that have made the extensive changes
necessary to comply with SOX.
Data and methodology will be discussed in the form of two studies, including
both quantitative and descriptive data. The first part of the study follows the literature
review, reviewing a study performed by Ellen Engle, Rachel M. Hayes and Xue Wang on
the privatization trend of U.S. firms pre- and post- SOx. Next, the study is revised and
performed incorporating a longer time period for study and additional factors to consider
in the results. The results and analysis of the data are then explained. Finally, the paper
concludes with a synopsis of the studies and supporting information including inferences
of future influence SOX will have on U.S. firms and business.
CHAPTER II
THEORY
The Sarbanes-Oxley Act of 2002 (SOX) provided the newest piece of legislation
for publicly traded companies since the Securities Exchange Act of 1934. 1 Enacted after
a series of accounting scandals that injured an already suffering U.S. stock market, the
intentions behind SOX were to hold corporations, their boards, and management
responsible for disclosing accurate financial information and, as stated in the preamble of
the act, "to protect investors by improving the accuracy and reliability of corporate
disclosures made pursuant to the securities laws, and for other purposes.,,2 SOX
mandates have provided both benefits and consequences for publicly traded firms. The
effects, whether positive or negative, have changed the shape of the way U.S.
corporations do business, and ultimately, the face of the U.S. stock market. There will
also be some significant affects to the economy as more firms struggle to deal with
compliance fees and regulations. Corporations have been modified inside and out in an
effort to comply with SOX provisions. This chapter discusses the theories associated
with the ramifications of SOX, including agency theory, corporate governance,
I Lawrence A. Gordon et a!., "The impact of the Sarbanes-Oxley Act on the corporate disclosures of information security activities," Journal of Accounting and Public Policy, Volume 25, 2006: 504.
2 As cited in Haidan Li et a!., "Market Reaction to Events Surrounding the Sarbanes-Oxley Act of 2002" (MBA Thesis, Tippie College of Business, 2004), 1.
5
6
reliability, disclosure and transparency, market regulation and barriers to entry created by
the costs of compliance.
Agency
Agency theory is well known throughout boardrooms across America, because it
describes the relationships among a corporation's shareholders, board of directors and the
management. Agency within a corporation is basically two tiered. On the first tier the
principals, or shareholders of the corporation, appoint the board of directors, or the agents
to carry out business on their behalf. Principals control the compensation of agents and
therefore are generally able to control the agents' behavior. 3 Therefore, the board of
directors has a major incentive to comply with their role as agents for the shareholders.
On the second tier, the principal is the board of directors. They are responsible for hiring
the corporation's managers, which are the agents on this level, to handle business daily in
a manner that suits the interests of the board and the shareholders.
Radin and Stevenson explain, "The costs associated with the board's oversight of
this relationship are called agency costs and include losses associated with management
not acting in the company's best interests and the board's costs associated with
monitoring management's activities.,,4 Since the management is in control of corporate
information, there is the opportunity to disclose incomplete or inaccurate information to
the board of directors. When management does not disclose information that is necessary
for the board to make responsible decisions it is called "information asymmetry." SOX
provisions now require financial information to be disclosed in a more detailed and
3 Robert F. Radin and William B. Stevenson, "Comparing Mutual Fund Governance and Corporate Governance, Corporate Governance: An International Review, Volume 14, Number 5, 2006: 368.
4 Ibid: 368.
7
timely manner. Additionally, signatures of chief executives are required promising
accurate information. Since the board of directors is responsible for the compensation of
managers, and shareholders for that of the board of directors, it is in the best interests of
everyone for managers to disclose any and all financial information in an accurate form
to the principals. Further, boards of directors attempt to avoid or overcome information
asymmetry by hiring consultants or the like to keep management acting on behalf of the
shareholders. 5 Firms that were "well-governed" prior to the passage of SOX are least
likely to benefit from the act. Companies that had proper communication between
boards, shareholders and management before still have to restructure their internal
systems, making them subject to the same compliance costs as the poorly governed firms.
Demski suggests, "It is common to worry whether the board is doing an adequate
job of protecting the shareholders, and a commonly proposed mechanism to address this
potential conflict has been stock-based compensation for outside directors.,,6 SOX
requires boards of directors to be made up of a majority of outside directors. Therefore, a
resolution to the agency problem must be to involve methods of aligning the motivations
of the board and the management. Corporations that have had the most trouble
complying with SOX are companies that were reliant on earnings management prior to
the enactment of SOX. Cohen et al. explain that" ... earnings management, particularly if
it results from agency conflicts between shareholders and management, is likely to make
5 Ibid: 368.
6 Joel S. Demski, "Corporate Conflicts ofInterest," Journal o/Economic Perspectives, Volume 17, Number 2,2003: 59.
it more difficult to infer the actual level of corporate performance.,,7 Earnings
management is a concept universally depicted as income smoothing, or minimizing
fluctuations in income so as not to depress stock prices. Earnings management is
essentially part of a financial manager's job but can often be abused. Cohen et al.
describe "earnings management" as managers acting in their own best interests during a
period. They conclude that if earnings management is a result of agency conflict, then
potentially it will affect the relationship between earnings and variations in stock prices.8
SOX provisions attempt to prevent illegal distortion of income that results from
the extreme use of earnings management. Li et al. suggest that SOX not only costs firms
internally but externally through politics and contracts: "For example, given agency
problems between managers and shareholders, constraining managers' abilities to
manage earnings could affect existing compensation contracts (namely, managers'
abilities to increase their compensation).,,9 Costs further arise as SOX inhibits managers
attempting to prioritize shareholders' interests by limiting the amount of private
information they are able to give shareholders through earnings reports. Because
agency theory describes the relationship between principals and agents or boards and
management, it requires discussion of the SOX-required improvements to corporate
governance.
7 Daniel A. Cohen, et aI, "Trends in Earnings Management and Informativeness of Earnings Announcements in the Pre- and Post-Sarbanes Oxley Periods" (MBA Thesis, Northwestern University, 2004) 1-2.
8 Ibid: 2.
9 Li et al: 4.
8
9
Corporate Governance
According to Radin and Stevenson, "Corporate governance for publicly traded
companies is based on the principle that boards are empowered and guided by the law,
including the Securities Act of 1933, the Securities Exchange Act of 1934, and the
Sarbanes-Oxley Act of 2002.,,10 SOX required a restructuring of corporate governance
within publicly traded firms. The provisions include a board with a majority of
independent directors, an external auditing company, the Public Company Accounting
Oversight Board CPCAOB), and increased accountability to executives. These elements
are all subject to what Demski refers to as "corporate conflicts of interest." The boards of
directors prior to the creation of SOX were sometimes members of management who
could also sit on the auditing committee. SOX not only eliminated a conflict of interest
with this provision but also a problem of agency. Ifmembers of a corporation's board of
directors or management were also on the audit committee, it would be more convenient
to be selective of the financial information they chose to disclose. The opportunity to
provide false or embellished accounting information was ultimately what led to the
alleged fraud of corporations such as Enron, Tyco, WorldCom, and Xerox. Li et al. note
that" ... the Act require[ s] members of boards of directors serving on audit committees to
be independent of management, mandate CEO and CFO certification of financial
statements ... and prohibit accounting firms from performing certain non-audit services for
the audit client." 1 1
10 Radin and Stevenson: 367.
II Li et al: I.
10
Amendments to the SOX act effective May 6, 2003, limited the amount of
nonaudit services that could be billed from accountants to their corporate clients. These
nonaudit services include such acts as bookkeeping, design of financial information
systems, appraisal services, and internal audit outsourcing services. 12 Demski uses the
example of Arthur Anderson at Enron. "[Anderson's account] ... delivered an average
weekly billing of $1 million, over half being for nonaudit services.,,13 Another fault of
Enron was that according to Demski, " ... Andersen also housed a number of its staff in
Enron facilities, was a routine supplier of accounting staff to Enron and counted
numerous members of the Enron management team among its alurnni.,,14 This is
representative of an issue that was commonplace prior to the establishment of SOX;
many companies employed members of their accounting firms and therefore had conflicts
of interest. According to SOX the auditors are required to be external to the corporation
and cannot have any direct economic relationship with the corporation they represent,
thus eliminating potential conflicts of interest.
Sections 302 and 404 of SOX require that Chief Executive Officers (CEOs) and
Chief Financial Officers (CFOs) sign certifications that their disclosed financial
information and internal accounting controls are reliable and accurate. IS Firms currently
face the issues of retaining executive officers because of this particular SOX provision.
The question of risk versus reward is a new issue for these executives to consider in
deciding if in fact the job still makes sense economically. The business is now
12 Securities and Exchange Commission, Release No. 33-8183, "Strengthening the Commission's Requirement Regarding Auditor Independence," http://www.sec.gov/rules/finaI/33-8183.htm. February 1, 2007.
13 Joel S. Demski: 57.
14 Ibid: 57.
15 Lawrence A. Gordon et al: 504.
11
increasingly risky for CEOs and CFOs, since they are required to swear that all of the
disclosed infonnation to their knowledge is accurate and reliable. The risk is that the
penalty for criminal activity and fraud was increased from the original five years to 20
years. The reward is less due to the regulation of incentive-based compensation by SOX,
such as the restriction that executives are now unable to make stock transactions during
"blackout" periods regulated by employee pension plans. 16 Executives that were used to
such perks prior to the passage of SOX have discovered that they are now responsible for
the actions of the company and entitled to fewer perks.
Reliability. Disclosure and Transparency
The SOX Act requires that the executives of corporations take responsibility for
the reliability of disclosed financial infonnation. Kieso et al. define reliable accounting:
" ... it is verifiable, is a faithful representation, and is reasonably free of error and bias.
Reliability is a necessity for individuals who have neither the time nor the expertise to
evaluate the factual content of the infonnation.,,17 Kieso also explains how reliability is
associated with "decision usefulness.,,18 Financial statements are prepared by finns to
provide infonnation for their investors and creditors. When investors and creditors are
able to see their potential earnings from a finn, this is called decision usefulness. It is
essential that financial statements are reliable so that the investors and creditors can better
assess the ability of the finn to generate cash flows and therefore make a decision
whether or not to invest.
16 Kenneth A. Kim and John R. Nofsinger, Corporate Governance, 2nd ed. Prentice Hall, New Jersey (2007): 135.
17 Donald E. Kieso and Terry D. Warfield, Fundamentals of Intermediate Accounting (Massachusetts: John Wiley & Sons, 2003), 30.
18 Ibid: 28.
12
Reliability and transparency of information is closely related to agency theory, as
it is essential for management to supply both the board of directors and the shareholders
with information that is clear, accurate and consistent. This is because boards of directors
must in tum provide this same information to gain capital for the corporation. Investors
and creditors are interested in providing resources to companies that are secure
financially and that can produce clear and logical financial information. For capital
allocation to be efficient, investors and creditors must have faith in the accuracy of the
reported profits and financial data. If capital providers are uncertain about the numbers,
corporations risk a drop in stock prices, reduced lending and/or increased interest rates.
All of these are representative of investors and creditors protecting themselves from the
perceived additional risk. WorldCom and Xerox are examples of firms that failed to
disclose accurate and transparent financial records. In 2000, Xerox allegedly disclosed
erroneous financial reports for five years, which increased the company's income by $1.5
billion. 19 Then in 2002, WorldCom allegedly loaned its founder $400 million offthe
books, and according to Forbes Scandal Sheet, "overstated cash flow by booking $3.8
billion in operating expenses as capital expenses.,,20 Several other U.S. corporations have
been found guilty of similar acts of accounting fraud, making the disclosure of reliable
information one of the most critical elements of the SOX Act of 2002.
Reliability, disclosure and transparency are linked to a recent debate involving
current accounting practices and the potential need for reform. The Generally Accepted
Accounting Principles (GAAP) functions under "rules-based" standards. Basically, this
approach, known as "the cookbook approach" by many in the accounting industry, gives
19 Ibid.
20 Penelope Patsuris, "The Corporate Scandal Sheet," Forbes.com (2002): 3.
13
a specific set of criteria on what accountants should do. Alexander and lennakowicz
argue that " ... rules by themselves are inadequate, whether or not they are based on
principles ... ,,21 The argument against further claims that a rules-based approach
encourages finns to focus on compliance with accounting rules instead of the bigger
picture, the finn's economic goals.22 The shortcomings of a rules-based system were
discovered in Enron's scandal with Arthur Anderson,23 the fault being that the system
allows a finn to follow specific rules, but does not account for the overall representation.
The rules also leave room for interpretation, which invites a finn to defend any
indiscretions by claiming a difference in understanding the rules. An alternative
approach is a "principles-based" system which generally does not tell an accountant what
to do but how to do what needs to be done. This option is favorable because it holds a
finn accountable for reliability, disclosure and transparency overall, not simply to a few
rules. SOX has refonned the rules-based system somewhat by applying disclosure
requirements for finns which are not open to interpretation, holding the finn accountable.
Market Regulation
While SOX increased responsibility for corporations, their management and
boards of directors, and restored the confidence of investors and shareholders, currently,
SOX provisions also influence market regulation. Li et al. make this prediction: "If SOX
contains substantive accounting, auditing, or corporate governance refonns that improve
the accuracy and reliability of financial reporting, then we would expect the Act to have a
21 David Alexander and Eva lennakowicz, "A True and Fair View of the PrincipleslRules Debate," Abacus, Volume 42 (2006): 132.
22 Ibid: 134.
23 Ibid: 147.
14
significant impact on shareholder value.,,24 They conclude that uncertainty of
information is reduced with the provisions that require increased accuracy and reliability
and should therefore increase stock prices for firms that comply.25 The regulation that
CEOs and CFOs must sign certifications that to their knowledge the disclosed
information is accurate and reliable also encourages market regulation. The S.E.C. has
promised to list on its website the names of corporations and their executives who do not
adhere to this requirement. Li et al. note, "News reports suggest market participants paid
attention to updates on the S.E.C.'s Web site about certifications (or lack thereof) on
August 141\ 2004 as well as to the news coverage the next day.,,26 The reaction of the
public was driven by the fact that investors want certainty from the firms in which they
invest. If investors feel that their money is secure in a firm they will continue to invest
which means a potential increase in share prices for that firm.
Market regulation is explained by Demski's "herding model": "The basic idea in a
herding model is learning from the behavior of others, learning that leads to coordinated
behavior or clustering ... emulating others thereby substitutes for acquiring and analyzing
information on private account.,,27 When investors see companies that are compliant,
they consider it a less risky and uncertain venture and are willing to become shareholders.
Other investors see this behavior and emulate it, causing compliant firms to have greater
positive stock prices. The herding model works in a negative way as well. As Li et al.
explain, " ... the WorldCom announcement caus[ed] investors to re-examine the earnings
24 Li et al: 3.
25 Li et al: 3.
26 Ibid: 12.
27 Joel S. Demski: 67.
15
quality of other finns and react by bidding down stock prices more, the more finns had
managed earnings in prior years.,,28 Thus, a finn's compliance or non-compliance can be
the driving force in the price of its shares.
Capital allocation and market efficiency are important conceptual components in
market regulation as well. As Demski's model explains, creditors and investors are
responsive to the behaviors of one another. Lenders and investors want to provide
resources for economic activity to companies whose numbers are credible. If they feel
that there is uncertainty in a corporation's infonnation, they will most likely decrease
lending or increase interest rates to account for the potential increase in risk, and stock
prices will fall due to decreased investment. SOX provisions can therefore be beneficial
or detrimental based on compliance efforts.
Barrier to Entry
SOX compliance costs are one of the most cornmon complaints by companies.
Large corporations are able to bear the financial burden of hiring external auditors,
restructuring boards and management, and other costs. However, small and medium
sized finns often do not have the financial resources to fulfill SOX requirements. Many
smaller finns have turned to other options such as taking their company public in
international markets or going private. As an increasing number of small and mid-sized
companies have to move business out of the U.S. publicly traded market, it is
simultaneously becoming more difficult for new ones to enter. A barrier to entry occurs
when a company desires to enter the market but experiences hindrances to keep it from
doing so. The development of this type of barrier to entry could prove consequential in
28 Li et al: 24.
16
the long run to the overall U.S. economy by limiting the publicly traded market to large
firms.
SOX seems to have created barriers to entry for smaller audit firms as well.
Chapman et al. propose that "the registration process mandated by the [PCAOB] has
created a large barrier to entry with its difficult compliance requirements. Every firm
cannot meet these requirements, thereby limiting many firms' access to certain
clientele.,,29 Smaller audit firms have difficulty financing the fees required to register
with the PCAOB every year and the amount of manpower needed to audit some of the
United States' large corporations, among other challenges.
The fact that SOX seems to have created barriers to entry for small to mid-sized
firms in both the public and auditing markets is unfortunate. As smaller audit firms raise
their prices trying to keep up with the growing competition in their market, they become
less affordable for smaller public firms. As these public firms become unable to afford
audit services, they cannot comply with that element of SOX. If smaller firms cannot
enter the U.S. public market, then they take their business overseas or to the private
market. The result is a decrease in competition and an overall decrease in potential
revenue for the U.S. stock market. Engel et al. explain: "Critics argue the costs of
complying with SOX-forty-eight percent of companies will spend at least $500,000 to
comply in the first year ... will dwarf the benefits for many smaller firms. ,,30 Small and
mid-sized firms will only remain in the market if the benefits outweigh the costs, which
as noted above is unlikely.
29 Peter Chapman et ai., "Strategic Planning Initiative and Ethical Question" (Indiana CPA Society Case Competition, Indiana University, 2003), 6.
30 Ellen Engel et ai., "The Sarbanes-Oxley Act and Firms' Going -Private Decisions" (MBA Thesis, University of Chicago, 2004), 1.
17
SOX has created significant changes to the U.S. public market. It offers benefits
to some corporations yet other provisions are cause for concern. Theoretically, SOX has
done what it set out to do by holding corporations, their boards and their managers
responsible for reporting accurate and reliable information to one another and investors.
Further, it has provided the majority of companies that are compliant the advantage of
information certainty, which eventually helps increase overall stock price. However, in
an economic sense, SOX may have hindered the market in making it more difficult in the
long run for smaller firms to compete with larger ones, limiting competition. Further
discussion of the historical background of SOX, general provisions of the act and general
opinion of its successes and failures will follow in the next chapter, the review of
literature.
CHAPTER III
LITERATURE REVIEW
The literature offers extensive coverage on the Sarbanes-Oxley Act of 2002
(SOX). First, it is necessary to review pertinent background literature. Some knowledge
of history (the initial intentions and potential problems associated with SOX) provides the
essential foundation for comprehending the issues faced by corporations. Second, the
body of literature that explains the direct effects on large businesses is assessed. The
major issues investigated include corporate governance and the effects on company
managers of the added pressure of accountability in large business and what this means
for the future. Finally, small businesses' responses to SOX will be discussed including
new trends in privatization and foreign investment. Articles addressing companies'
major complaints about SOX, its stringent provisions, as well as its direct effects on
business and the potential benefits of reform conclude the review of literature.
Background Literature
The Sarbanes-Oxley Act of2002 (SOX) was created in the aftermath of the
events of the 1990s-the burst of the stock market bubble and infamous accounting
scandals such as Enron, WorldCom, Xerox and Tyco. As the first significant piece of
economic legislation since the Securities and Exchange Act of 1934, SOX was
introduced at a time when it was needed to restore faith in the financial markets.
However, the broad scope and overall effects of SOX are somewhat controversial. As
Wiesen notes, "The Sarbanes-Oxley Act of 2002 .. .is as broad an attempt to correct free-
18
19
market externalities as any legislation passed by the federal government in recent
memory." I Due to the enactment of the law immediately following a string of accounting
scandals, Congress seemingly created a law encompassing such strict principles as to
avoid any further disgrace in the financial market. Coffee studies why different types of
accounting scandals occur in different economies and, further, why when looking at
economies that are associated through the same global economy, a series of accounting
scandals happens in one economy but not another, such as the United States and Europe.
He then explains his theory behind corporate scandals and the resulting Sarbanes-Oxley
Act of 2002. Coffee hypothesizes that the disparities in the structure of share ownership
(dispersed or concentrated) provide insight into the differences in accounting scandals.
Dispersed ownership puts the corporate managers in control, whereas concentrated
ownership gives the control to the shareholders. The U.S. system of share ownership is
primarily dispersed ownership, which accounts in part for the wave of scandals that has
occurred. This system puts increased pressure on firms to perform to the standards of the
shareholders and give them their desired results. Coffee's study concludes that
" ... governance protections that work in one system may fail in the other. .. different
gatekeepers need to be designed into different governance systems to monitor for
different abuses.,,2 Sarbanes-Oxley resulted as the inferred solution to that wave. 3
I Jeremy Wiesen, "Congress Enacts Sarbanes-Oxley Act of2002: A Two-Ton Gorilla Awakes and Speaks," Journal of Accounting, Auditing and Finance, Volume 18,2003: 429.
2 John C. Coffee, Jr., "A Theory of Corporate Scandals: Why the USA and Europe Differ," Oxford Review of Economic Policy, Volume 21, Number 2,2005: 198.
3 Ibid: 209.
20
The accounting scandals that spurred the creation of SOX consisted of finns
allegedly guilty of some sort of disclosure fraud. Lev explores reported corporate
earnings and analyzes fraudulent misstatements of financial infonnation to explain the
intricacies of corporate accounting.4 He explains, "Both aggregate and cross-sectional
research confinn the anecdotal evidence that the correspondence to the reality of reported
earnings deteriorated throughout the 1990s."s Lev studies earnings manipulation,
specifically citing Enron as an example, true earnings versus generally accepted
accounting principles (GAAP), and how often earnings manipulation occurs. Lev
ultimately concludes, "Trying to regulate earnings manipulation out of existence with
ever-more-detailed rules seems unlikely either to produce more infonnative financial
reporting or, ultimately, to reduce the extent of earnings manipulation, which actually
thrives in a thicket ofrules.,,6 Akhigbe and Martin logically propose that, due to the
complexities of corporate financial accounting, the initial intention of SOX "was to
improve the integrity of and reduce the opacity of financial statements [of businesses ].,,7
More specifically the act developed methods for the government to better regulate the
finances of public companies.
SOX is comprised of many different provisions that attempt to regulate business
and avoid fraud at all costs. Coates notes the essential components of the SOX act:
4 Baruch Lev, "Corporate Earnings: Facts and Fiction," The Journal of Economic Perspectives, Volume 17, Number 2,2003: 27-50.
5 Ibid: 27.
6 Ibid: 48.
7 Aigbe Akhigbe and Anna D. Martin, "Valuation impact ofSarbanes-Oxley: Evidence from disclosure and governance within the financial services industry," Journal of Banking and Finance, Volume 30, 2006: 990.
21
creation of the Public Company Accounting Oversight Board (PCAOB) (created to hold
companies to the ethics of professional accounting systems), greater independence for
public auditing firms, greater corporate responsibility including disclosure of financial
information, increased Securities and Exchange Commission (SEC) funding, and harsher
penalties for criminal activity within corporations. 8 It is her conclusion that the true
problem in the corporate world" ... lies in the stickier region of institutional visions,
values and beliefs, as modeled by the highest executives in corporations.,,9 Coates's
conclusion that SOX must address the executives' behavior to reveal the true issue
behind corporate defiance is one of the many SOX issues regarded as problematic.
Beggs and Dean propose that SOX is a way to legislate ethics, when perhaps
ethics should be taught to a greater extent. They suggest: "Thus, as more ethics scandals
surface and deepen, we have seen two approaches to prevent such behaviors gaining
momentum in the future: increased ethics educational coverage at the university level as
well as sweeping new anti-corruption legislation."]O The question is if the current
legislation, with its increased requirements and penalties, will be enough to discourage
individuals from future manipulation of the rules. Beggs and Dean report that, in 2001
prior to the passage of SOX, the SEC received news from approximately 6400 "whistle-
blowers" monthly, and at the time their article was published, the SEC was receiving
8 Breena E. Coates, "Corporate Culture, Corporate Mischief and Legislated Ethics: the SarbanesOxley Act," Journal of Public Affairs, Volume 7, Issue 1,2004: 40.
9 Ibid: 40.
10 Jen M. Beggs and Kathy L. Dean, "Legislated Ethics or Ethics Education? : Faculty Views in the Post-Emon Era," Journal of Business Ethics, Volume 71, 2007: 20.
22
nearly 45,000 "whistle-blower" reports per month. I I Perhaps SOX has been somewhat
effective in holding employees accountable for taking an active role in compliance.
The SOX provisions were created to improve corporate governance and
disclosure and were intended to improve the valuation of firms. However, Karmel
indicates that after the 1990 burst of the stock market bubble and the rise in accounting
fraud discoveries, Congress quickly passed SOX (without much deliberation over why
these things occurred) in order to rebuild the confidence of investors and creditors in the
market. 12 However, the haste in which SOX was passed has caused speculation among
critics. Jeremy Wiesen observes "Congress was presented with reform proposals for
decades [after the Watergate scandal], but it only started thinking of reforms in earnest
after the Enron revelations in the fall of2001 and then rushed to action after reports of
accounting abuses at WorldCom in the spring of2002.,,13 Further criticism ensues that
provisions of the act are too fitted to the mistakes made by Enron, and perhaps the act is
too intense a piece of legislation for all to comply. Wiesen comments, "The principals in
our financial reporting system, corporate management, accountants, and lawyers, must
feel like the patient who goes in for a small operation and is later told by the surgeon,
'While I had you opened-up, I decided to do everything! ,,,14 It is as if Congress wanted
to create a system that was of such a broad scope that the act would have governance
over any further corporate issues leaving nothing to chance. Engel, Hayes and Wang
II Ibid: 33.
12 Roberta S. Karmel, "Realizing The Dream of William 0 . Douglas-The Securities and Exchange Commission Takes Charge of Corporate Governance," Delaware Journal o/Corporate Law, Volume 30, 2005: 98.
13 Wiesen: 446.
14 Ibid: 431.
23
explain that "SOX proponents have asserted that increased disclosure requirements and
stiffer penalties for corporate malfeasance wi11lead to greater transparency, and thus
generate gains for investors.,,15 In reference back to the theory of reliability, investors
and creditors alike aspire to put their economic resources into firms whose numbers are
credible. Akhigbe and Martin discuss that the success of these specific provisions for
their original intent is questionable. They explain, "If investors and analysts determine
that these disclosure and governance requirements generate net benefits, positive
valuation effects should have resulted from the adoption ofSarbox.,,16 They further
discuss that it seems this has not occurred, and "[they] hypothesize that the share prices
of firms that were expected to incur greater compliance costs were less favorably affected
by Sarbox.,,17
Over time, corporations have come to find compliance with SOX regulations
more difficult than originally expected. Holmstrom and Kaplan suggest two potential
dilemmas in SOX. First, many of the stipulations are vague and can be interpreted in too
many directions. Second, SOX has set a rigid framework for corporate governance and
legislation in contrast to the more accommodating corporate governance of state laws. 18
These problems are noted too by Wiesen who confronts the ambiguity of SOX
provisions, saying, "The Act is so comprehensive it could be called a wish list in the form
15 Ellen Engel et al., "The Sarbanes-Oxley Act and Firms' Going-Private Decisions" (Thesis, University of Chicago, 2004), 1.
16 Akhigbe and Martin (2006): 990.
17 Ibid: 990.
18 Bengt Holmstrom and Steven N. Kaplan, "The State of U.S. Corporate Governance: What's Right and What's Wrong?" National Bureau o/Economic Research, INC NBER Working Papers: 9613,2003: 22.
24
of a stream of consciousness that goes after what people do, not how pieces of paper-
that is, securities-must be handled.,,19 The general consensus of the body ofliterature
expresses that the most frequently noted issues behind SOX are the cost of compliance to
firms, the unexpected negative valuation impact on firms and the different effects it has
on small and large businesses.
Effects on Large Firms
The primary complaint of large businesses is the increased pressure on upper
management to take responsibility for the company's integrity. Mann exposes the degree
to which new accountability for corporate executives was created by SOX. Mann
explains that "[SOX] says you are responsible not just for what you say, but for the truth
of what you say. It [SOX] also says you have got to sign a certification that what you say
is true." The key is in his conclusion" ... That [ certification] is the portion that makes a
difference, the penalty of prosecution for that signature if it turns out to be false. ,,20
Many large firms are finding it difficult to keep CEOs and CFOs on board with the new
implementation of accountability. SOX proponents require that executive officers swear
that the information in each annual and quarterly report is true to their knowledge;
additionally, they must provide an analysis of their firm's internal control system.
Karmel recognizes the importance of internal controls yet questions, "But do the new
certification requirements really ensure the reliability of financial statements by adding
layers of bureaucratic review that is costly and time consuming?,,21 Holmstrom and
19 Wiesen (2003): 447.
20 Michael E. Mann, "Preserving the Integrity of Financial Markets in North America," u.s. Law Journal, Volume 29, 2003: 293.
21 Karmel: 103.
25
Kaplan rationalize that" ... the greatest risk now facing the U.S. corporate governance
system is the possibility of overregulation.,,22 Basically, large firms have the financial
resources to pay compliance costs of SOX but are struggling to maintain the manpower
willing to take credit for the other measures of compliance. Braendle and Noll note that
one reason for this dilemma is the SOX provision that the CEOs and CFOs of American
firms with annual revenues exceeding $1.2 billion" ... have to swear in front of a notary
that 'to the best of [their] knowledge', their latest annual and quarterly reports neither
contain an 'untrue statement' nor omit any 'material fact' relevant to investors.,,23
Demski suggests that large firms also suffer from conflicts of interest within their own
firms due to the requirement of SOX to keep executives from receiving "improper
benefits" attributed to their position in the company.24 These effects stand to cause some
economic hardships for large U.S. firms. As executive positions become more risky and
less rewarding, it will become increasingly difficult for firms to retain their executive
officers.
Effects on Smaller Firms
Small firms on the other hand get hit hard financially. Block conducted a survey
of 236 publicly traded companies, of which 110 responded. The first question on the
survey was "What was the primary reason you went private?" The most common
22 Holmstrom and Kaplan (2003): 2.
23 Udo C. Braendle and Juergen Noll, "A Fig Leaf for The Naked Corporation," Journal of Management and Governance, Volume 9, 2005: 80.
24 Joel S. Demski, "Corporate Conflicts ofInterest," Journal of Economic Perspectives, Volume 17, Number 2,2003: 60.
26
response from 33 of the 110 firms was "Cost of being public.,,25 Small firms are
suffering from the exorbitant costs of staying public and complying with the requirements
of sox. Seidenberg explains that compliance costs the average public company $4.3
million annually, a figure high enough to hurt small companies.26 One of the major costs
Holmstrom and Kaplan explain is the requirement" ... that the audit committee hire the
outside auditor and that the committee consist entirely of directors with no other financial
relationship with the company.,,27 This can be particularly expensive for small firms to
do. Engel, Hayes and Wang cite a 2003 study by Bushee and Leuz, " ... they find a
striking willingness on the part of these small firms to evade securities regulation by
selecting less liquid forms of organization.,,28 Compliance fees are not variable but fixed
costs which Seidenberg reveals" ... are eating up a much higher percentage of [small
firms'] revenue-up to 50 times more than for big companies.,,29 Small companies are
taking different approaches to dealing with this problem. One method is privatization,
which Holmstrom and Kaplan reveal became a trend between 1984 and 1990 through a
method called leveraged buyouts (LBOs) whereby companies reacquire their own shares
and use their own assets to repay the loans on the firm.30 In a study by Engel, Hayes, and
25 Stanley B. Block, "The Latest Movement to Going Private: An Empirical Study," Journal of Applied Finance, Volume 14, Issue 1,2004: 37.
26 Steve Seidenberg, "SEC May Ease Small Companies' Burdens," American Bar Association Journal, Volume 92, Issue 1,2006: 4l.
27 Holmstrom and Kaplan (2003): 2l.
28 Engel, et al.: l.
29 Steve Seidenberg (2006): 4l.
30 Ibid:41.
27
Wang, where 353 privatization transactions were reviewed, they argue that " .. .it is value-
maximizing for a firm to go private in response to SOX only if the SOX-imposed costs to
the firm exceed the SOX-induced benefits to the shareholders, and this difference
swamps the net benefit of being a public firm prior to the passage of SOx.,,3l They find
that smaller firms did indeed have a surge of going private transactions after the passage
of SOX. Further, according to a survey by Gibeaut, in 2003 the number of small firms
that went private was at 80, up from 48 in 2001. The values of these transactions went
from $5.8 billion in 2001 to $8.7 billion in 2003,32 an indication of potential (and
significant) economic impact of the legislation.
For small businesses when the costs of SOX outweigh the benefits, they have
little or no incentive to stay in the public, domestic market. An alternative to
privatization is going public in foreign markets such as London's Alternative Investment
Market (AIM). Carney explains that "[there is a] possibility of exit from the United
States public markets because of increased ( and cumulative) regulatory costs that exceed
the benefits that these firms perceive.,,33 The public market allows many smaller firms to
grow through investor and creditor distribution of capital. Therefore, leaving the public
market completely, as in privatization, can perhaps limit the overall growth of a small
corporation. Taking a firm public abroad helps smaller corporations avoid the heavy
compliance costs of SOX while allowing them to continuously experience growth
31 Engel, et al.: 2.
32 John Gibeaut, "Private Drive," American Bar Association Journal, Volume 91, Issue 1,2005: 20-21.
33 William J. Carney, ''The Costs of Being Public after Sarbanes-Oxley," Emory Law Journal, Volume 55, Issue 1,2006: 142.
28
through foreign investment. This is perhaps why this option has become more attractive
to smaller firms in recent years.
The effects of the Sarbanes-Oxley Act can be comprehended after looking at the
principles behind and theoretical implications ofthe ACT. Some of the major problems
behind SOX are the high compliance costs for firms, negative valuation effects on firms,
results on corporate governance and the ambiguity of many of the provisions. Many
provisions not only affect the way firms do their own business but how they work with
other firms. Large and small businesses both are also affected by compliance costs yet in
different ways. Large firms are affected more by the stress on executives' liability and
various costly changes in corporate governance. The financial compliance costs
ultimately hurt small companies the most to a point where they are either turning private
or going public in foreign markets. This is shown by the data and methodology discussed
in the next chapter.
CHAPTER IV
DA T A AND METHODOLOGY
The methodology for this study is two-fold. Engel, Hayes and Wang
performed a study in 2004 that relates closely to the current one. Therefore, in the
first section of this chapter, their data will be presented and briefly analyzed to lay the
foundation for the current study. The second section will describe the methods of the
current study, the data and how it relates to the previous study. The authors of the
first study examined going private transactions in both pre- and post-SOX time
periods, defining the pre-SOX period as 19 months prior to the passage of SOX in
July of 2002 and the post-SOX period as 18 months after. The current study further
demonstrates the impact of SOX over time using a post-SOX period of 19 months to
54 months (4.5 years) after. It complements the previous study with further analysis
of data to investigate the continuing trend in privatization, whether small firms are
more likely to go private than large ones, and which industries or SIC codes were
most prevalent in going private transactions during this time period.
The current thesis hypothesizes that compliance with the Sarbanes-Oxley Act
of 2002 has become more difficult and expensive for firms, resulting in
a privatization trend that is just as prevalent in 2007 as it was immediately following
the passage of the Act. In order to present SOX's impact on this trend overall, the
background study must first be examined.
29
30
Engel et al. Study
In their study Engel, Hayes, and Wang attempt to prove that the compliance
costs, the value of SOX-related corporate governance restructuring, and the benefits
of being public before the passage of SOX are all relevant factors in how SOX affects
individual firms. I The authors pose three questions to be answered by the study:
First, how much of an effect did the passage of SOX have on the increase in firms
choosing to go private? Second, did the reasons behind firms' decisions to go private
change near the time SOX was passed? Third, were the factors behind going private
modified near the time SOX was passed?2 They study firms that filed Schedule 13e-3
privatization transactions in a pre-SOX period beginning in 1998 (19 months prior to
the passage of SOX) and a post-SOX period ending January 31,2004 (18 months
after the passage of SOX). The authors were able to collect a sample that consisted of
353 firms that filed privatization transactions during this time period. Engel, Wang
and Hayes select their sample using the SEC definition of a firm that has gone
private: " ... when the company reduces the number of its shareholders to fewer than
300 and is no longer required to file reports with the SEC.,,3 When a firm is no
longer publicly traded on the U.S. market and is not required to file reports with the
SEC, it is then also exempt from complying with SOX.
After collecting their sample, Engel, Hayes and Wang make several
predictions about the data. They explain that " ... one would expect the post-SOX
I Ellen Engel et aI., "The Sarbanes-Oxley Act and Firms' Going-Private Decisions" (Thesis, University of Chicago, 2004): 8-9.
2 Ibid: 2.
3 As cited in Engel et al.: 11.
31
going-private firms to be those where (1) SOX compliance costs are relatively high,
(2) SOX-related benefits to shareholders are small, and (3) net benefits to being
public are relatively small prior to the passage ofSOX.,,4 They suggest that all three
of these criteria apply to the small firms in the market. The public market is a place
where many small firms start out and use the capital earned from investments to
grow. Compliance, as noted in the authors' research, consists of both fixed and
variable costs. Thus, the authors suggest that due to the significance of the fixed
costs, smaller firms' growth in the public market is more likely to be stunted,
therefore making privatization seem a more logical option for these firms. 5 If these
firms are unable to continue growth, they will be hindered in competing with their
larger counterparts. Further, the authors explain that" ... two groups of firms are
likely to benefit least from SOX-related reforms: those that were well governed prior
to SOX, and those for whom insiders' ownership stakes were relatively illiquid prior
to SOx.,,6 SOX was enacted after a string of firms was accused of fraudulent
activity; however, not all firms were guilty of violating the SEC policies. The authors
suggest that firms that complied with the rules prior to the passage of the act may be
the ones to suffer or at least not benefit from SOX.
The agency theory addressed in the previous chapter provides insight into the
definition behind a well governed firm. A well governed firm exists when the
shareholders, boards of directors and management team are all working towards a
common goal of succeeding as a firm. Since the board of directors is elected by the
4 Ibid: 2.
5 Ibid: 9-10.
6 Ibid: 9.
32
shareholders and the management team appointed by the board of directors, it is
essential that they communicate with one another truthfully. The management team
must provide any and all necessary documented information in a transparent and
honest manner to the board of directors, and the board in tum reveals the necessary
information to the shareholders. It is when withholding or manipulation of
information occurs within a firm either at the management or executive level that
problems begin to occur. Engel, Hayes and Wang add that measuring whether a firm
is well governed is extremely difficult. However, they propose that a firm's
percentage of insiders' ownership shares affects their decision to go private. They
explain, "Insiders with very high ownership face a high cost of consuming agency
goods such as perquisites or shirking, and thus their firms may not benefit from
reduction in agency costs as a result of SOX."?
The authors create tables with the collected data and run a multivariate
regression on 182 of the transactions in the sample. They begin by creating a timeline
of SOX events including the announcement of intended legislation in February of
2002, through the official passage of SOX in July of 2002. They use this process to
identify significant changes in data around certain times and events. 8 The timeline of
events provides another potential explanation for the behavior of firms. If the
concentration of privatization transactions were higher near February 13, 2006, when
the SEC first announced that they would be recommending improvements to the
financial system, then it would suggest that firms reacted to this event by getting out
of the market. The authors attempted to relate characteristics of the firms to the
7 Ibid: 9.
8 Ibid: 16.
33
variables within their regression. The variables in the regression include the log of
market value and turnover, which the authors predict will explain both costs and
benefits of SOX and of being public. Additionally, they use control variables such as:
"BM (adjusted book-to-market), leverage (Lev, total liabilities deflated by assets),
free cash flow (CF), accounting profitability (ROA), and stock return volatility
(StdRet).,,9 Controlling these variables allowed for the authors to determine ifthe
factors behind the decision to go private changed over time. This element was
essential, because if in fact those factors did change, this would suggest that there
may not be consistency in firms' reasoning for going private. This regression was
also used to determine if the announcement returns were related to firm size and share
turnover.
Finally, Engel, Hayes and Wang discussed whether their study can predict
which characteristics make a firm more likely to go private. They matched the firms
in their sample to firms of similar characteristics that had remained publicly traded
companies and used the public firms as a control sample. They then performed a
regression on both samples: "We include variables we expect to relate to the costs and
benefits of being public, such as inside ownership and share turnover, and control
variables."lo Tables 4.1 and 4.2 show a summary of relevant data found by Engel,
Hayes and Wang.
Table 4.1 is a selection ofthe authors' collection of data on the frequency of
privatization transactions. Their study of the frequency of schedule 13-e3
9 Ibid: 18.
10 Ibid: 19.
34
transactions produced results that were consistent with their hypothesis. The numbers
show a relevantly low privatization frequency in 1998-2000. In the second quarter of
2001, right before the events of September 11 th and the plunge in the stock market,
the frequency of firms filing these transactions spiked. It was reduced in the third
quarter but was still high in comparison to previous years. July of 2002, when SOX
was passed, turned out the lowest number of transactions, while in the five quarters
and two months following the passage of the act, the rate was at its highest point.
Table 4.2 shows the data collected with respect to industry codes; in this case
the authors used 2-digit SIC codes. Though the authors did not predict which
industries would be most highly represented in the study, their data provided a
pathway for predictions for the current study. The table shows the SIC code matched
with the industry title it represents. It also shows the number of firms that went
private in each industry in total, pre-SOX and post-SOx. These numbers are then
given as a percentage. Engel, Hayes and Wang find that the two firms most
prevalently represented in their study are depository institutions (SIC 60) and
business services firms (SIC 73). II Other notable industries in their research include
computer and electrical industries (SIC 35 and 36) about which the authors reveal:
"of the 23 going-private transactions, 19 took place before the passage of SOX. This
suggests that stock market conditions might playa role in those firms' going private
decisions.,,12 They also find that the firms that went private post-SOX were smaller
in terms of size (market value, sales and assets) than were the pre-SOX firms that
II Ibid: 12.
12 Ibid: 12-13.
35
Table 4.1: Engel, Hayes and Wang study of going private frequency offinns Per quarter
Filing Quarter Frequency Percentage 1998q1 8 2.27 1998q2 9 2.55 1998q3 4 1.13 1998q4 4 1.13 1999q1 12 3.39 1999q2 17 4.82 1999q3 14 3.97 1999q4 9 2.55 2000q1 9 2.55 2000q2 13 3.68 2000q3 10 2.83 2000q4 9 2.55 2001q1 12 3.4 2001q2 27 7.65 2001q3 14 3.97 2001q4 12 3.4 2002q1 12 3.4 2002q2 13 3.68 Jul. 2002 3 0.85 Aug., Sept. 2002 7 1.98 2002q4 24 6.8 2003q1 18 5.1 2003q2 28 7.93 2003q3 22 6.23 2003q4 33 9.35 Jan. 2004 10 2.83
Engel, Ellen, Rachel M. Hayes and Xue Wang. "The Sarbanes-Oxley Act and Finns' Going -Private Decisions." MBA Thesis, University of Chicago. (2004): Table 2-30-31.
36
Table 4.2: Engel, Hayes and Wang study: Distribution of Privatization Transactions among Industries (2-digit SIC numbers)
SIC # # Pre- # Post-No. Industry All SOX SOX % All
1 Agriculture Production-Crops 4 1 3 1.13 7 Agriculture Services 2 1 1 0.57
13 Oil and Gas Extraction 8 3 5 2.27 15 Building Construction-Gen Contr, Op Bldr 3 2 1 0.85 16 Heavy Construction 2 1 1 0.57 17 Construction-Special Trade 1 0 1 0.28 20 Food and Kindred Products 10 8 2 2.83 21 Tobacco Products 1 1 0 0.28 22 Textile Mill Products 5 5 0 1.42 23 Apparel and Other finished Products 3 2 1 0.85 24 Lumber and Wood Products, Ex Furniture 4 3 1 1.13 25 Furniture and Fixtures 6 5 1 1.70 26 Paper and Allied Products 2 1 1 0.57 27 Printing, Publishing and Allied 8 6 2 2.27 28 Chemicals and Allied Products 6 4 2 1.70
Petroleum Refining and Related 29 Industries 2 1 1 0.57
Rubber and Miscellaneous Plastics 30 Products 2 1 1 0.57 32 Stone, Clay, Glass, Concrete Products 2 0 2 0.57 33 Primary Metal Industries 1 0 1 0.28
Fabricated Metal, Ex Machinery, Trans 34 Eq 7 3 4 1.98 35 Indl, Comml Machinery, Computer Eq 11 10 1 3.12
Electronic, Other Electrical Eq, Ex Comp 36 Eq. 12 9 3 3.40 37 Transportation Equipment 5 5 0 1.42
Measurement Instr, Photo Goods, 38 Watches 9 6 3 2.55 39 Miscellaneous Manufacturing Industries 6 5 1 1.70 42 Motor Freight Transportation, Warehouse 4 2 2 1.13 48 Communications 9 6 3 2.55 49 Electric, Gas, Sanitary Service 4 4 0 1.13 50 Durable Goods-Wholesale 13 10 3 3.68 51 Nondurable Goods-Wholesale 5 2 3 1.42
Building Material, Hardware, Garden-52 Retail 4 1 1 1.13 54 Food Stores 2 2 0 0.57 55 Apparel and Accessory Stores 2 1 1 0.57 58 Eating and Drinking Places 17 13 4 4.82 59 Miscellaneous Retail 8 6 2 2.27 60 Depository Institutions 34 13 21 9.63 61 Nondepository Credit Institutions 4 1 3 1.13 62 Security and Commodity Brokers 2 1 1 0.57 63 Insurance Carriers 11 5 6 3.12
37
64 Insurance Agents, Brokers and Service 1 1 0 0.28 65 Real Estate 19 12 7 5.38 67 Holding, Other Investment Offices 16 12 4 4.53 70 Hotels, Other Lodging Places 3 1 2 0.85 72 Personal Services 1 1 0 0.28
11.9 73 Business Services 42 21 21 0 75 Auto Repair, Services, Parking 1 1 0 0.28 76 Miscellaneous Repair Services 1 1 0 0.28 78 Motion Pictures 2 2 0 0.57 79 Amusements and Recreation 7 4 3 1.98 80 Health Services 6 5 1 1.70 82 Educational Services 1 0 1 0.28 83 Social Services 3 2 1 0.85 86 Membership Organizations 1 0 1 0.28 87 Engr, Acc, Resh, Mgmt, Rei Svs 7 5 2 1.98 99 Nonclassifilable Establishment 1 1 0 0.28
Total 353 219 134 100
Engel, Ellen, Rachel M. Hayes and Xue Wang. "The Sarbanes-Oxley Act and Firms' Going -Private Decisions." MBA Thesis, University of Chicago. (2004): Table 2-30-31.
38
went private. 13 Engel, Hayes and Wang conclude their study by explaining that their
hypotheses were supported by their empirical evidence. In answer to their questions
the authors find that "( 1) the quarterly frequency of going private increased modestly
after the passage of SOX; (2) the abnormal returns associated with the passage of
SOX were positively related to firm size and share turnover; (3) smaller firms
experienced higher going-private announcement returns in the post-SOX period
compared to the pre-SOX period.,,14 This information therefore, creates a path for
further examination as presented in the next section.
Current Study
The current work differs from Engel, Hayes and Wang's in three ways. It
extends the time period to include 2004 through 2007. It investigates whether more
small firms than large firms went private during the period. Finally, it investigates
whether there has been a change in which industries are more likely to go private.
The sample in this study consists of 400 firms that filed Schedule I3-e3 privatization
transactions with the SEC between February 1,2004, and January 1, 2007. The
sample was collected by running a search on the SEC's EDGAR data engine for
Schedule I3-e3 transaction filings during this time period. The data were then
analyzed for several factors: firm size, industry (SIC numbers), and frequency of
transactions.
Firm size was determined by the number of employees in each firm. The
average "size" of the firms and the standard deviation of the sample were used to
create each range. Small firms are therefore defined as any firm having between
13 Ibid: 15.
14 Ibid: 23.
39
9000 and 999,999 employees. Medium firms have 1,000,000-9,999,999 employees,
and large firms consist of 10,000,000 and more. Once the ranges of firm size were
set, the data were sorted in ascending order of firm size to determine the frequency of
firms in each range. The number of firms in each range that went private will verify
if smaller firms are more susceptible to privatization than large ones.
The industry codes were collected with the data on the SEC's EDGAR data
search engine. Each code was recorded with its respective company. The data were
then sorted in ascending order by industry code and the mode was taken to find the
most frequently occurring industry. Further, the second and third most prevalent
industries were investigated to better illustrate which were most likely to privatize in
the given time period. The industries which appear the most frequently within the
data reveal industries on which SOX had the most impact. This is important as it
helps explain which industries are most influenced by compliance laws.
Finally, the data were sorted into date order and divided into years. The
previous study divided the data into quarters for their analysis, but their time period
was shorter than the current one, thus quarterly evaluation would be unnecessary for
this study given the extended time period. The total number of firms per year was
summed and then listed as a percentage of total firms for the entire time period. The
purpose of these calculations is to explain which years were the most subject to (
privatization transactions and to determine if the number of firms overall has
increased or decreased since the previous study.
Several hypotheses are postulated. First, smaller firms will be more frequent
in the privatization transaction because, as the research has shown, they receive the
least amount of benefits from being public and are hit the hardest from costs of
compliance with SOX as public firms.
40
Second, the industries most prevalent in going private transactions will be
computer technology firms and/ or U.S. financial institutions such as banks or
accounting firms. These companies seem susceptible to greater variable compliance
costs than the average firm given that their external audits are more likely to be much
more extensive and therefore costly. This is because these companies vary in size
from very small firms to very large ones. The large firms bring in more revenue, and
therefore it is relatively less costly, but with the more extensive audits, it is the
smaller branches that have trouble. Financial firms such as auditors must hire
external auditors for their own business compliance, which is much more expensive
than if they could use internal resources. Both financial and computer technology
firms provide services to other businesses, which could potentially incriminate them
if any of their clients are accused of fraud, as in the case of Enron. Enron was using
an auditing firm and at the same time employing some of their auditors; when Enron
was found guilty, so was their auditing firm.
Finally, the data should show a decline in the number of firms that go private
from 2004 to 2007 given that (1) more firms are aware ofthe financial obligations of
SOX and therefore firms that were present in the public market prior to the passage of
SOX will have already made their way out whether through privatization or another
method, and (2) new firms will not enter the public market due to the significant
initial SOX costs or the simple fact that they cannot afford compliance in general.
41
The results and analysis of the current study follow in the next chapter. The
data will be examined in a similar fashion to the previous one with attention given to
the size of firms, representation of industries, and frequency of privatization
transactions. The data will be compared to the results of the previous study and
evaluated to discover the similarities, differences and significance of these details.
Further, the data and analysis will lead to discussion on the effects SOX has had on
privatization and what it could mean for the future of business in the United States.
CHAPTER V
RESULTS, ANALYSIS, AND DISCUSSION
The last chapter discussed the study and its methodology. This chapter will
show the results of that study and provide an interpretation and analysis of the results.
It will conclude with a discussion on the significance of the results and what they
mean for U.S. business in the future.
Results and Analysis
The results of the study explain several things with respect to the effects of
Sarbanes-Oxley on firms. The sample turned up 400 firms that had filed schedule 13-
e3 going private transactions between February 1,2004 and January 1, 2007. The
data that were pertinent included the size of the firm, the SIC number (industry
codes), and the filing date. The first task was to divide the firms into small, medium
and large groups to identify which size firms most commonly filed these types of
transactions. The size of the firm was determined by the number of employees in
each company.
The descriptive statistics ofthe data, including the mean, median, mode and
standard deviation are shown in Table 5.1. Graph 5.1 displays the data points in an
area graph to get an idea of the concentration of firm sizes in certain areas. The graph
shows that the majority of firms are smaller in size; there are a comparable number of
mid-sized firms, but large firms are rare within the sample. The data therefore
provided a range for each size classification of firm, with the smallest between 9000
42
43
Table 5.1: Descriptive Statistics with respect to Firm Size.
Mean 2,646,904.454
Median 541,723.5
Mode 1,711,124
Standard Deviation 5,172,873.963
Sample Minimum 9,792
Sample Maximum 47,665,172
Outliers 9,792 47,665,172
44
Graph 5.1: Area Graph of Firm Size Distribution.
~~----------
Frequency of Firm Size Finn Size
60000000
50000000 -+---~-
40000000
30000000 --f-----------~--
20000000
10000000 +-------- .--:---~ Finn Sample #
o -~ ___ Iiiiiiiiiiiiii;;;;;;;;~ ..... ..J
1 48 95 142 189 236 283 330 377
[~U~~equency of Firm Siz~J
45
and 999,999 employees, the mid-sized 1,000,000 to 9,999,999 and the largest
10,000,000 employees and more. Table 5.2 shows the frequency of firms in each size
range. The small firms make up more than 50% of the sample, which indicates that a
majority of the privatization transactions were made by small companies. SOX
provides few benefits for companies of this size and therefore makes going private a
more attractive option.
The SIC number puts firms into categories and the number of digits
determines how specific the category. Therefore, knowing which industry is most
often losing firms to privatization is useful for discovering which industries are
benefiting least from sox. The data were sorted by SIC number and the SPSS data
program generated the frequency of each industry code to determine the top three
industries affected by privatization. The report showed that the most represented
industry was SIC code 7372, which is a specific industry (as indicated by the four
digit code) in the service industry: pre-packaged software. The second industry was
state commercial banks, closely followed by national commercial banks (See Table
5.3). These findings are fairly consistent with those of Engel, Hayes and Wang. The
difference is that pre-packaged software is lower on their list. This suggests that
perhaps these firms have struggled more in recent years, giving them greater reason to
go private.
The final task was to look into the frequency of going private transactions per
year to determine if the number of firms leaving the public market is continuing to
increase this long after the passage of SOX. Sorting the data by filing date of the
transaction showed how many firms filed the schedule 13-e3 transactions per year in
46
Table 5.2: Total Frequency of Small, Medium and Large Firms within the Sample
Firm Size Frequency of Size Percentage of Total Sample
Small 220 55%
Medium 154 38.5%
Large 25 6.25%
47
Table 5.3: 10 Most frequent industries represented in the sample.
SIC Code Industry Name Frequency 7372 Services-Pre-packaged 46 transactions
Software 6022 State Commercial Banks 33 transactions 6021 National Commercial Banks 16 transactions 6035 Savings Institutions, Federally 13 transactions
Chartered 7389 Services-Business Services 12 transactions 5812 Retail-Eating Places 12 transactions 4813 Telephone Communications 10 transactions 4911 Electric Services 9 transactions 1311 Industrial Organic Chemicals 8 transactions
48
comparison to the Engel, Hayes and Wang study. The outcome is shown in Table
5.4. The year 2005 produced the highest number of going private transactions in the
sample. The current study found 149 companies went private in 2005, while Engel,
Hayes and Wang only discovered 193 companies that went private in the 18 months
following SOX. This suggests that perhaps the trend for going private is growing.
However, when the data are broken into frequency by quarters (See table 5.5), as in
the Engel, Hayes and Wang study, the trend has not increased but remained rather
consistent. This study does not involve outside factors, but if the privatization
transactions are a result of SOX provisions, perhaps firms are still trying to figure out
how to remain in the market.
The hypothesis of this study is that SOX has become a physical and financial
burden on firms and is causing firms to tum to other options, mainly privatization, to
remain in business. The data show that the smallest firms filed a majority of the
going private transactions, which is consistent with the Engel, Hayes and Wang
findings. The industries that are most likely to file include depository institutions and
software companies, followed by other commonly known business industries,
including restaurants. Finally, the frequency of firms going private each year has
increased since the passage of SOX, though quarterly analysis suggests a similar
pattern. It seems that SOX has in fact made leaving the public market a more
attractive option. Whether firms are privatizing, going public abroad, or simply
merging with larger corporations, the fact is they are going anywhere but the U.S.
public market.
49
Table 5.4: Annual Frequency of Going Private Transactions for 2004-2007.
Year Frequency Percentage of Total Sample
2004 122 30.6% 2005 149 37.4% 2006 124 31.2% 2007 3 00.75% Total 398 99.95%
50
Table 5.5: Quarterly Frequency of Going Private Transactions for 2004-2007
Quarter Frequency Percentage of Sample 2004q1 24 6.00% 2004q2 24 6.00% 2004q3 26 6.50% 2004q4 45 11.25% 2005q1 22 5.50% 2005q2 41 10.25% 2005q3 43 10.75% 2005q4 40 10.00% 2006q1 16 4.00% 2006q2 54 13.50% 2006q3 30 7.50% 2006q4 21 5.25% 2007q1 3 0.75%
51
Discussion
The analysis of the data shows that in fact certain size finns and certain
industries are more vulnerable than others to the consequences of SOX provisions.
This may be an indication that refonn is necessary. Wiesen calls Congress the "two-
ton gorilla" that woke up and decided the creation of SOX was necessary. However,
in creating the law Congress may have been too eager to put a stop to fraudulent
activity and created a system that is currently resulting in overregulation. Not only
are publicly traded finns required to comply with SOX provisions, but so are their
lawyers and auditors. Wiesen notes, "Lawyers reading Sarbanes-Oxley must have
had the same expectation as the old man who reads the obituaries first thing every
morning-to check ifhe is still alive.'" There is a provision for the responsibilities of
lawyers and auditors within the legislation that makes them both responsible for
whistle-blowing. Wiesen also discusses that at first Americans were asked to look
out for and report terrorism. Now, the three women who blew the whistle on Enron,
WorldCom and the FBI, are being rewarded for tattling on white-collar criminal
activity with the SOX provided mandate for the protection ofwhistle-blowers.2
Protecting themselves against provisions like this is what is costing finns so much
money. The ramifications of market overregulation may be detrimental to the overall
economy.
Colvin suggests, "The worst unintended consequence would be a change in
what most boards focus on, which ought to be taking risks and creating wealth ... If
I Jeremy Wiesen, "Congress Enacts Sarbanes-Oxley Act 0[2002: A Two-ton Gorilla Awakes and Speaks," Journal of Accounting, Auditing and Finance, Volume 18, 2003: 436.
2 Ibid: 441.
52
directors take their eyes off their real job and instead become consumed with
compliance, shareholders on the whole will be worse off. .. ,,3 Taking risks and
creating wealth are what these firms do, and these things drive competition.
Therefore, competition stands to suffer in two ways. First, if directors are primarily
concerned with compliance, they will make much more conservative business
decisions, creating a more risk averse environment that ultimately drives down their
firms' ability to compete with others. Second, smaller firms that cannot afford
Sarbanes-Oxley compliance costs are being forced to go elsewhere with their firms,
whether it be privatizing or turning to foreign markets. These firms cannot go public
in the u.S. market because the costs of remaining here exceed the benefits; therefore,
the remaining firms will be those that can afford the costs. Eventually, the market
could be left predominately to large firms who have the resources, financial and
otherwise, to comply.
The results of this study coupled with abundant criticism of the act suggest
that there is an essential need for SOX reform. Small firms are continually being
driven from the public market due to lack of the financial resources necessary for
compliance. Industries such as financial institutions and computer technologies are
more vulnerable to the penalties of the act and therefore are privatizing at a higher
rate than similar size firms in other industries. Finally, managers, employees and
boards of directors of firms are finding that their jobs are subject to increased risk and
decreased reward, which might cause discouragement for potential future employees.
The intentions behind the creation of SOX were to restore good faith in the financial
market to shareholders. However, this goal will not be met by driving out smaller
3 Geoffrey Colvin, "Sarbanes & Co. Can't Want This," Fortune, Volume 146 (2002): 66.
finns and destroying competition. It will be interesting to see if and how the SEC
decides to manage the new situation, of overregulation, at hand.
The following chapter concludes the thesis. It will review the
accomplishments of the individual chapters and conclude with comments about the
general effects SOX may have in the future.
53
CHAPTER VI
CONCLUSION
Sarbanes-Oxley has no doubt had an impact on the U.S. market that will
forever change the way the United States does business. Regulation of firm activities
is causing more and more firms to reevaluate their systems and make necessary
changes to appease the SEC. The act has made it more difficult and expensive for
small to mid-size firms, resulting in a privatization trend that has continually
progressed since the passage of the act in 2002.
Chapter II introduced the theoretical concepts behind the effects of SOX,
including its relevance to agency, corporate governance, reliability, disclosure and
transparency, market regulation, and barrier to entry. Agency theory presents the idea
of agents (managers) working for the principals (board of directors) and thus
presented the potential problems when conflict of interest occurs. Corporate
governance discussed the problems firms experienced in restructuring to conform to
the rules of Sox. Theory suggests that there are many benefits to SOX due to the
fact that transparent disclosure of information provides uncertain investors with a
renewed certainty. However, it also shows the overall effects that the passage of
SOX is having. Market regulation is one of the ways SOX is economically affecting
the market. Consumer confidence is enhanced when a firm discloses valid and
transparent financial information. SOX provisions have developed disclosure laws to
ensure that shareholders can maintain confidence in firms and therefore continue to
54
55
invest. SOX has made executive and management positions less attractive as the
risks for these positions have increased without reward. It has also created a barrier
to entry for smaller firms that cannot afford the fixed and variable compliance costs.
Theory was then supplemented by the review of literature.
The literature review in Chapter III provided a look at the historical events
leading up to the passage of SOX, the primary provisions of the act, and general
opinion regarding its successes and downfalls. It also introduced the controversies
caused by the quick passage of the act and its potential problems. Large companies'
concerns were addressed with respect to the excessive pressure on chief officers and
employees to maintain complete awareness of the actions of their companies. Small
companies on the other hand are more concerned with the financial cost of
compliance as well as whether the benefits of remaining public outweigh the costs
and the other options that these firms have if they choose not to remain public.
Finally, possibilities and suggestions for reform were mentioned including the
creation of alternative compliance rules for smaller firms, or even amending the
original act to make compliance more reasonable for all firms.
Chapter IV detailed the data collected from a previous study performed by
Engle, Hayes and Wang as well as the current study. The data collected from the
prior study examined the repercussions of SOX on firms of different sizes and
industries and discussed outside characteristics that allowed firms to be successful in
compliance or drove them to privatize. The results of the study found that a
continuous stream of smaller sized firms began going private right before SOX was
passed until 2004. United States financial institutions and accounting firms as well as
56
business services finns were the industries that most frequently privatized during this
time period. The current study extended the time period but asked similar questions
to investigate whether the trend in privatization has continued even four years after
the passage of sox.
The results ofthe current study were discussed in Chapter V, illustrating that
copious numbers of smaller finns were privatizing continuing through 2006. The
industries most often privatizing in this study were u.s. financial institutions and
accounting finns as well as computer technology companies. The results were then
analyzed and discussed as to what the long-tenn effects of SOX would be if the trend
continues. These effects include loss of competition and creation of barriers to entry
for smaller finns, which may eventually leave the market to the large finns that are
willing and able to pay for compliance.
This study was perfonned using data from an older study that was then
updated and similarly studied. Both studies speculate that, due to the time period the
finns went private and everlasting criticism behind the act, the finns going private are
doing so because of sox. A venues for further research may include surveying finns'
data for the factors that caused them to go public and showing how many actually cite
SOX compliance somewhere in their reasoning. There is also potential for interesting
results through studying whether SOX has worked in keeping directors honest,
resulting in accurate financial data. The overall economic effects of Sarbanes-Oxley
on the u.s. financial market will continue to develop as time goes on, and with or
without refonns, u.s. finns will never do business the same as before the passage of
SOX again.
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Empirical Studies
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Engel, Ellen, Rachel M. Hayes and Xue Wang. "The Sarbanes-Oxley Act and Firms' Going -Private Decisions." MBA Thesis, University of Chicago. (2004).
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59
Mann, Michael E. "Preserving the Integrity of Financial Markets in North America." U.S. Law Journal. Vol. 29 (2003): 291-298.
Radin, Robert F. and William B. Stevenson. "Comparing Mutual Fund Governance and Corporate Governance." Corporate Governance: An International Review. Vol. 14, No.5. (2006): 367-376.
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