Has Section 404 of the Sarbanes-Oxley Act Discouraged Corporate Investment? New Evidence from a Natural Experiment

Ana Albuquerque is Associate Professor of Accounting at Boston University Questrom School of Business, and Julie Lei Zhu is Assistant Professor of Accounting at Shanghai Advanced Institute of Finance. This post is based on their recent article, forthcoming in Management Science.

The US Congress’s passage of the Sarbanes-Oxley Act (SOX) in 2002 following a string of high-profile corporate scandals resulted in the most significant change in securities regulation since the Securities Act of 1933. One of the most important components of SOX is Section 404 (SOX404), which is arguably the most contentious and onerous section of the act (Coates and Srinivasan, 2014, and Zhang, 2007). Congress’s objective in creating SOX404 was to increase the reliability of financial statements in order to prevent accounting fraud. Section 404 requires that companies document, test and assess procedures for monitoring their internal systems, that managers file a special “management report”, in which they evaluate the firm’s internal control system on financial reporting, and that the outside auditor attest to the management’s assessment of the companies’ controls. Commentators and empirical evidence suggest that an unintended consequence of SOX, and SOX404 in particular, was a reduction in investment and risk taking (e.g., Bargeron, Lehn, Zutter, 2010; Kang, Liu, Qi, 2010). According to these authors, investing in risky projects increases the likelihood that SOX-compliant firms compromise their internal control systems and disclose material weakness in their management reports, which can trigger a stock price decline or litigation.

However, the argument that a financial-reporting burden such as SOX404 would induce a CEO to pass up valuable investment opportunities sharply contrasts with the management objective of promoting shareholder value and firm growth. In fact, some studies suggest that SOX404 could have had a positive impact on corporate investment, as investors benefit from greater transparency conferred by improved disclosure, which can lead to lower cost of capital for firms. The objective of this article is to reexamine prior evidence and shed new light on the debate of the impact of SOX, in particular Section 404, on corporate investment using a quasi-natural experiment as the main identification strategy.

An important challenge for studies of SOX is to isolate the “SOX effect” from other confounding factors around the same time. SOX was passed amid major changes in the business environment and other events with far-reaching economic effects (e.g., the burst of the tech bubble in 2000/2001, 9/11, the 2001 recession, new NYSE and NASDAQ rules, and the Enron and WorldCom scandals), any of which could have affected firms’ investment decisions. Prior studies that analyze the impact of SOX on corporate investment rely on non-US (e.g., UK and Canadian) firms as controls. Using non-US firms as the benchmark to examine the effects of SOX may impose two limitations. First, it ignores possibly different trends affecting US firms during the period leading up to SOX. Second, it does not account for the fact that US and non-US firms are exposed to different contemporaneous economic and regulatory events.

When we re-examine the Bargeron et al. (2010) results showing that SOX had a strong negative impact on corporate investment and other risk-taking activities for US firms (compared to a control group of UK and Canadian firms), we find that the documented “post-SOX” decrease in investment and other risk-taking behavior actually starts in 1999, and not 2003—the year when SOX became effective. Hence, the decline in capital expenditures, and total investment is consistent with US firms starting to reduce investment in 1999 to adjust to an economic and legal environment that had gone through substantial changes prior to SOX’s introduction.

To revisit the question of SOX’s impact on corporate investment, we use the requirements during the implementation of SOX404 and a sample of small US firms as a “quasi-natural experiment” that isolates the impact of the regulation from contemporaneous events. The use of US firms as a control group allows for a better identification strategy than in prior studies. Specifically, firms with a public float above $75 million in 2002 had to comply with Section 404 in 2004, while firms with a public float below $75 million in 2002, 2003, and 2004 did not have to comply until the end of 2007. We compare the behavior of a sample of small firms with a public float that is just above $75 million (the “filers” or “treatment group”) in 2002 to the behavior of firms with a public float just below this threshold (the “control group”). This allows us to benchmark the changes in investment activities, from the pre- to post-SOX404 periods, made by similar firms that were forced to comply with the section. The $75 million threshold was not known in 2002, so there is little risk of firms manipulating their public float—an endogeneity concern—at that time. This provides for a natural experiment and allows for a differences-in-differences research design, which mitigates potential biases from unobservable factors that might be correlated with corporate investment and risk-taking activities.

With a sample of 455 unique firms over the period from 2002 to 2005, we find that, relative to control firms, filers do not decrease investment as a result of the enhanced disclosure quality mandated by SOX404. In fact, we find that filers increase total investment (the sum of capital expenditure and R&D) more during the post-SOX404 period than the control group does. There is also no evidence that filer firms increase their cash holdings or that the volatility of their stock returns decreases following SOX404. These results are inconsistent with the argument that the level of risk taking activities by filers becomes lower relative to the control firms due to SOX404. In addition, we find that filer firms receive better terms on their bank loans—greater loan size and lower collateral requirements relative to the control group—following SOX404. These findings are consistent with filer firms benefitting from enhanced transparency following SOX404. Exploiting cross-sectional variations among the sample firms, we find that those likely to benefit more from the regulation (e.g., financially constrained firms and firms facing less litigation risk) invest more after SOX404. Furthermore, we provide a number of robustness tests, including the use of a regression discontinuity design, and obtain similar results. Overall, our tests and results reject the notion that SOX404 had adverse effects on investment and other risk-taking activities.

This article contributes to the debate on the effects of SOX404, a centerpiece of the set of regulations that represent the most significant economic regulatory actions since the 1930s. By focusing on investment—a core activity and a defining characteristic of any firm—our tests and results shed new light on the impact of SOX404. Our sample of small firms helps us better understand the effects of SOX404 on corporate investment, for two reasons. First, several studies show that small firms bear disproportionately higher costs, relative to large firms, due to the fixed component of the total compliance costs of SOX404. Second, small firms typically have high levels of investment activities and growth opportunities. These first two considerations suggest that small firms are likely to be the most negatively affected by the SOX404 regulation, both in terms of compliance costs and opportunity costs of missed investment opportunities. Our finding that investment and risk-taking activities do not decrease post-SOX404 in these firms provides important evidence against the presumably negative effect of SOX404 on other, larger firms.

The complete article is available for download here.

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