Lobbyists Speak in Numbers

Although the Sarbanes-Oxley Act has come to be known as SOX, it has nothing to do with baseball teams or fancy foot coverings. Like sports teams, however, the law spurs heated debates because it addresses a hot-button topic: corporate accountability. Since SOX was passed in 2002, people have argued whether or not it will indeed improve operations, decrease corporate mismanagement, and thus benefit shareholders. Some insist it will prove detrimental because of high compliance costs and be ineffective in preventing corporate misconduct, and that it will drive companies to list on foreign exchanges.

Annette Vissing-Jørgensen has long discussed SOX with Yael V. Hochberg and Paola Sapienza, her colleagues in the Kellogg School’s Finance Department. Eventually they began a yearlong collaboration to investigate the law’s impact on shareholders, which resulted in their National Bureau of Economic Research Working Paper in 2007. They took an unconventional approach, looking at how companies, individuals, and organizations lobbied the Securities and Exchange Commission (SEC) about SOX. In contrast to other studies, this one shows that positive shareholder expectations about SOX were warranted.

Unlike other legislation such as the 1964 Securities Act, SOX affects all publicly traded companies in the United States. Initial studies of SOX looked at aggregate stock market returns, which led to negative views about SOX. These studies, however, suffered from the lack of a control group of unaffected firms. “Now there is a second generation of papers, including ours, which tries to compare returns for firms that are more affected to the returns of firms that are less affected, thereby canceling out any overall market effect,” says Vissing-Jørgensen.

The Sarbanes-Oxley Act, signed into law on July 30, 2002, arrived in the wake of the Enron debacle and scandals at companies such as Global Crossing, Qwest Communications, Tyco, and WorldCom. The intent was to change financial disclosure practices at companies and to improve corporate governance.

While the researchers examined how companies and individuals lobbied the SEC about SOX, it was not lobbying in the sense of trying to persuade members of Congress pondering a new law. It was more an attempt to tweak the law’s implementation. “You could define lobbying in this context as those [who were] trying to affect the strictness with which these rules are implemented,” says Vissing-Jørgensen.

Congress delegated to the SEC the design of the actual SOX rules and their enforcement strategies. For example, explains Sapienza, “In a provision about the independence of board members, the SEC might propose a particular definition of ‘independent.’” After the SEC first publicized its proposed rules, a period of SEC-solicited public comment followed (August 2002 to June 2004), and then the SEC released the final rules. Hochberg, Sapienza, and Vissing-Jørgensen plowed through a pile of 2,689 letters to the SEC from corporate insiders, investor groups, individual investors, lawyers, accountants, and academics (see Table 1). Lobbying is “in essence revealed preference,” says Hochberg, and it created self-identified groups of those more and less affected by SOX. It also helped avoid the challenge of a lacking control group.

Table 1: Opinions of Letters, by Rule and Type of Commenter

The researchers found that an overwhelming majority of insiders in lobbying companies opposed strict implementation of SOX and sought delays, exemptions, and loopholes. Of the comments by corporate directors and managers, 82 percent were negative, as were 72 percent of letters from non-investor groups. However, only 47 percent of letters from non-publicly traded firms were negative. Comments by accountants and lawyers were also mainly negative—70 percent and 82 percent, respectively. In contrast, 78 percent of all individuals and 88 percent of the investor group letters were positive about SOX, while 56 percent of academics expressed positive views.

Comparing company letters was not straightforward. For example, at least one CEO of a large publicly-traded firm stated that he favored SOX because compliance costs would give larger firms a competitive advantage. To compare companies, the researchers performed portfolio-level analysis to match lobbying firms with similar firms on the non-lobbying side. They sorted according to size, book-to-market equity ratios, and industry. They took into account variables such as firm book assets, profitability, corporate governance characteristics, the number of years the firm had been publicly traded, and whether or not the firm had a political action committee for its lobbying efforts.

The researchers also picked two windows for their timeline. The first was the 24-week period up to passage of SOX from February 8, 2002, to July 26, 2002. The second was the post-passage period from July 26, 2002, to December 31, 2004. “The firms that lobbied against strict implementation of SOX were likely to be the firms that would be most affected by the legislation—either because they would experience the highest compliance costs, or because they would experience the largest changes in governance and disclosure,” says Hochberg. To obtain a clear picture of how investors perceived SOX, the researchers compared the returns for lobbying firms to those of non-lobbying firms, who were likely to be less affected by SOX. As the probability of SOX passing in Congress grew, investors should have impounded their assessment of its likely effects into stock prices. If investors perceived SOX as likely to be beneficial and governance improving, the relative returns for lobbying firms—those who would be most affected by the law—should have been higher over the period leading up to SOX’s passage. On the other hand, if investors perceived SOX as predominantly cost-increasing, and therefore detrimental, returns for lobbying firms should have been lower than for non-lobbying firms.

As it turns out, prior to the passage of SOX, the study shows that cumulative stock returns were approximately 10 percent higher for corporations who lobbied against SOX than for non-lobbying firms of similar size, suggesting that shareholders perceived SOX as beneficial overall. “We were surprised at how large the effects were,” says Vissing-Jørgensen. After passage of the law, however, something striking happened to the return lines (see Figure 1): the return differential between the lobbying and non-lobbying companies disappeared. “What’s nice in the graphs of returns is that there is a kink in the return lines right after passage,” adds Vissing-Jørgensen. “The kink convinced us that the effects were most likely due to SOX.”

Figure 1: Cumulative excess returns for publicly traded companies that lobbied the SEC

After SOX was passed, the difference between lobbying companies and non-lobbying companies disappeared. “We don’t find any differential effects in the returns between the two groups,” says Sapienza. The lobbying behavior showed the average effect of SOX on shareholders, say the researchers. Their findings suggest that even post-implementation, investors felt they were right to have had a sunny outlook on SOX.

Because firms sometimes lobbied against several categories of SOX, the researchers grouped the law’s sections. One group contained the provisions relating to enhanced financial disclosure, including the much-debated Section 404 and the establishment of the Public Company Accounting Oversight Board. Another grouping included provisions about auditor independence. A third category covered the provisions about corporate responsibility, such as the necessity for management to certify financial reports.

In order to isolate separate effects, the team performed firm-level regression analysis. “All the positive effect from SOX came from the enhanced disclosure provisions, which included Section 404,” says Vissing-Jørgensen. “The companies that were more affected by the enhanced disclosure provisions outperformed companies that were less affected by the enhanced disclosure provisions.” The other groups of SOX rules, auditor independence and corporate responsibility, had comparatively little effect on firms, the researchers say.

Compliance costs were another factor to consider, and were higher than originally estimated. In order to rule out that these costs were so great that they overcame the 10 percent excess returns during the lead-up period, the researchers pulled them into their analysis. “Once you bring in the compliance costs, you can actually say at an absolute level whether the lobbying firms benefited from SOX overall,” says Vissing-Jørgensen. She and her colleagues believe their study shows that the net benefit of SOX is positive for shareholders of lobbying firms.

The researchers plan to continue their analysis by looking at the effect of SOX on small firms. Their recent study focused on large firms, since the lobbying companies were mainly large. The researchers also explain that their study cannot evaluate the losses corporate insiders might experience because of SOX. It cannot draw conclusions about corporate decision-making, for example, the reasons some companies may choose to de-list, stay private, or seek listing on foreign exchanges. Clearly, the debate about SOX is far from over.