Today at the AEI: the Sarbanes-Oxley debacle

Henry Butler and I, with expert commentary from Peter Wallison, Alex Pollock and Rich Booth, made our case today at the AEI for repeal or drastic revision of Sarbox. You can view the video, the revised slides, and an early draft of the forthcoming monograph.

So my brain has been filled with SOX.  I promise that this is my last lengthy tirade on this subject, at least for awhile. But I can't resist one more shot. Tomorrow it's back to the more typical diet of postings on various subjects.

The bottom line is that SOX was a colossal mistake. For those with any doubt, see our summary of SOX costs (slide 15), and some recent evidence (slide 16). Moreover, Congress gave virtually no consideration to potential costs – there was no time for that in the hasty, panic-stricken atmosphere in which SOX was hatched.

The substantive argument for SOX seems to be that there was fraud, SOX addresses fraud, therefore we need SOX. Even if we assume that SOX actually reduces fraud (as discussed in our paper, a point not proven), can anyone honestly believe that SOX costs shouldn't matter – that fraud should be reduced at any cost? This seems to be what some SOX defenders are saying. We don’t even take that view with respect to drug or automobile safety where human lives are at stake. Surely nobody could seriously believe that diversified investors deserve greater protection.

Then there are those who say that, even if SOX is imperfect, Enron and related scandals demonstrate that a SOX-less market would be even worse. Yet as Henry and I argue, there's no reason to believe that SOX's ill-conceived provisons will be effective, and every reason for confidence in the protection provided by strong markets and elaborate legal rules in place prior to SOX.

Others will contend that much of SOX's costs are now sunk. The compliance programs are in place and everything gets cheaper now. Wrong again. We estimate that only about 20% of the estimated $1.4 trillion loss in market value that have been attributed to SOX are direct compliance costs. The rest are indirect costs such as excessively risk averse management and the opportunity costs of managerial resources. These costs will surely continue. Moreover, the biggest costs are yet to come – the litigation that surely will accompany the next sharp reduction in stock prices.

As the enormity of the SOX mistake has started to sink in, commentators have been temporizing: let’s just take out the small firms. So say the Democrats, the L.A. Times, the SEC’s own Advisory Committee on Smaller Public Companies, and others. But this would be an unsatifactory resolution. SOX is a problem for all firms. Moreover, taking out a subset of firms will only cause more dislocations. Perhaps these would be justified if SOX made sense for the remaining firms. But, as discussed above, it does not.

Finally, one might argue that fixing the internal controls provisions would take care of the problem. Wrong yet again. Although the internal controls disclosure provision is the worst part of SOX, there's a lot of other bad stuff, including the many provisions on internal corporate governance that erode our nuanced and sophisticated system of state corporation law.

There's much more in the paper and the slides. The bottom line is that SOX has to go. No doubt any effort in this direction will be met with howls from the journalists and reformers who helped push SOX through, and the auditing and consulting industry that SOX has created. I recognize that the idea of repeal may seem Quixotic. But the case against SOX is so compelling that, at least with a push from the PCAOB suit, it could happen.

Comments

[Ed Wilcox]

Based on a total market cap of about $10 trillion, $6 billion doesn't seem that large - about 2 cents per share to Microsoft for example. With over 200 restatements and 15 percent of companies with material weaknesses, it seems like there was certainly a problem of some magnitude. These restatement and weakness disclosures were only the tip of the iceberg at many companies, and many other companies were on the edge of these problems also.

[Larry E. Ribstein]

As we discuss at length in our paper, the $6 billion is only direct costs, and the tip of the iceberg of total costs, as shown by the Zhang study.

[William Goodwin]

I am astonished that scholars are continuing to cite that $1.4 trillion estimate of SOX's costs as if it's really credible. Zhang's paper effectively relies on (or has been quoted as relying on) a single-variable model to explain all of the market's action during the relevant periods. Somehow, we are supposed to believe that the market went down in July 2002 (which is when the vast majority of the loss in market cap she refers to occurred) solely (or even primarily) because of the debate/agreement over SOX.This is naive at best, and wilfully obtuse at worst.

Even if we set aside the fact that the market had been declining steadily since March of 2000, and had been on a shorter-term downward trend since early in 2002, let's just consider the fact that at the very same time as SOX was being debated/enacted, Bernie Ebbers was in front of Congress taking the Fifth Amendment, WorldCom was declaring bankruptcy, the Rigases of Adelphia were being marched out in handcuffs and their massive fraud was being publicly exposed, and the Senate was passing a law allowing the reimportation of prescription drugs. That's just in July 2002. In February 2002, on the day of the SOX "event" that Zhang says caused a major market sell-off -- the event was a speech by Treasury Sec. Snow -- the Powers report on Enron, documenting the massive fraud and failure of oversight at that company, was released. Yet somehow the market loss gets attributed to Snow's speech. Is this really credible?

Even more curious is that the single word that does not appear in Zhang's paper: "Iraq." In the summer of 2002, the prospect of impending war was clearly weighing on the market, and information about the adminstration's plans was becoming public. The Downing Street memo, after all, was written on July 23, 2002. Tony Blair gave a speech in mid-July saying the West would have to deal with the threat posed by WMD, and Congress announced that it would be holding hearings at the end of July into the threat posed by Saddam. Yet supposedly none of this had any impact on the stock market. It was all SOX.
Again, do you really think anyone could look at this data with an open mind and find the $1.4 trillion number believable?

[Larry E. Ribstein]

Have you read the paper? It's not obvious from your comment, since the paper does make an exceptional effort to filter out confounding events, as well as, of course, focusing on abnormal returns. Moreover, the Zhang study is corroborated to some extent by Kate Litvak's study, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=876624, which differentiates cross-listed and non-cross-listed firms within the same country.
I think you should be a bit more careful about throwing adjectives like "naive and wilfully obtuse" at a researcher whose conclusions do not happen to match your priors.

[Marc Hodak]

$6 billion cost wouldn't be bad...if you actually got something for it. There is no proof, or even a decent indication, that all the SOX-mandated costs would have prevented the last Enron, let alone prevent the next one.

Whether SOX cost us $1.4 trillion is up for debate. No single event study is that good at quantifying something that transcends multiple time periods, as SOX adoption did. All I know is that the investment community (i.e., the purported beneficiaries) I cater to is very skeptical about the value of SOX. And I agree with Larry that the full costs of the law are only beginning to be felt.

[John Coates]

As reported last summer in the WSJ, Ms. Zhang herself would not endorse Larry's reading of her paper:

"It's hard to say all of these $1.4 trillion [in losses] are directly related to Sarbanes-Oxley," [Zhang] told [WSJ Online journalist Carl Bialik]."

The article is "How Much Is It Really Costing to Comply with Sarbanes-Oxley?" (June 16, 2005), available here if you have a WSJ subscription:

http://online.wsj.com/article/SB111885041027560378.html

Moreover, as Bialik reported:

"The $1.4 trillion in market losses she identifies came almost entirely during three periods, all in July 2002: the Senate's debate of the bill from July 8-12, during which time President Bush delivered a speech backing corporate reforms; a period from July 18-23 when the House and Senate wrangled over competing versions of the bill; and a period from July 24-26 when the Senate and House reached agreement. The market tanked in that second period, reflecting about three-quarters of Ms. Zhang's estimated losses."

Further, he notes:

"[T]wo earlier studies of the same question -- how the market responded to key legislative and rulemaking actions in the development of Sarbanes-Oxley -- found entirely different results: Stock markets rose as a result of the bill. The differences show how sensitive this kind of analysis is to seemingly small choices by researchers."

(I wonder why Larry didn't include those on his AEI slides?) (Actually, I don't really wonder.)

You can find those studies:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=475163

and

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=498083

Finally, Larry says that Zhang's study has been "corroborated to some extent" by Litvak. But Litvak finds that only one of the three events that drive Zhang's results had her predicted statistically significant larger negative effect on cross-listed foreign firms subject to SOX than on cross-listed foreign firms not subject to SOX (see Litvak Table 4), and none of Zhang's big three events had a statistically significant differential effect once she divides her sample by geographic region (Litvak 5). Litvak's study of the market reaction abroad to SOX, is careful and interesting, and suggests that European stock markets feared the impact of the imposition of a US law (creating an entirely new US regulatory body, the PCAOB) on European companies. simply because they were cross-listed in the US. But if anything it undermines my confidence in Zhang's study. And I don't think any fair-minded observer would think it "corroborates" (even "somewhat") the claim that SOX destroyed $1.4 trillion of US market cap.

Professor John Coates
Harvard Law School

[William Goodwin]

Ditto to what Professor Coates said, in particular his citatation of the Razaee and Jain paper, and of Zhang's own disavowal of the $1.4 trillion number, which is apparently nonetheless going to appear in Professor Ribstein's monograph.

To respond to Professor Ribstein's point, it's not true that Zhang made "an exceptional effort" to filter out the effects of these other events. To begin with, it's not really clear what such an effort would consist of. If you have two events of market-moving significance happening roughly contemporaneously, how do you propose to distinguish between the two, given the fact that you cannot read the mind of investors? Zhang uses three different techniques in her paper:

1) she measures the market's reaction over an hour, or at market opening, and judges the significance of an event based on that. This is an impoverished definition of market impact. The xpectations she uses in evaluating whether an event was negative or positive for the market are also curious: for instance, because the market fell at the opening on the day the Adelphia executives were arrested (at 6 am), she assumes that stock returns that day were not influenced by the Adelphia arrest. In other words, she seems to believe that the arrest of Adelphia executives would have been seen by investors as positive for the market. Can we agree that this is a rather peculiar interpretation?

2) She omits potential market-moving factors. The absence of any discussion of the build-up to the war in Iraq is particularly striking.

3) She admits she can't separate the impact of events. For example, in discussing the negative market return on February 4, 2002 (the first market day after the Snow speech and the release of the Powers report), she writes, "I cannot distinguish which event gave rise to the negative return on February 4, 2002." Yet somehow the decline on February 4, 2002 ended up included in the $1.4 trillion.

I give Zhang an A for inventiveness and energy. But single-event studies are hard enough to do when applied to a single company. Trying to apply them to the market as a whole -- effectively arguing that you can understand all the myriad factors that were influencing investors' decisions, and isolate not just the factor that was most important, but also quantify just how important it was -- is, by its nature, a flawed task. And it's irresponsible to cite Zhang's estimates as if they are, in some real sense, fact when it comes to calculating the costs and benefits of Sarbox.

[Larry E. Ribstein]

Response to Coates:

First, the two earlier studies are discussed in my Sarbanes Oxley After Three Years, as well as in the AEI draft. As pointed out there, the studies are contradictory and ambiguous, which is why I didn't include them on the slide (which also was explicitly incomplete).

Second, of course Zhang doesn't prove causation -- no event study does. Perhaps I should have made that clearer on the blog, but I do make clear in the longer paper (p. 71) that Zhang's evidence "estimates the loss in total market value of firms around legislative events leading to the passage of SOX," which is an accurate statement of the study. In future statements about the Zhang study I'll be more careful to use this boilerplate.

Third, with respect to Bialik, it's clear from Romano's history of SOX's enactment that the Republicans' political options in response to SOX were crumbling (largely because of Bush's Harken problems) around the time of the worst stock market losses. There may not be a precise day-to-day correspondence, but it's pretty close. Since the Republicans were putting all their hopes for opposition on the conference committee, these events were key to prospects that a strict version of SOX would be passed.

Fourth, the stock market had been rising in 2002 prior to the time that a strict version of SOX started looking likely. This doesn't prove causation, but it also suggests that a link with SOX isn't far-fetched.

Fifth, with respect to Litvak, note that I don't use Litvak in the article to support Zhang. My reference to the Litvak article in the comment was, like the rest of the comment, a response to Goodwin's assertion that other market events, and not SOX, had caused the stock decline. I thought I made that pretty clear. It may be that foreign stocks reacted more negatively than US stocks because, as I've argued separately, they incurred higher costs (although, of course, the PCAOB was new for both US and European stocks). But the Litvak study tends to show that stocks were reacting to SOX rather than, as Goodwin asserts, to events like Iraq that would have unsettled the entire market (e.g., because of the effect on oil prices).

[William Goodwin]

What puzzles me most about the $1.4 trillion hypothesis is this (and if you have an answer, Professor Ribstein, I'm genuinely curious to hear it):

On July 10, just as, by Zhang's account, the push for Sarbox was really getting underway (three-quarters of the supposed $1.4 trillion loss comes between July 18 and July 23) the S&P 500 closed at 920.47.

On July 31, in the immediate wake of the passag of Sarbox and President Bush's signing of the bill, the S&P 500 closed at 911.62. In other words, it was in essentially the same place as it had been on July 10.

If investors believed that Sarbox was going to do immense damage to corporate profits (and therefore equity prices), why did the market end up, after three weeks of Sarbox mania, in the same place where it started?

[Larry E. Ribstein]

The critical dates were July 9, when Bush called for immediate action to deal with corporate fraud, and July 10, when the Sarbanes bill went to the Senate floor and passed virtually without opposition. On those days the Dow fell 462 points. On July 16-24, it fell another 1000 points. On July 24-29, the Dow rose 936 points.

See Peter Wallison, Sarbanes-Oxley as an Inside-the-Beltway Phenomenon, http://www.aei.org/publications/pubID.20582/pub_detail.asp.

Note that the 1500 point market drop occurred in the two weeks after Bush made it clear he wanted a strong act and it was evident there would be no significant opposition to such an act. That had not been evident prior to then -- the Republicans had been banking on having leverage in conference to make the Act more like the House than the Senate bill.

It's not farfetched to suppose that the market took awhile to absorb the ramifications of the law, particularly given the haste with which the act was passed, and that a strong law seemed unlikely until July 9. However, it seems likely the market had absorbed this information by July 24.

No, this is not "proof" of causation. My point all along is that this rough correspondence with events merely makes a causal link credible.

[William Goodwin]

I'll accept that the market took a while to absorb the ramifications of the law -- though it's important to note that this is precisely the opposite of what Zhang (who believes that market responses to events are incorporated almost immediately) believes. The point is that although the market on July 24, on your reading, was convinced that Sarbox was going to be disastrous for equity prices, by July 31 it had apparently decided that the impact was going to be negligible. That at least calls into question the meaningfulness of the $1.4 trillion.

Although I, on balance, disagree with it, I think your argument that Sarbox's costs outweigh its benefits is a reasonable one. But relying on Zhang's study makes your case seem weaker rather than stronger.

One other point: the article you cite in your last post explains the decline of the stock market in 2002 this way:

"This points to the reason for the long decline in the Dow, and it has nothing to do with investor confidence. Beginning in March 2002, well before WorldCom, investors began to anticipate the possibility of war in Iraq. . . . Investors famously hate uncertainty, and it seems clear that the uncertainties associated with impending Iraq war caused the 3,000-point decline in the Dow that began in March 2002."

Again, the word "Iraq" does not appear in Zhang's paper.

[Robert Schwartz]

I think the debate over whether SOX costs $1.4 trillion, $6 billion, or one dollar and fifty-seven cents, is interesting, but not very relevant.

It has cost a lot, and what ever it has cost has been completely wasted, and everybody in the real world (i.e. outside the Washington beltway, the upper left side of Manhatan, the people's Republic of Cambridge and a few other homes for the criminally insane) knows it.

The law was passed so that the Republican Congress and President Bush could look just as agressive against corporate fraud (in particular Enron because Ken Lay was a campaign donor to the president) as the Democrats. Remember when the NYT colmunist who claims to be an economics professor said that the Enron collapse was more important than 9/11.

The result was a poorly drafted and poorly thought out law, which will plauge us for years. The current administration, which threw the interests of its friends under the bus will be no more willing to discuss SOX than it would be willing to discuss Skull & Bones.

[Larry E. Ribstein]

One last (probably) comment about the evidence of market loss. As John Coates notes, two pre-Zhang studies show positive market moves around events favorable to SOX enactment. The current version of one of the studies differs from the summary in our draft, and our paper needs to be fixed in that respect. But there's a more serious problem with both studies we don't discuss: the focus on favorable enactment events in late July, particularly including the House and Senate final votes, that occurred weeks after it was clear Congress would enact something like the strong Senate version (see my above comment in response to Goodwin).

As for Goodwin's comment about Iraq, Wallison (cite above) notes that key sabre-rattling took place months before, in late January and early March, and months after, in early October and, of course, the invasion in March '03. The market started falling at the beginning of that period, and then rose both in October '02 and March '03. Zhang doesn't account for Iraq because it's not evident there were important Iraq events confounding the SOX enactment events.

Finally, thanks to the commentors for an interesting discussion. Seems to me this sort of thing is the best of blogdom.

[Neal]

I can add little in the way of hard research to this discussion, so discount this comment as you will.

I am a CPA for a public company. Pre-Sarbox, our audit fees were approximately $0.35MM. Post-Sarbox, they are approximately $1.10MM, with no relief in sight. This is to say nothing about the internal cost of compliance, which includes wasting time bickering with auditors, needless documentation, misunderstood controls, and other added bureaucracy. There is no doubt in my mind that Sarbox has had costs far outweighing benefits in our case. The added stress of compliance where people are punished due to a failure to perform XYZ control (even when the end numbers are good) is even more problematic. Good accountants are leaving accounting.

You don't need to prove that Sarbanes-Oxley has cost over a trillion dollars to know that it's a bad law. All you need to do is understand that regulating compliance is extremely costly with questionable benefits and many unintended consequences. And unfortunately, by trying to shelter people from losses due to investing in public companies, the government has once again subsidized bad decisions. Accordingly, history is bound to repeat itself.

Neal