Rules Of The Game

Based on research by Jefferson Duarte, Katie Kong, Lance A. Young and Stephan Siegel. 

• In the wake of corporate fraud scandals, the Sarbanes-Oxley Act (2002) imposed major regulations upon corporations.
• Foreign firms that want to list in the U.S. must comply with these regulations.
• Reaction to Sarbanes-Oxley from foreign firm stakeholders was split: Inside management and majority shareholders were less inclined to list in the U.S., while outside minority investors were more inclined to list in the U.S.

What do you think about SOX?

If you think they could go all the way next season, this article is for you.

SOX is not the team you love (or hate) on the baseball diamond: It's short for the 2002 Sarbanes-Oxley Act, the rare regulatory measure passed with hearty bipartisan support. Only three members of the House of Representatives, and nobody in the Senate, voted against the biggest package of corporate reform legislation in 60 years. Designed to prevent corporate accounting fraud, Sarbanes-Oxley was a response to a rash of high profile, enormously costly corporate financial fraud cases. In their wake, Enron, WorldCom and Tyco all became synonymous with cooking books. The cost of these cases to the economy has been estimated at $35 billion. 

Key provisions of SOX included a mandate for senior management to personally certify the accuracy of financial statements, and a requirement for internal controls and reporting methods on the adequacy of those controls. 

At the time it was passed, the legislation was assessed in terms of its ability to prevent future accounting scandals. Now, with the passage of time and insights from recent research, a new element can be considered: How have the regulations of SOX affected foreign firms? 

The answer seems to come from left field. According to a study by Rice Business professor Jefferson Duarte and co-authors Katie Kong, Lance A. Young and Stephan Siegel of the University of Washington, foreign firms are less likely post-SOX to list in the United States relative to the UK. Yet the average abnormal return of a foreign firm listing in the U.S. is about 4 percent higher after SOX.

How could this be? 

It turns out that the regulation’s impact differs between corporate insiders and minority shareholders. While foreign firms’ insiders – that is, management and controlling shareholders – believe that SOX makes extracting value in the U.S. too costly, outside investors tend to see SOX as a boon to investment value. 

Of course, these investors realize the increased cost involved with incorporating SOX regulations. They just believe that the value gained outweighs it. But outside investors don’t make the decision of where to list. The insiders do. In the end, the people who have to do the work of complying with SOX are the ones who hesitate. 

There is one caveat: Firms in countries that have strong existing regulation have been more likely to list in the U.S. after SOX. If you are already used to playing by the home team rules, in other words, you are less daunted by the away team rules. Rules, after all, are rules. 

So the impact of SOX on foreign firms is split: Those used to rules at home are more likely to list in the U.S., while those less used to rules aren’t as likely to list. 

In the end, just as in sports, the rules are meant to preserve the integrity of the game. It is, always, a tricky balance. While no one wants regulation to be prohibitive, everyone benefits when it’s preventative. 
Now, play ball.

Jefferson Duarte is an associate professor of finance and the Gerald D. Hines Professor of Real Estate Finance at the Jones Graduate School of Business at Rice University.

To learn more, please see: Duarte, J., Kong, K., Siegel, S., & Young, L. (2014). The impact of the Sarbanes–Oxley Act on shareholders and managers of foreign firms. Review of Finance, 18(1), 417-455.