Yearly Archives: 2009

Why the SEC should not further restrain short selling

Posted by James Chanos, President of Kynikos Associates LP, on
Thursday, July 2, 2009
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This post is by James Chanos of Kynikos Associates LP.

The hedge fund coalition that I chair, the Coalition of Private Investment Companies (CPIC), recently submitted a comment letter to the Securities and Exchange Commission (SEC) in which we laid out our case for why the Commission should drop proposals to further restrain short selling. Under consideration by the regulator is a series of proposals that range from a “national bid test” to “circuit breakers,” which, if triggered, halt short selling transactions.

The SEC has repeatedly acknowledged the benefits of short selling, from improving liquidity in capital markets to enhancing price discovery, and, in the past, the agency has expressed reluctance to restrict an investment strategy that serves as a necessary counterweight to unbridled optimism. But, it has departed from this traditional view in a variety of efforts ─ some misguided ─ to address the circumstances of the largest market drop in decades. When the SEC imposed bans on short selling last summer, investors’ interests were harmed as market quality deteriorated, including higher transaction costs through wider spreads. (More information about short selling is available here.)

Our letter emphasizes, as Commissioner Kathleen Casey did when the SEC announced its newest short sale rule proposals, that the SEC must provide empirical evidence that validates the necessity for action and demonstrates the benefits investors would receive in excess of the harm done from new restraints on short selling.

In proposing several regulatory “speed bumps” on short selling, particularly in down markets, the SEC emphasized two considerations that will guide its decision: that “naked” short selling is a problem demanding regulatory attention and that one cause of the low level of investor confidence is the prevalence of short selling and its role in the fall in stock values.

In our letter, we point to actions already taken by the SEC to eliminate “naked short selling,” which occurs when an investor has failed to have identified or gained commitment for stocks they have shorted. Our industry, including myself, supported those actions. As a result, there has been a further decline in the already very low level of naked short selling that does occur.

As to investor confidence, it is on the rise again albeit it in fits and starts, according to several polls, including that produced by State Street Bank. To gauge investors’ thinking, the State Street survey looks at several macro- and microeconomic factors, which do not include short selling. Given this, we questioned the link the SEC has suggested between the prevalence of short selling and low levels of investor confidence. In another comment letter, an Ohio State University Professor Ingrid Werner similarly questions the link. She concludes that “there appears to be no evidence supporting the hypothesis that high levels of short selling activity contributed to low levels of investor confidence during the recent financial crisis.”

Removing information from the markets — whether it be by posing barriers to short selling or by rolling back mark-to-market accounting standards — as a means to promote “investor confidence” is a terrible precedent.

The full text of the CPIC letter is available here.

SEC Advocates Broad Reforms of Synthetic Ownership Instruments and Markets

Posted by Theodore Mirvis, Wachtell, Lipton, Rosen & Katz, on
Thursday, July 2, 2009
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This post is based on a client memo by Theodore N. Mirvis and Adam O. Emmerich of Wachtell, Lipton, Rosen & Katz.

As we have pointed out for some time, non-traditional structured and derivative arrangements that create economic exposure to publicly traded securities have allowed activist and short-term investors to exert vast but hidden influence. With respect to equity securities, investors have used such instruments to secretly accumulate large equity positions with a view to exercising control over corporate decisionmaking, with little or no disclosure of the existence or nature of these positions or their plans. With respect to debt securities, such devices have often been used – frequently in conjunction with short selling – to manipulate the market in bear raids, placing companies dependent on access to the capital markets in peril. While these phenomena directly implicate the policies underlying traditional disclosure requirements and anti-manipulation rules, they have thus far largely escaped adequate regulation.

In testimony yesterday before the Senate, advancing Treasury Secretary Geithner’s regulatory reform agenda announced on May 13, SEC Chairman Schapiro has now addressed these concerns foursquare, calling for long-needed fundamental reform in the regulation of derivatives by the SEC. Chairman Schapiro put the matter clearly in saying:

The current regulatory framework has permitted certain opaque securities-related OTC derivatives markets to develop outside of investor protection provisions of the securities laws. These provisions include requiring the disclosure of significant ownership provisions and … prophylactic measures against fraud, manipulation, or insider trading…. … Trading in securities-related OTC derivatives can directly affect trading in the securities markets. From an economic viewpoint, the interchangeability of securities and securities-related OTC derivatives means that they are driven by the same economic forces and are linked by common participants, trading strategies, and hedging activities. … [M]anipulative activities in the markets for securities-related OTC derivatives can affect US issuers in the underlying equity market, thereby damaging the public perception of those companies and raising their cost of capital. To protect the integrity of the markets, trading in all securities-related OTC derivatives should be fully subject to the US regulatory regime designed to facilitate capital formation.

Chairman Schapiro called upon Congress to enact legislation to bring securities-related OTC derivatives clearly under the umbrella of the federal securities laws, including so that the SEC might require regulated central counterparties (CCPs) for derivatives markets, to address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of counterparties. In her testimony, Chairman Schapiro also recognized that “[a]ny new regulatory framework… should take into consideration the purposes that appropriately regulated derivatives can serve, including affording market participants the ability to hedge positions and effectively manage risk.”

Broad-based reform of the OTC derivatives market to prevent the abuses and dangers exposed by the recent financial crisis – without destroying the ability of financial institutions, corporations and investors to make appropriate use of derivatives to assist in the process of capital formation and risk management – is a complicated project that will require a great deal of judgment and compromise. Disclosure under the Securities Exchange Act of 1934 of equity derivatives so that ownership and transactions in the derivatives would be treated equally with ownership and transactions in the underlying security is but one part of this larger task. It is, however, an important part, and one that we do not believe requires legislation but only rule-making and interpretation by the SEC. For so long as the current loopholes in the 13D reporting regime are not closed, parties seeking to disguise their activities or manipulate the market will try to take advantage of those loopholes. So too with manipulative trading in credit default swaps and short selling. We encourage the SEC to close the gaps in the current disclosure regime and to actively take enforcement action against abusive transactions, even while the SEC, other regulatory bodies, the Congress and the Administration together pursue the larger project of comprehensive reform of the regulation of derivatives that is now under consideration.

Financial Visibility and Going Private

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 1, 2009
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This post comes to us from Hamid Mehran and Stavros Peristiani of the Federal Reserve Bank of New York.

In our forthcoming Review of Financial Studies paper Financial Visibility and the Decision to Go Private we investigate the determinants of the decision to go private over a firm’s entire public life cycle.

We investigate the decision to go private by estimating several variations of the hazard model. Initially, we estimate a broad competing risk model where the decision to remain public or go private is evaluated against all alternative termination outcomes (merger, liquidation, or negative delisting). Most of our analysis, however, focuses on estimating a hazard model that excludes all other competing choices. In this case, the regression sample consists of an annual panel of observations of all IPO firms that either had an LBO or were bought by another private company and all surviving IPO firms that remained in the public market.

Our sample includes completed deals in which an IPO firm was a target in an LBO or was acquired and became a private company from January 1, 1990, to the end of October 2007. Our tests focus on those firms that 1) went public after 1988 and subsequently were buyout targets after January 1, 1990 and 2) were included in Compustat. Our final sample consisted of 262 firms (169 LBO targets and 93 non-LBO firms that were acquired by nonpublic companies or investor groups). Of these 262 IPO firms, 218 (150 LBO and 68 non-LBO targets) were followed by securities analysts.

Our evidence reveals that firms with declining growth in analyst coverage, falling institutional ownership, and low stock turnover were more likely to go private and opted to do so sooner. We argue that a primary reason behind the decision of IPO firms to abandon their public listing was a failure to attract a critical mass of financial visibility and investor interest. Consistent with the findings of earlier literature, we also find strong support for Jensen’s free-cash-flow hypothesis, which argues that these corporate restructurings are a useful tool in capital markets for mitigating agency problems between insiders and outside shareholders.

The full paper is available for download here.

The Proper Limits of Shareholder Proxy Access

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, June 30, 2009
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Editor’s Note: The post below by Commissioner Paredes is a transcript of remarks by him at the Center for Capital Markets Competitiveness, U.S. Chamber of Commerce on June 23, 2009 in Washington, D.C.

It is a pleasure to be speaking at this timely conference on “Shareholder Rights, the 2009 Proxy Season, and the Impact of Shareholder Activism” hosted by the U.S. Chamber of Commerce. Before I begin, I must remind you that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.

As a practical matter, public company shareholders are not well-positioned to run the enterprises in which they invest. Managerial responsibility over a firm’s corporate strategy and day-to-day business and affairs instead is in the charge of directors and management. That said, shareholders retain the right to vote on fundamental corporate changes, such as a merger, a sale of all or substantially all of the corporation’s assets, and an amendment to the corporate charter or bylaws. Most notably, shareholders vote for board members. Shareholders also have the right of “exit,” as they can sell their shares if they disapprove of the company’s performance.

The animating question behind any discussion of shareholder rights thus presents itself: What is the proper institutional arrangement for ensuring that the company is managed in the best interests of shareholders when those who own the firm do not actively run it? [1]

Last month, in May, the SEC took a significant step toward setting the balance of control in corporations. [2] The Commission proposed new Exchange Act Rule 14a-11 creating a direct right of access for shareholders to the company’s proxy materials for nominating board members. For example, for the largest public companies, a nominating shareholder or group would have the right to include director nominees in the company’s proxy materials if the shareholder or group beneficially owned at least one percent of the company’s shares for at least one year.

The Commission also proposed amending Exchange Act Rule 14a-8(i)(8) to allow shareholders to include in the company’s proxy materials a proposal to amend the company’s bylaws to provide for a shareholder access regime. Notably, the SEC’s proposal prohibits shareholders from adopting a bylaw that opts out of the Rule 14a-11 access regime, even if shareholders want to.

As you may know, I voted against the Commission’s proposal and instead offered a counterproposal, which I will discuss later. [3] First, let me explain my core concern with what the SEC has advanced. As always, I look forward to considering the comments we receive on the proposal.

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Toxic Tests

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, June 29, 2009
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Editor’s Note: This post is Lucian Bebchuk’s current column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newpapers Project Syndicate. The series focuses on finance and corporate governance and may be accessed here. Below is the text of Professor Bebchuk’s column:

The United States government is now permitting ten of America’s biggest banks to repay about $70 billion of the capital injected into them last fall. This decision followed the banks having passed the so-called “stress tests” of their financial viability, which the US Treasury demanded, and the success of some of them in raising the additional capital that the tests suggested they needed.

Many people have inferred from this sequence of events that US banks – which are critical to both the American and world economies – are now out of trouble. But that inference is seriously mistaken.

In fact, the US stress tests didn’t attempt to estimate the losses that banks have suffered on many of the “toxic assets” that have been at the heart of the financial crisis. Nevertheless, the US model is catching on. In a meeting this month, finance ministers of G-8 countries agreed to follow the US and perform stress tests on their banks. But, if the results of such tests are to be reliable, they should avoid the US tests’ fundamental flaw.

Until recently, much of the US government’s focus has been on the toxic assets clogging banks’ balance sheets. Although accounting rules often permit banks to price these assets at face value, it is generally believed that the fundamental value of many toxic assets has fallen significantly below face value. The Obama administration came out with a plan to spend up to $1 trillion dollars to buy banks’ toxic assets, but the plan has been put on hold.

It might have been hoped that the bank supervisors who stress-tested the banks would try to estimate the size of the banks’ losses on toxic assets. Instead, supervisors estimated only losses that banks can be expected to incur on loans (and other assets) that will come to maturity by the end of 2010. They chose to ignore any losses that banks will suffer on loans that will mature after 2010. Thus, the tests did not take into account a big part of the economic damage that the crisis imposed on banks.

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Retaining Key Target Employees: Lessons For Acquirors

Posted by Eduardo Gallardo, Gibson, Dunn & Crutcher LLP, on
Sunday, June 28, 2009
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This post is by Eduardo Gallardo’s colleagues Jonathan Layne, Mark Lahive and Ben Ross. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Common issues confronting acquirors involve retaining the target company’s key employees and protecting against the loss of business to defecting employees. A recent Delaware Court of Chancery decision addressed issues faced by an acquiror, where a group of the target company’s employees plotted to leave the target company and launch a competing business prior to the acquisition’s close. The court’s decision in Ivize of Milwaukee, LLC v. Compex Litigation Support, LLC [1] will likely cause acquirors to more aggressively seek and obtain employment and/or non-competition agreements from key target employees, particularly where the success of the acquisition depends upon a relatively small number of key employees.

The Case

In early 2007, Compex Legal Services (“Compex”), a provider of legal support services to law firms, decided to divest its Milwaukee and Kansas City facilities. Compex negotiated such divestures with another provider of legal support services, Ivize, LLC (“Ivize”), culminating in a simultaneous signing and closing on July 26, 2007 of a pair of Asset Purchase Agreements (one for each facility).

During the negotiations, Pete Cobb (“Cobb”), the manager of the Milwaukee facility, was advised of the transaction and that he would not be retained full-time after closing. In response, Cobb discussed the transaction with key salespeople who accounted for roughly 90% of Compex’s sales. Cobb and the key salespeople, in violation of existing non-competition agreements with Compex, (1) formed a rival entity (“Quantum”), (2) met multiple times to discuss Quantum business, (3) solicited key Compex employees, (4) rerouted business to Quantum, and (5) stole company records and equipment.

On the morning after closing, Ivize’s representatives found the Milwaukee facility abandoned and ransacked. In the days that followed, Ivize and Compex jointly uncovered Cobb’s activities.

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Modernizing Pension Fund Legal Standards

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, June 27, 2009
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This post comes from Keith L. Johnson, Program Director for the International Corporate Governance Initiative at the University of Wisconsin Law School, and Frank Jan de Graaf, Professor of International Business at Hanze University of Applied Sciences in the Netherlands.

In Modernizing Pension Fund Legal Standards for the Twenty-First Century, we explore the symbiotic relationship between sustainable success of the corporate sector and the ability of pension funds to successfully fulfill their mandate. We note that exponential growth in the size of pension fund assets since the 1970s and their current collective ownership of public corporations has turned pension fund governance into a major corporate governance factor. We argue that traditional views of pension fund governance and fiduciary responsibility, which developed during a time when pension fund investment practices had little effect on the markets, are outdated. With institutional investors owning 76 percent of the Fortune 1000, pension fund governance and corporate governance are now opposite sides of the same coin, with each exerting a major influence on long-term success of the other.

We concentrate on the pension fund side of this relationship and argue for a modernized interpretation of fiduciary duty. We maintain that prevailing interpretations of pension fund legal duties and common pension fund governance practices may be ill-suited for the complex investment instruments and the market-moving amount of assets now being managed by pension investors. We recommend changes in the interpretation of pension fund legal standards and identify priorities for improvements in pension fund governance to promote sustainability of wealth creation for both the pension and corporate sides of this symbiotic relationship.

The full paper appears in the Spring 2009 issue of the Rotman International Journal of Pension Management, published jointly by the Rotman International Centre for Pension Management and University of Toronto Press and is available for download here.

Compensation Peer Groups

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Friday, June 26, 2009
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This post comes to us from Michael Faulkender of the University of Maryland and Jun Yang of Indiana University.

In our forthcoming Journal of Financial Economics paper entitled “Inside the black box: the role and composition of compensation peer groups” we investigate how much compensation peer groups explain observed variation in CEO compensation and what determines the composition of these groups. Effective December 15, 2006, the SEC required that firms disclose “Whether the registrant engaged in any benchmarking of total compensation, or any material element of compensation, identifying the benchmark and, if applicable, its components (including component companies).” This study is the first to collect and examine the list of compensation peer companies used by the S&P 500 firms and S&P MidCap 400 firms in their first fiscal year ending after the compliance date of December 15, 2006.

We find that the median compensation of the peer group generates significant incremental explanatory power in understanding cross-sectional variation in the observed CEO compensation among disclosing firms even after including controls for CEO labor market conditions. We find that CEOs whose pay was below the median pay level of their counterparts in companies of similar size and in the same industry receive pay raises that are larger in both percentage and dollar terms. In contrast, having actual compensation peer group membership enables us to demonstrate that peer companies outside the firm’s industry and size group also have a significant influence on executive compensation.

When we examine the composition of peer groups, we find that firms select companies in the same industry, of similar size, and with a history of observed talent flows between them to be members of their compensation peer groups. Using both multivariate probit models and a propensity score matching (PSM) approach, we show that the level of CEO compensation at a potential peer company is statistically significant in determining its likelihood of being chosen as a compensation peer, after controlling for industry, size, visibility, talent flows and CEO characteristics. In other words, compensation committees seem to be endorsing compensation peer groups that include companies with higher CEO compensation, everything else equal, possibly because such peer companies enable justification of the high level of their CEO pay.

One interpretation of our results is that entrenched CEOs in firms with weak corporate governance are likely to have more power to influence their own compensation. An alternative interpretation of our findings is that higher CEO compensation (for more complex firms) is likely to be an equilibrium result in a well-functioning labor market. To distinguish between these two theories, we examine the variation in pay differences between selected and unselected peers across measures of corporate governance. We find that highly paid potential peers are more likely to be chosen as compensation peers by firms where the peer group is smaller, where the CEO is the Chairman of the BOD, where the CEO has been in the post longer, and where directors are busier serving on multiple boards.

The full paper is available for download here.

SEC Must Constrain Abusive Short Selling

Posted by Edward D. Herlihy, Wachtell, Lipton, Rosen & Katz, on
Thursday, June 25, 2009
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This post sets forth the text of a letter to the Securities and Exchange Commission by Edward D. Herlihy and Theodore A. Levine of Wachtell, Lipton, Rosen & Katz in response to the Commission’s request for comments on its proposed amendments to Regulation SHO (short sale proposals). A facsimile of the letter is available here.

The repeated abuse of short selling over the past eighteen months has led to the destruction of businesses, cost countless numbers of jobs and created systematic risk in the global economy. Though some have asserted that short selling aids liquidity and price discovery in the market, the possibility of such functions should not be used to justify the damaging and corrosive consequences of abusive short sales. Since the repeal of the uptick rule in 2007, the market has suffered a resurgence of manipulative short selling, including widespread “bear raids,” in which short sales of equity securities are employed, sometimes in combination with other trading strategies, in a concentrated effort to drive down their prices. These practices have badly damaged institutions, destroyed billions of dollars in shareholder value, and crippled investor confidence.

We strongly urge the Commission to adopt effective regulation to constrain abusive short selling and related trading strategies, thereby protecting institutions, employees, shareholders and the wider economy from the manipulation and ensuing damage that have been pervasive over the past several years. [1]

First, we urge the Commission to adopt a short sale price test to decelerate the short selling process, thereby reducing short sellers’ ability to overwhelm companies’ shares and quickly profit from the resulting “downward spiral” in share prices. We believe that, in order to function effectively in the modern marketplace, a price test based on the national best bid is appropriate. To provide the most comprehensive protection against manipulation, any price test should be adopted through both the “policies and procedures” and “straight prohibition” approaches. The former requires that exchanges and other trading centers develop the policies, systems and technology necessary to ensure trades’ compliance with the price test, while the latter gives all market participants responsibility for compliance and provides the Commission with maximum enforcement authority over any violations.

Such a price test rule must not overlook the myriad ways traders are able to effect a short position in a company’s stock, including synthetic short positions created through the use of options and exchange traded funds. Thus, any short sale price test rule adopted by the Commission should address these strategies and provide the Commission with enforcement authority over synthetic shorting activity aimed at evading the price test.

In addition to a price test based on the national best bid, we recommend that the Commission implement a “circuit breaker” rule that would impose additional restrictions on short sales of a security that has been the subject of a severe price decline. Following a decline of five percent in a security’s price from its previous day’s close, short sales in the security should be suspended for the remainder of the trading day. This suspension will prevent a destabilizing downward spiral in the triggering security and give the market time to arrive at a rational valuation. Short sales should be allowed to resume on the next trading day, albeit with additional restrictions, such as strict “pre-borrow” requirement for certain recovery period to ensure that aggressive short sellers are not permitted to further damage the security’s price during this sensitive time. A properly calibrated “circuit-breaker,” in combination with a short sale price test, will interrupt the instances of extreme intraday volatility that destabilize the market, prevent efficient price discovery and cause investors to doubt the fairness and integrity of the market.

Any action the Commission attempts to take against manipulative short selling will not be completely effective without parallel, reinforcing reforms applied to the derivatives market, particularly with respect to credit default swaps (“CDS”). The responsiveness of equity prices to changes in CDS spreads makes the purchase of CDS a powerful device for bear raids, particularly when used in connection with short sales. Combining a short sale with the purchase of CDS sends a false signal into the marketplace about a company’s credit and, accordingly, causes a drop in the stock price that makes the short position profitable. Such manipulation is dangerously cost-effective, as a relatively small investment in an institution’s CDS is sufficient to spark rumors of default or a ratings downgrade and immediately sink stock prices.

To prevent this and other abuses of the CDS market, we believe that only those who are economically exposed to the underlying credit risk of a company should be allowed to buy CDS protection on the company. The purchase of a “naked” CDS, made by a purchaser with no exposure to the reference company, is more akin to gambling than obtaining insurance, and such instruments are capable of causing serious distortions in the market. A prohibition on naked CDS would allow the appropriate use of these instruments while restraining those using the CDS market in a manipulative and abusive way. As an intermediate step, the Commission should use its ability to regulate short sales to require a waiting period between any purchase of a CDS and short sale involving the same reference company. In addition, to alert the marketplace to situations when CDS are being used to manipulate share prices in conjunction with short selling, the Commission should require disclosure when an actual or synthetic short position in a company’s equity securities is accompanied by a long position in the company’s CDS.

Stock and derivative markets must be effectively regulated so that a few profit-seeking bear raiders cannot contribute to a “run on the bank” that destroys an enterprise and risks global systemic collapse, as in the cases of Bear Stearns and Lehman Brothers. We urge the Commission to ensure that the regulatory scheme it formulates in response to the current financial crisis has sufficient flexibility to reach the many ways abusive and manipulative practices have affected the market and harmed small investors and the wider economy.


Footnote:
[1] In addition to the adoption of a price test and other actions described below, we believe that the Commission should extend and strengthen the rules it adopted last fall aimed at curbing naked short selling and requiring greater short selling disclosure.
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Sarbanes-Oxley and Corporate Risk-Taking

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, June 24, 2009
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This post comes to us from Leonce L. Bargeron, Kenneth M. Lehn, and Chad J. Zutter of the Katz Graduate School of Business, University of Pittsburgh.

In our paper, Sarbanes-Oxley and Corporate Risk-Taking, which was recently accepted for publication in the Journal of Accounting and Economics, we empirically examine whether the adoption of SOX is associated with a subsequent decline in corporate risk-taking.

We examine whether several measures of corporate risk-taking changed significantly after SOX was signed into law in 2002 for publicly traded U.S. companies as compared with non-U.S. companies not bound by SOX. In an attempt to isolate effects associated with SOX, it is important to compare U.S. firms, which are subject to SOX, to non-U.S. firms that are most like U.S. firms with the exception that they are not subject to SOX. For this reason, the sample of non-U.S. firms is comprised of publicly listed U.K. and Canadian firms that are not cross-listed in the United States. We use publicly listed firms in the U.K. and Canada as a benchmark sample because these firms operate in similar capital market environments and under similar regulations to firms listed in the U.S.

Using data for a large sample of U.S. and non-U.S. firms during the period of 1994 through 2006, we find that after SOX U.S. companies significantly reduced their investments, as measured by the sum of their capital and R&D expenditures, in comparison with their non-U.S. counterparts. In addition, U.S. firms significantly increased their holdings of cash and cash equivalents, which represent non-operating, low-risk investments, as compared with the non-U.S. firms. Also, we find that the standard deviation of stock returns, a conventional measure of a company’s equity risk, declined significantly for U.S. firms compared with non-U.S. firms, after SOX. Finally, these findings are consistent for an industry and size matched sample of U.S. and non-U.S. firms.

The changes in the risk-taking variables are significantly greater for large versus small U.S. firms, consistent with the view that the expected costs of complying with Section 404 are greater for firms characterized by more complexity. The changes are also significantly greater for firms with high versus low R&D expenditures before SOX, consistent with the view that the expected costs of complying with Section 404 are directly related to the degree of specialized knowledge in a firm. The changes in cash holdings and stock price volatility are significantly greater for firms that did not have a majority of outside directors before SOX, and hence were most affected by the SOX-related rules governing the independence of boards, than for other firms. The changes in capital and R&D expenditures were not significantly different across these two groups of companies.

While we cannot rule out the possibility that other factors, unique to U.S. firms and unrelated to SOX, might account for the relative decline in risk-taking by U.S. companies after SOX, we are not aware of any such factors, and as such, conclude that our evidence is most consistent with the view that SOX has discouraged risk-taking by U.S. companies.

The full paper is available for download here.

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