In 2002 the U.S. Congress responded to the corporate governance crisis that followed the scandal-ridden behavior of Enron, Tyco, WorldCom, and other high-profile corporations by passing the Sarbanes-Oxley Act (SOX). The legislation set out to restore investors’ confidence in financial markets by improving corporate governance. However, in the case of at least one group of companies, the act seems to have produced unexpected results. A study co-authored by Thomas Lys (Professor of Accounting Information & Management at the Kellogg School of Management) indicates that the managements of poorly governed foreign-domiciled firms responded to the act by closing shop in the United States. They continued operations—replete with their managerial faults—in their own countries. “So with the act we have exported the problem,” Lys says. “This is an unintended consequence.”
Regarded by some commentators as the most radical federal legislation in disclosure regulations since the Securities Act of 1933, SOX aimed to compensate for the failures of governance that had culminated in the Enron, WorldCom, and Tyco scandals. The act established more stringent standards, overseen by the federal government, for internal controls, auditing, disclosure, and management control and accountability of publicly traded firms.
SOX affects domestic and foreign corporations traded conventionally on U.S. stock exchanges. It also applies to foreign firms that rely on American Depository Receipts (ADRs) to be traded in the United States without incorporating there and without being directly listed in the United States. ADRs are certificates issued by individual overseas firms and backed by shares issued in their home countries through a depository institution that acts as a custodian. “It’s like a mutual fund on a single share or a series of shares,” Lys explains. “You can trade the share in New York City rather than, say, Frankfurt. It’s much cheaper for U.S. investors because they know what’s happening in New York much better than in Frankfurt. ADRs also give overseas shareholders some protection—they can rely on U.S. GAAP [generally accepted accounting principles], disclosure rules, and, as a last result, they can sue in the United States.”
The High Cost of Compliance
Complying with SOX costs money. Domestic firms can avoid that cost by going private or trading on the so-called “Pink Sheets,” an electronic quotation system that is not regulated by the Securities and Exchange Commission. But these options are quite expensive, particularly due to the loss of liquidity and loss of the ability to raise money in public equity and debt markets.
Foreign firms that use ADRs have another option: they can delist in the United States—that is, cease being traded on U.S. stock exchanges but continue to be publicly traded in their home countries. “With SOX, suddenly it’s costlier to be in the United States,” Lys explains. “So you expect some companies to leave.” Delisting carries other costs, but it is not as drastic as it might seem. After all, the departing companies retain liquidity and the ability to raise capital in public markets because they are still publicly traded in their home countries.
Delisting has two consequences for companies. They save the costs of complying with SOX and they avoid the act’s accountability requirements. In collaboration with three of his former students, Peter Hostak of the University of Massachusetts at Dartmouth, Emre Karaoglu of Columbia University, and Yong “George” Yang of The Chinese University of Hong Kong, Lys set out to discover the motives of firms that delisted after SOX became law. They asked a basic question: did foreign firms delist because of compliance costs or because SOX made life less comfortable for their managers and controlling shareholders?
Evaluating Governance Quality
The team used records held by the largest U.S. depository banks and other sources to obtain information on foreign firms with ADRs between January 2001, before SOX became law, and May 2006, well after the deadline for final implementation of the act’s requirements. They found eighty-nine firms that had voluntarily delisted during that period and matched them against eighty-nine control firms that had continued to trade in the United States.
Then came the difficult part: determining the quality of governance of the two groups of companies. To try to identify poorly governed companies, the team studied the amount of independence of boards of directors, the extent to which individual firms were closely controlled by a small group of managers and large shareholders, the quality of firms’ financial reporting, and the impact of SOX on firms’ stock prices.
Lys admits that the attempt to define poor corporate governance represents something of an Achilles heel for the study. “On the one hand,” he says, “the more managers have skin in the game, the more incentive they have to be on their best behavior. But on the other hand, the more skin they have in the game, the more control they have. They are more difficult to control and, in the extreme, to replace.”
Delisting to Protect Private Benefits
Nevertheless, the study produced a clear conclusion. “The [delisting] firms experienced a significantly negative price reaction to their delisting announcements—a result that is contrary to the argument that these SOX-related delistings are primarily undertaken on the basis of cost savings that is associated with the burdensome SOX requirements,” the team writes. “Instead, the evidence suggests that the delistings are motivated by [managers’] desire to protect their private benefits that SOX would curb and investors seem to understand that these delistings are not value enhancing for outside shareholders.”
From a positive point of view, the team finds no evidence suggesting that the large compliance costs imposed by SOX have played a driving role in foreign firms’ delisting decisions, and hence that the legislation has not undermined the competitiveness of U.S. capital markets. However, Lys adds, “The purpose of SOX was to force companies with poor governance to improve. Paradoxically, the ones that stayed were those that have the better governance and the ones that left had poorer governance. In the effort to improve, SOX lost the ability to control.”
As Lys sees it, his group’s research sends a dual message on the success of SOX. “If your primary goal is to prevent U.S. investors investing in assets in which they can be defrauded, you’ll want them to improve or leave. To that extent, SOX has been successful. But if you want to make a better world, you have moved these companies offshore—making the rest of the world worse off since overseas regulations are weaker.”