When regulation doesn’t throttle risk-taking

After a slew of high-profile corporate accounting scandals — most notably Enron — Congress passed the Sarbanes-Oxley Act (SOX) in 2002. Among the components of the legislation was Section 404 (SOX 404), a series of reporting and compliance requirements designed to monitor a company’s internal controls on financial reporting.

At the outset, many speculated that such onerous reporting would reduce the amount of investment and risk-taking that a firm might be willing to take. For Questrom accounting professor Ana Albuquerque, the reasoning seemed fishy. “If I’m a CEO, am I going to stop creating excellent products and generating value for shareholders because I have to comply with SOX 404? Probably not.”

To understand the nuanced effects of the requirements, Albuquerque and Fudan University’s Julie Lei Zhu studied how similar US firms with different SOX reporting requirements invested differently. Their research was recently accepted for publication in Management Science and featured in the Harvard Law School Forum on Corporate Governance and Financial Regulation.

Specifically, the pair looked at more than 400 US firms that were just above and just below a $75 million “public float” in 2002— the threshold at which a firm must begin SOX 404 filing. They examined the investment activities of such firms during a short window of time, between 2002 and 2003, when the exact public float threshold was not yet known, and there was little incentive for the firms to manipulate that number. They then compared those details to investment activities at the same firms in 2004 and 2005, after the exact details of compliance requirements were in place.

Their findings bore out their initial suspicions. Not only did filing firms not decrease their investment activities, some measures suggested that firms actually increased their investments after the reporting requirements were put into place. Filing firms also appeared to benefit in other ways. Banks typically offered filing firms larger loans with lower collateral requirements compared to non-filing firms. “Credit terms improved [for filing firms], because they were disclosing more information,” Albuquerque says.

While some regulation can have the effect of tamping down risk-taking and investment, SOX 404 did not appear to hinder firms’ investment activities. “We find that that in this case, the benefit was higher than the cost of compliance,” Albuquerque says.

Read the complete paper.

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