Going dark and the defense of SOX

Steve Davidoff, the NYT's Deal Professor, presents yet another defense of SOX against the mounting evidence of its negative effects on US markets. The article's hook is an anecdote about Syms' attempt to "go dark" – that is, deregister from the Securities Exchange Act of 1934 and then trade without having to comply with SOX. (As Davidoff points out, firms can fall under the minimum number of record holders to have to register while still having a significant number of actual shareholders whose shares are held by nominees.)

Syms said its reason for deregistering was to avoid the costs of complying with SOX, estimating "direct recurring annual savings will exceed $750,000."  However, a group of shareholders protested that this action would harm shareholders.  Davidoff says:

Behind their words was an unexpressed fear that the Syms family, which controls 58 percent of the company, would either take the company private without the protections of the federal securities laws or otherwise use the absence of federal disclosure requirements to reap their own private advantages taken from the company. The stock price of Syms plummeted more than 40 percent in the wake of this action. Last week Syms relented and reregistered Syms’ shares listing them on the Nasdaq. On that day the shares rose more than 11 percent.

The story is a boon to those who see value in the obligations and protections imposed by the federal securities laws and Sarbanes-Oxley in particular.

I would draw very different lessons.  To begin with, Henry Butler and I, in our Sarbanes-Oxley Debacle, while acknowledging the harm to shareholders from "going dark," note that this harm is to some extent exacerbated by SOX rather than evidence of the need for SOX. As we explain:

[T]here is . . . evidence that firms that go dark have characteristics such as lower accounting quality and more free cash, indicating greater likelihood of insider misconduct. In other words, they may have perverse reasons for wanting to avoid disclosure. Even before SOX, insiders could try to avoid disclosure obligations by going private and dark. But SOX’s higher disclosure costs now give them a legitimate explanation. Even if this is the real explanation, SOX would be indirectly causing a loss of securities law protection for precisely those shareholders who need it most.

Moreover, the Syms anecdote indicates that shareholders are not powerless to protect themselves against this loss of protection. This supports arguments by Butler and me and other SOX critics that SOX should be made optional. Shareholders should be given a meaningful choice, rather than being forced to swallow SOX's extra costs just because the firm happens to meet a particular threshold for trading – the rule that gives rise to perverse scenarios like Syms.

Davidoff cites other evidence that supposedly casts doubt on the adverse effects of SOX on US markets. But this evidence is ambiguous, and he omits persuasive counter-evidence, particularly including Kate Litvak's careful studies of SOX effects on cross-listed firms. For example, in a recent study of SOX's long-term effects on cross-listing firms, Litvak shows:

Using monthly data on cross-listing premia between 1990 and 2006, and controlling for a variety of firm- and country-level characteristics, I find that premia for firms cross-listed on levels 2 or 3 (and therefore subject to SOX) declined in the year of SOX adoption and remained significantly below their pre-SOX level thereafter (second difference). I also find that firms listed on level 2 or 3 (subject to SOX) experienced stronger after-SOX declines in premia than firms listed on levels 1 or 4 (not subject to SOX) (third difference).

To be sure, the evidence of SOX's negative effects on US markets is not conclusive. But the evidence is mighty convincing, particularly in lining up with the powerful theoretical arguments against SOX. SOX's defenders need to present the full picture, and to understand the implications of their anecdotes.