Policy Finance & Accounting May 1, 2008

Lob­by­ists Speak in Numbers

Eval­u­at­ing the Sar­banes – Oxley Act of 2002

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 (SOX) is finan­cial dis­clo­sure and cor­po­rate gov­er­nance leg­is­la­tion. It was signed into law by Pres­i­dent George W. Bush on July 30, 2002. SOX is based on sep­a­rate finance reform bills intro­duced and passed in the House and Sen­ate, intro­duced by Sen­a­tor Paul Sar­banes, Demo­c­rat of Mary­land, and Rep­re­sen­ta­tive Michael Oxley, an Ohio Repub­li­can. These bills were merged and passed by the House and Sen­ate as one piece of leg­is­la­tion on July 25, 2002. The intent of SOX was to change finan­cial dis­clo­sure prac­tices by com­pa­nies and to improve cor­po­rate gov­er­nance. SOX includ­ed eleven titles, the first four of which are the most rel­e­vant for pub­lic com­pa­ny com­pli­ance. Title I estab­lished the Pub­lic Com­pa­ny Account­ing Over­sight Board (PCAOB), charged with over­see­ing and reg­is­ter­ing pub­lic account­ing firms and estab­lish­ing stan­dards relat­ed to audit­ing and inter­nal con­trols. Title II of the act cov­ers issues relat­ed to audi­tor inde­pen­dence. Title III deals with cor­po­rate respon­si­bil­i­ties and Title IV cov­ers issues of enhanced finan­cial disclosure.

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 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.

Featured Faculty

Yael Hochberg

Member of the Department of Finance faculty from 2005 to 2013.

Paola Sapienza

Donald C. Clark/HSBC Chair in Consumer Finance, Professor of Finance, and Zell Center Faculty Fellow

Annette Vissing-Jørgensen

Member of the Department of Finance faculty from 2002 to 2013

About the Research

Hochberg, Yael V., Paola Sapienza, and Annette Vissing-Jørgensen (2007). “A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002.” National Bureau of Economic Research (NBER) Working Paper, No. 12952, March.

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