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Sarbanes-Oxley and Corporate Risk-Taking

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes to us from Leonce L. Bargeron, Kenneth M. Lehn, and Chad J. Zutter of the Katz Graduate School of Business, University of Pittsburgh.)

In our paper, Sarbanes-Oxley and Corporate Risk-Taking, which was recently accepted for publication in the Journal of Accounting and Economics, we empirically examine whether the adoption of SOX is associated with a subsequent decline in corporate risk-taking.

We examine whether several measures of corporate risk-taking changed significantly after SOX was signed into law in 2002 for publicly traded U.S. companies as compared with non-U.S. companies not bound by SOX. In an attempt to isolate effects associated with SOX, it is important to compare U.S. firms, which are subject to SOX, to non-U.S. firms that are most like U.S. firms with the exception that they are not subject to SOX. For this reason, the sample of non-U.S. firms is comprised of publicly listed U.K. and Canadian firms that are not cross-listed in the United States. We use publicly listed firms in the U.K. and Canada as a benchmark sample because these firms operate in similar capital market environments and under similar regulations to firms listed in the U.S.

Using data for a large sample of U.S. and non-U.S. firms during the period of 1994 through 2006, we find that after SOX U.S. companies significantly reduced their investments, as measured by the sum of their capital and R&D expenditures, in comparison with their non-U.S. counterparts. In addition, U.S. firms significantly increased their holdings of cash and cash equivalents, which represent non-operating, low-risk investments, as compared with the non-U.S. firms. Also, we find that the standard deviation of stock returns, a conventional measure of a company?s equity risk, declined significantly for U.S. firms compared with non-U.S. firms, after SOX. Finally, these findings are consistent for an industry and size matched sample of U.S. and non-U.S. firms.

The changes in the risk-taking variables are significantly greater for large versus small U.S. firms, consistent with the view that the expected costs of complying with Section 404 are greater for firms characterized by more complexity. The changes are also significantly greater for firms with high versus low R&D expenditures before SOX, consistent with the view that the expected costs of complying with Section 404 are directly related to the degree of specialized knowledge in a firm. The changes in cash holdings and stock price volatility are significantly greater for firms that did not have a majority of outside directors before SOX, and hence were most affected by the SOX-related rules governing the independence of boards, than for other firms. The changes in capital and R&D expenditures were not significantly different across these two groups of companies.

While we cannot rule out the possibility that other factors, unique to U.S. firms and unrelated to SOX, might account for the relative decline in risk-taking by U.S. companies after SOX, we are not aware of any such factors, and as such, conclude that our evidence is most consistent with the view that SOX has discouraged risk-taking by U.S. companies.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on June 24, 2009 (boomark / email).