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SARBANES-OXLEY: THE EVIDENCE REGARDING THE IMPACT OF SOX 404

Robert Prentice*

INTRODUCTION

The central debate regarding the way forward for U.S. capital

markets centers upon the Sarbanes-Oxley Act of 2002 (SOX) generally and, more specifically, upon its provision requiring audits of internal financial controls, Section 404 (SOX 404). When decidedly banal securities laws gain the attention of presidential candidates and other high-profile politicians,1 as has happened with SOX, it is clear that something significant is happening.

The premise of this Article is that while empirical academic literature cannot conclusively settle the ongoing controversy over SOX 404, especially at this relatively early stage, it can contribute importantly to the conversation as well as serve as a crucial check upon the self-interested and often short-sighted views of many of the more active participants in the debate.

There are two primary sets of complaints regarding SOX 404. First, corporate managers legitimately complain about SOX 404’s costs for implementation and ongoing maintenance. The empirical evidence will indicate, however, that critics tend to exaggerate SOX 404’s admittedly substantial costs and ignore its countervailing benefits.2

Second, Wall Street and its supporters claim that SOX, particularly through SOX 404, is damaging New York’s status as center of the financial world. Mayor Bloomberg and Senator Schumer commissioned McKinsey & Co. to study the matter.3 Secretary of the

* Ed & Molly Smith Centennial Professor of Business Law, McCombs School of Business,

University of Texas at Austin.

1 See Steve Forbes, Right Man for Our Times, FORBES, Apr. 23, 2007, at 19 (supporting

Giuliani’s presidential aspirations in part because of his opposition to various SOX provisions).

2 See Donald C. Langevoort, The Social Construction of Sarbanes-Oxley, 106 Mich. L. Rev.

(forthcoming 2008) (working paper at 22), available at http://ssrn.com/abstract=930642

[hereinafter Langevoort, Social Construction] (observing that managers “believe they deserve

autonomy and control over the institution so long as they respect very basic legal and business

norms and keep their constituents satisfied” and assuming that “on average, managers consider

SOX an intrusion and resent nearly all of it”).

3 See MCKINSEY & CO., SUSTAINING NEW YORK’S AND THE US’ GLOBAL FINANCIAL


704 CARDOZO LAW REVIEW [Vol. 29:2

Treasury Hank Paulson assembled a group of academics and others, the Committee on Capital Markets Regulation (CCMR), which decried the role of SOX in the decline of U.S. dominance in investment banking and related businesses.4 In March 2007 the U.S. Chamber of Commerce’s Commission on the Regulation of U.S. Capital Markets in the 21st Century issued a similarly critical report.5 The evidence adduced in this Article will indicate that although SOX 404 is having some adverse impact upon New York’s securities business, so many other factors are at play that even outright repeal of SOX 404 would likely have little beneficial effect.

Importantly, SOX critics assume that when those who control U.S. companies take them private or those who control foreign firms drop their U.S. listing in apparent efforts to evade SOX’s requirements, they are acting in the best interests of the firm. The academic literature indicates that this is not a safe assumption.

The controversy could not be more important, because substantial political pressure is being applied by opponents of SOX 404,6 which has become nearly synonymous with Sarbanes-Oxley itself.7 Whether SOX is ultimately considered a success or a failure will likely depend upon SOX 404’s legacy. At the moment, the smart money seems to be on the proposition that SOX is a disaster,8 with SOX 404 being “the law’s most complained-of provision.”9 Although the critics may ultimately be proved correct, there are substantial grounds, based in empirical academic literature,10 to be deeply skeptical of most of their primary

SERVICES LEADERSHIP (2007) [hereinafter MCKINSEY REPORT].

4 COMMITTEE ON CAPITAL MARKETS REGULATION, INTERIM REPORT (2006) [hereinafter

CCMR REPORT].

5 COMMISSION ON THE REGULATION OF U.S. CAPITAL MARKETS IN THE 21ST CENTURY,

REPORT AND RECOMMENDATIONS (2007) [hereinafter CHAMBER REPORT].

6 See Brett H. McDonnell, Recent Skirmishes in the Battle Over Corporate Voting and

Governance 10 (Minn. Law School Legal Studies Research Paper No. 07-04) (Jan. 2007),

available at http://ssrn.com/abstract=960278 (“Much political pressure has built to roll back the

most controversial elements of SOX, especially section 404.”).

7 See Donald C. Langevoort, Internal Controls After Sarbanes-Oxley: Revisiting Corporate

Law’s “Duty of Care as Responsibility for Systems” 2 (Sept. 2005) (unpublished manuscript, on

file with Georgetown University Law Center), available at http://ssrn.com/abstract=808084

[hereinafter Langevoort, Internal Controls] (noting that objections to other portions of SOX have

largely quieted so that today “the sustained [criticism] is largely reserved for just one piece of the

legislation: the internal controls requirements found [in] section 404 . . .”).

8 See Gregory Carl Leon, Stigmata: The Stain of Sarbanes-Oxley on U.S. Capital Markets 7

(George Washington Univ. Law School Public Law Research Paper No. 224) (Nov. 8, 2006),

available at http://ssrn.com/abstract=921394 (“The voices of those that persist in the opinion that

SOX is beneficial to the U.S. market are few and far between.”).

9 A Price Worth Paying?—Auditing Sarbanes-Oxley, ECONOMIST, May 21, 2005.

10 Due to page constraints, this article does not address the substantial number of studies

focusing on how the stock market reacted to various announcements that SOX had passed certain

legislative and administrative hurdles in its passage and implementation. Those studies are wildly

conflicting and of uncertain value. For an earlier discussion of some of those studies, see Robert


2007] SARBANES-OXLEY: THE EVIDENCE 705

claims. A statute can shape the beliefs and norms that are prerequisite for

effective legal compliance, but only if it is viewed as legitimate. SOX has the potential to have substantial beneficial influence in creating a culture of compliance so that corporate employees are not simply trying to “game” the financial reporting system, but are instead truly committed to producing accurate financial information for investors.11 However, if critics succeed in discrediting SOX, it may be no more effective than was Prohibition in shaping beliefs and actions. On the other hand, if SOX comes to be viewed more accurately as a well-intended but imperfect means to protect U.S. capital markets from their own excesses, then perhaps its credibility can be salvaged so that it can be studied and, if necessary, amended, without being discredited. In the final analysis, whether SOX’s benefits exceed its costs may turn upon whether its legitimacy is maintained. This Article adduces substantial evidence supporting the essential soundness of SOX and its Section 404.

I. SOX 404’S BACKGROUND

A. SOX Internal Control Provisions

Sarbanes-Oxley was enacted against a backdrop of infamous

corporate scandal. Enron, WorldCom, and many other companies engaged in massive securities frauds that undermined the very heart of the federal securities laws—their antifraud and mandatory disclosure provisions. Many CEOs had been paying little attention to these reports, and many CFOs had been viewing their jobs primarily as bullying their firms’ outside auditors into certifying as aggressive a set of financial statements as possible on the theory that all their competitors were doing the same. Centrally, for purposes of this Article, Congress enacted a triumvirate of provisions aimed directly at reestablishing investor confidence in financial statements.

Section 302 requires that CEOs and CFOs of public companies certify that the company’s periodic reports do not contain material misstatements or omissions and “fairly present” the firms’ financial

A. Prentice & David B. Spence, Sarbanes-Oxley as Quack Corporate Governance: How Wise is

the Received Wisdom?, 95 GEO. L.J. 1843, 1856-57 (2007).

11 Langevoort has correctly noted that the social construction of SOX may ultimately decide

whether it actually influences actors within the financial reporting system to take their

responsibilities seriously or simply causes them to insincerely “check the box.” Langevoort,

Social Construction, supra note 2, at 30.



condition and results of operations.12 In addition, the officers must affirm that they are responsible for the internal controls, have designed them to ensure that material information is brought to their attention, have evaluated their effectiveness, have presented in the report their conclusions about their effectiveness, and have discussed in the report any changes in the internal controls, including corrective actions taken.13 Section 906(a) creates a new criminal penalty for officers who knowingly certify an inaccurate financial statement.14 Finally, and most significantly, SOX 404 requires the filing of a management report attested to by the external auditor assessing the reliability of the issuer’s internal financial controls.15

Although most legal scholars have been highly critical of SOX 404,16 taken together, the three provisions seem a logical response to the problems Congress was trying to solve. Given substantial evidence of widespread and serious corporate reporting fraud, it was sensible for Congress to conclude that a signal should be sent to CEOs and CFOs of public companies that they should take seriously their responsibilities in the public company reporting system. Although these officers were already signing financial statements filed with the SEC, Congress plausibly concluded that a new message needed to be sent via sections 302 and 906.17 Congress then enacted SOX 404 after reasonably concluding that executive certification would be more meaningful and

12 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 302, 116 Stat. 745, 777-78 (2002)

(codified at 15 U.S.C. § 7241 (2000)).

13 See Langevoort, Internal Controls, supra note 2, at 8-9 (summarizing provisions of

Sections 302 and 404).

14 Pub. L. No. 107-204 § 906(a), 116 Stat. at 806 (codified at 15 U.S.C. § 1350).

15 Id. § 404, 116 Stat. at 789 (codified at 15 U.S.C. § 7262). See generally Thomas C.

Pearson & Gideon Mark, Furthering SOX’s Goals with Statutory and Regulatory Enhancements

and More Effective Investigations to Assure Reliable Financial Information, 86 NEB. L. REV.43

(2007) (explaining SOX 404 in detail).

16 See, e.g., Robert Charles Clark, Corporate Governance Changes in the Wake of the

Sarbanes-Oxley Act: A Morality Tale for Policymakers Too 2 (Sept. 2005) (Harvard Law and

Econ. Discussion Paper No. 525), available at http://ssrn.com/abstract=808244; Larry E.

Ribstein, Sarbox: The Road to Nirvana, 2004 MICH. ST. L. REV. 279, 293 (arguing that SOX is an

example of “Sudden Acute Regulatory Syndrome”).

17 See A Price Worth Paying?, supra note 9 (“It has certainly been a salutary reminder to

corporate leaders that they are paid a lot of money because they are responsible for a lot of

things—in particular, for ensuring that their companies’ accounts provide investors with as honest

a view as possible of the state of their organisation.”).

Firms were also supposed to be filing timely 8-Ks before SOX, but their performance in that

regard improved substantially after SOX reminded them of their responsibilities. See Robert E.

Pinsker, Has Firms’ Form 8-K Filing Behavior Changed Since Section 409 of the Sarbanes-Oxley

Act Became Effective? 4-5 (Sept. 13, 2006) (unpublished manuscript, on file with Old Dominion

University), available at http://ssrn.com/abstract=930063 (finding that firms’ filing behavior has

“significantly improved” with SOX, “valid[ating] the [SEC’s] effort (and that of SOX) to shorten

the Form 8-K filing time and provide corporate information to investors in a more timely

fashion”).



persuasive to investors if those executives had reasonable grounds to believe that the internal financial controls on the process producing those numbers were solid.

B. SOX 404’s Rationale and Lineage

Events at Enron and WorldCom, the two most damaging

scandals,18 certainly justify Congress’s emphasis on internal financial controls. For example, Enron’s stated strategy was to aggressively take risks because tight internal controls would ensure that things did not get out of hand.19 However, Enron’s vaunted Risk Assessment and Control Department was an utter sham, resulting in a situation where “[e]veryone at Enron was concerned with hitting the numbers; no one was concerned with the integrity of the numbers.”20

[What Enron-era frauds rendered apparent was not] that some managers were unscrupulous (which had always been the case) but that the controls on their financial disclosures were weaker than most people thought and, perhaps even more important, that the weaknesses were heightened rather than reduced by powerful trends shaping the current business environment, such as the acceleration of corporate restructuring, disruptive technology changes, and constant financial innovation.21

Congress’s conclusion regarding the importance of internal financial controls was consistent with the academic literature. Experts in accounting theory have long emphasized the importance of internal controls to all parties interested in production of accurate corporate financial statements.22 If reliable internal financial controls are relevant to the accuracy of the financial statements produced, then theoretically

18 Weak internal controls are also assigned major blame in one of the scandals that has come

to light post-Enron—the stock option backdating scandal. See Victor Fleischer, Options

Backdating, Tax Shelters, and Corporate Culture 2 (Univ. of Colo. Law Legal Studies Research

Paper No. 06-28) (Oct. 2006), available at http://ssrn.com/abstract=939914 (noting that

backdating was “collateral damage from weak internal controls and, in some cases, the rent-

seeking of executives”).

Many other scandals have been tied directly to internal control problems, including some of

Europe’s largest recent ones. See Bruno Cova, The Parmalat Fraud Has Generated Too Little

Reform, FIN. TIMES, Nov. 7, 2005, at 17 (Parmalat); Bernard Taylor, Shell-Shock: Why Do Good

Companies Do Bad Things? 14 CORP. GOV. 181, 181 (2006) (Shell Oil). 19 BETHANY MCLEAN & PETER ELKIND, THE SMARTEST GUYS IN THE ROOM 121 (2003)

(noting that Jeff Skilling claimed Enron “could be managed loosely because of its tight internal-

control mechanism”).

20 Fleischer, supra note 18, at 22 n.73.

21 NICOLAS VERON ET AL., SMOKE & MIRRORS, INC.: ACCOUNTING FOR CAPITALISM 1

(2006).

22 William R. Kinney, Jr. et al., Assertions-Based Standards for Integrated Internal Control,

4 ACCT. HORIZONS 1 (Dec. 1990).



firms with poor internal controls should have to pay more for capital because of the increased risk they present to investors.23 Empirical studies confirm the theory by indicating that firms with poor internal controls tend to (a) restate earnings more often,24 (b) be the subject of more SEC accounting and auditing enforcement releases (AAERs),25 (c) face more frequent SEC enforcement actions,26 and (d) be worse performers and systematically riskier than comparable firms.27

Langevoort supplemented the theoretical and empirical cases for internal controls by consulting the management and psychology literature to build a persuasive case for the common sense conclusion that auditing internal financial controls as demanded by SOX 404 is generally a good idea. A critical agency issue is at stake because managers are conflicted by the self-serving bias. They naturally do not wish to be monitored if they can avoid it, and are often motivated to fudge the numbers not only to help their firm (at least in the short run),

23 See, e.g., David Easley & Maureen O’Hara, Information and the Cost of Capital, 54 J. FIN.

1553, 1575 (2004) (“Reducing the risk of informed trading, and correspondingly increasing the

amount of public information, reduces the risk premium uninformed traders demand to hold the

stock.”); Christian Leuz & Robert E. Verrecchia, Firms’ Capital Allocation Choices, Information

Quality, and the Cost of Capital 22 (Jan. 2005) (unpublished manuscript, on file with University

of Chicago Graduate School of Business), available at http://ssrn.com/abstract=495363

(establishing a theoretical link between a firm’s information quality and its cost of capital).

24 Hollis Ashbaugh-Skaife et al., The Discovery and Reporting of Internal Control

Deficiencies Prior to SOX-Mandated Audits 26 (McCombs Working Paper No. ACC-02-05)

(Feb. 28, 2006), available at http://ssrn.com/abstract=694681 (finding that firms that disclose

internal control problems tend to have had a higher incidence of restatements); William R.

Kinney, Jr. & Linda S. McDaniel, Characteristics of Firms Correcting Previously Reported

Quarterly Earnings, 11 J. ACCT. & ECON. 71 (1989) (finding that a restatement indicates

problems with the internal control system).

Firms that must restate are typically punished by the market. Hemang Desai et al., The

Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management

Turnover, 81 ACCT. REV. 83 (2006) (finding that the market imposes a substantial penalty on

those firms that engage in earnings management and have to restate financials); Kinney &

McDaniel, supra note 24, at 71 (finding that firm profitability is negatively associated with

restatements).

25 See, e.g., Ashbaugh-Skaife et al., supra note 24, at 26-27.

26 See, e.g., Jeffrey T. Doyle et al., Accruals Quality and Internal Control over Financial

Reporting (Jan. 24, 2005) (AAA Financial Accounting and Reporting Section [FARS] Meeting

Paper), available at http://ssrn.com/abstract=789985 [hereinafter Doyle et al., Accruals Quality]

(finding that firms that disclosed at least one material weakness in internal controls 2002-2005

tended to have lower quality earnings); William Kinney, Research Opportunities in Internal

Control Quality and Quality Assurance, 19 AUDITING: J. OF PRAC. & THEORY 83, 84 (Supp.

2000) (noting that internal controls are linked with the quality of earnings).

27 Stephen Bryan & Steven Lilien, Characteristics of Firms with Material Weaknesses in

Internal Control: An Assessment of Section 404 of Sarbanes Oxley 24 (April 14, 2005), available

at http://ssrn.com/abstract=682363; see also Jeffrey Doyle et al., Determinants of Weaknesses in

Internal Control Over Financial Reporting (Sept. 14, 2005), available at

http://srn.com/abstract=770465 (reporting study finding that firms disclosing material

weaknesses after SOX tended to be financially weaker, as well as smaller, younger, more

complex, growing rapidly, or undergoing restructuring).



but also themselves.28 Congress’s focus on internal controls was not only consistent with

existing theoretical and empirical academic literature, it also followed in a tradition of pragmatic legislation. Thirty years ago in the shadow of the Watergate affair, Congress was forced to respond to a large scandal involving American corporations paying bribes to obtain contracts from foreign governments. In the Foreign Corrupt Practices Act of 1977 (FCPA),29 Congress not only enacted anti-bribery provisions,30 but also required public companies to install internal accounting controls sufficient to ensure that assets did not walk out the door without company authorization and to prevent top corporate officers from enjoying “plausible deniability.”31 Like SOX 404, the major goals of the internal accounting control provisions were to improve the accuracy of financial reporting already required by the SEC and to provide investors greater assurances regarding the integrity of firm management.32

In 1978, the Cohen Commission, a blue ribbon group convened by the American Institute of Certified Public Accountants (AICPA) noted that “[u]sers of financial information have a legitimate interest in the condition of the controls over the accounting system and management’s response to the suggestion of the auditor for correction of weaknesses.”33 Soon thereafter, the Treadway Commission, a private group sponsored by five accounting organizations, also recognized the importance of internal controls and made several recommendations for improving them. The Treadway Commission originally focused on fraud prevention, but later addressed internal controls as a broader concept.34 Its Committee on Sponsoring Organizations (COSO)

28 Langevoort, Internal Controls, supra note 7, at 15 (arguing that we should all agree “on

two points: internal accounting and disclosure controls cannot be left to management’s business

judgment, and they are costly”).

29 Pub. L. No. 95-213, 91 Stat. 1494 (1977) (codified as amended at 15 U.S.C. § 78dd-1

(2000)).

30 Exchange Act § 30A, 15 U.S.C. § 78dd-2.

31 Exchange Act § 13(b)(2); 15 U.S.C. § 78b(b)(2). For a more detailed history of those

provisions, see Peter Ferola, Internal Controls in the Aftermath of Sarbanes-Oxley: One Size

Doesn’t Fit All, 48 S. TEX. L. REV. 87, 89-92 (2006).

32 See JAMES D. COX ET AL., SECURITIES REGULATION: CASES AND MATERIALS 57 (5th ed.

2006); Renee Jones, Does Federalism Matter? Its Perplexing Role in the Corporate Governance

Debate, 41 WAKE FOREST L. REV. 879 (2006).

The FCPA provisions were not revolutionary in that they simply codified (nearly word-for-

word) the then-existing Institute of Internal Auditor’s Statement on Auditing Procedure No. 54,

which defined accounting control. Melvin A. Eisenberg, Corporate Governance: The Board of

Directors and Internal Control, 19 CARDOZO L. REV. 237, 240-44 (1997) (giving a history of

internal controls development).

33 AM. INST. OF CERTIFIED PUB. ACCOUNTANTS, THE COMMISSION ON AUDITORS’

RESPONSIBILITIES: REPORT, CONCLUSIONS AND RECOMMENDATIONS xxiii (1978).

34 Eisenberg, supra note 32, at 243-44.



developed a framework to flesh out the concept of good internal controls.35

SOX 404 was taken nearly verbatim from another legislative antecedent, the Federal Deposit Insurance Corporation Improvement Act of 1991,36 which required managers of all covered banks annually to evaluate risks and corresponding mitigating controls.37 Altamuro and Beatty’s recent empirical study found evidence that the provision accomplished its purpose by improving the quality of earnings reporting by regulated banks, which the authors concluded was good news for those who hope SOX 404 internal controls will have a similar effect.38

Delaware’s Chancellor Allen has also noted the importance of internal controls,39 ruling in the famous Caremark case that “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists . . . .”40

The persuasive logic and evidence supporting the importance of internal controls is widely recognized abroad.41 The Netherlands Corporate Governance Code requires “in-control statement[s] in which companies have to declare that the internal risk control and auditing systems are ‘adequate and effective.’”42 In 1998, Germany put mandatory requirements in place that defined internal controls beyond the reliability of financial reporting and provided a clear framework for

35 COMMITTEE OF SPONSORING ORGS. OF THE TREADWAY COMMITTEE, AM. INST. OF

CERTIFIED PUB. ACCOUNTANTS, INTERNAL CONTROLS: AN INTEGRATED FRAMEWORK (1992),

available at http://www.coso.org. This report has been a key influence in SOX 404’s

implementation. Troy A. Paredes, Corporation Decisionmaking: Too Much Pay, Too Much

Deference: Behavioral Corporate Finance, CEOs, and Corporate Governance, 32 FLA. ST. U. L.

REV. 673, 753 (2005) (noting that COSO reports were the primary sources for early attempts to

comply with SOX 404).

36 12 U.S.C. § 1831m(b)-(c) (2000).

37 Susan S. Bies, Keynote Address, 8 FORDHAM J. CORP. & FIN. L. 81, 85 (2003). Managers

implementing this provision also looked to COSO for guidance. Id.

38 Jennifer Altamuro & Anne Beatty, Do Internal Control Reforms Improve Earnings

Quality? (Sept. 15, 2006), available at http://ssrn.com/abstract=930690.

39 So have prominent legal scholars. See, e.g., Eisenberg, supra note 32, at 237.

40 In re Caremark Int’l Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996). The decision has

been termed “a creative marriage of the business judgment rule, the American Law Institute’s

Principles of Corporate Governance, and the Sentencing Guidelines for Organizations,

[extending] the fiduciary duties of corporate directors . . .to matters of organizational

compliance.” WILLIAM S. LAUFER, CORPORATE BODIES AND GUILTY MINDS 36 (2006).

41 Indeed, many SOX provisions have been widely adopted around the globe. See generally

Ethiopis Tafara, Statement by SEC Staff: A Race to the Top, International Regulatory Reform

Post Sarbanes-Oxley, http://www.sec.gov/news/speech/2006/spch091106et.htm (Sept. 2006)

(detailing these imitations).

42 Geert T.M.J. Raaijmakers, The Effectiveness of Rules in Company and Securities Law, 23

n.115 (Maastract Faculty of Law Working Paper, 2006), available at

http://ssrn.com/abstract=932022 (citing II.1.4. of the Netherlands Corporate Governance Code).



the monitoring and audit of internal control systems.43 Brown et al. recently found empirical evidence that the German provisions achieved the intended goal of increasing earnings quality.44 In 1999, India adopted a series of major corporate governance reforms that included CEO/CFO certification of internal controls. A recent empirical study found that those reforms were greeted positively by investors.45 Several other countries have (a) adopted comply-or-explain approaches to management assessment of internal controls,46 (b) adopted rules requiring a management assessment of internal controls,47 or (c) enacted corporate codes that recommend management assessment of internal controls.48

Ceteris paribus it is undeniable that a firm is better off with good internal financial controls than without them.49 Perhaps the Enron-era scandals would have been minimized had the SEC enforced the FCPA’s internal accounting control provisions more vigorously,50 or had Delaware courts taken Caremark more seriously.51

II. SOX’S APPARENT SUCCESSES

That there were reasonable grounds for Congress to believe that

SOX 404 was a sensible approach to bolstering the reliability of the federal securities disclosure regime does not mean that it is bound to succeed, but there have been some positive signs. Although advocating

43 Nerissa C. Brown et al., The Effect of Internal Control Regulation on Earnings Quality:

Evidence from Germany and Implications for SOX 302 and 404 (Sept. 2007), available at

http://ssrn.com/abstract=945590.

44 Id.

45 Bernard S. Black & Vikramadita S. Khanna, Can Corporate Governance Reforms Increase

Firms’ Market Values: Event Study Evidence from India 4 J. EMPIRICAL LEGAL STUD.

(forthcoming 2007) (working paper at 18), available at http://ssrn.com/abstract=914440

(conducting events study finding that when India announced a major securities law reform that,

among other things, required CEO/CFO certification of internal controls, the stock price of the

large firms to which the rules would apply rose by 4.5% relative to small firms to which the

reforms did not apply over a two-day window and 7% over a four-day window).

46 SEC Chair Christopher Cox, Hearing of the House Financial Services Committee Subject:

Sarbanes-Oxley at Four: Protecting Investors and Strengthening the Markets, FED. NEWS SERV.,

Sept. 19, 2006 (citing the UK, Australia, and Hong Kong); Tafara, supra note 41 (noting a variety

of approaches to requiring establishment and maintenance of internal control systems).

47 Tafara, supra note 41 (citing Japan, France, and Canada).

48 Id. (citing Mexico).

49 Eisenberg, supra note 32, at 244 (“The need for internal control is currently not a matter of

dispute.”). The cost, of course, is the factor that renders all other things not equal.

50 See Langevoort, Social Construction, supra note 2, at 30 (“[T]he SEC was simply not

diligent about its enforcement.”).

51 By July 2002, no director had been held liable in Delaware for breaching Caremark duties.

See LAUFER, supra note 40, at 114-15 (noting Caremark’s negligible impact).



for many changes in securities regulation, the recent Interim Report of the Committee on Capital Markets Regulation (CCMR) reached the conclusion that “[i]nvestors have benefited from the stronger internal controls, greater transparency, and elevated accountability that have resulted from this new law.”52 In many ways, SOX 404 has produced significant benefits.

A. Reviving the Capital Markets

When SOX was passed, the stock markets were nearly in a free

fall. From 2000 market peaks, the Dow Jones Industrial Average had dropped 25%, the S&P 500 had declined more than 40%, and NASDAQ had plummeted more than 70%.53 Investor confidence in the capital markets was at record lows, causing average trading volume to drop 54%.54 The lack of confidence stemmed not from worries that Congress would legislate, as conservative pundits have asserted, but from the fact that 84% of the investing public believed that corporate wrongdoing was widespread rather than isolated.55 Professor Paredes noted at the time that “restoring [investor] confidence might be the most important thing that the SEC and Congress can do, just as it was the top priority during the crisis of confidence following the 1929 stock market crash.”56

As even critics concede,57 SOX helped restored investor

52 CCMR REPORT, supra note 4, at xiii. After digesting the CCMR Report, the McKinsey

Report and the Chamber of Commerce Report, Secretary of the Treasury Hank Paulson

announced initiatives that scarcely touched SOX and noted, consistent with SOX’s philosophy,

that “[a]ccurate and transparent financial reporting is vital to the integrity of our capital markets

and the strength of the US economy.” Henry Paulson, The Key Test of Accurate Financial

Reporting is Trust, FIN. TIMES, May 17, 2007, at 11.

53 Leon, supra note 8, at 4.

54 Hsihui Chang et al., CEOs’/CFOs’ Swearing by the Numbers: Does It Impact Share Price

of the Firm?, 81 ACCT. REV. 1, 2 n.1 (2006) (citing sources).

55 Amy K. Choy & Ronald R. King, An Experimental Investigation of Trust and Justice:

Implications for Corporate Governance 3 (Feb. 2006) (unpublished manuscript), available at

http://ssrn.com/abstract=892332 (citing Conference Board report); see also Roberta S. Karmel,

Reconciling Federal and State Interests in Securities Regulation in the United States and Europe,

28 BROOK. J. INT’L L. 495, 545 (2003) (noting soon after July 2002 that “[a] similar [to the early

1930s] crisis of investor confidence exists today due to the bursting of the technology stock

market bubble and the corporate financial scandals of Enron Corp., WorldCom, and other

companies”).

56 Troy A. Paredes, Blinded by the Light: Information Overload and Its Consequences for

Securities Regulation, 81 WASH. U. L.Q. 417, 469 (2003).

57 K. Alvarado, CFOs Report Lower Compliance Costs, INTERNAL AUDITOR, June 1, 2006, at

15 (reporting results of Financial Executives International’s survey of CFOs that found 83% of

respondents agreed that Section 404 compliance had increased investor confidence in their

companies); Internal Control: Companies Start to Feel Less of a Pinch, ACCOUNTANT, Apr. 30,

2006, at 5 (noting that research commissioned by the Big Four showed that “most companies



confidence in the stock market,58 facilitating a rapid and dramatic recovery.59 This should be no surprise, for studies show that investors value increased transparency about a company’s corporate governance, including the internal audit functions, when making investment decisions.60 Indeed, Lord and Benoit’s post-SOX study showed that over a two-year period, there was a 27.67% increase in the average share prices for companies that had effective internal controls in both years, a 25.74% increase in average stock price for companies that had ineffective SOX 404 controls in year one but effective controls in year two, but a 5.75% decrease in average stock prices of companies that reported ineffective SOX 404 controls in both years.61

believe investor confidence has risen as a result of Section 404”); Greg Jonas, Moody’s Investors

Servs., The Second Year of Section 404 Reporting on Internal Control 1 (May 2006) (unpublished

comment), available at http://ssrn.abstract=959025 (noting that Moody’s “continue[s] to believe

that reporting on internal control has helped restore investor confidence in financial reporting”).

58 Given record budget deficits, record trade deficits, record gasoline prices, unprecedented

job outsourcing, the impact of Hurricane Katrina, and the burdens of fighting both terrorism and

the Iraq war, American capital markets have performed remarkably well since July 2002. See,

e.g., Edward Cone, Compliance: Is Sarbanes-Oxley Working?, CIO INSIGHT, June 12, 2006

(noting that the Dow Jones Industrial Average is up more than 50% above its 2002 lows); Jed

Graham, SEC Mulls Fresh Sarbanes-Oxley Fixes to Ease Small Firms’ Compliance Costs,

INVESTOR’S BUSINESS DAILY, May 11, 2006, at A01 (“[W]ith stock indexes near multiyear or

all-time highs, investors seem to have regained confidence in corporate books.”); Andy Serwer,

Stop Whining About SarbOx!; Critics Want to Repeal the Law, but It’s Been a Boon to the

Market,” FORTUNE, Aug. 7, 2006, at 39 (noting that the market value of the Wilshire 5000 index,

a proxy for all public companies in the U.S., increased 54% in the four years after SOX was

signed).

59 Bengt Holmstrom & Steven N. Kaplan, The State of U.S. Corporate Governance: What’s

Right and What’s Wrong? 22 (European Corporate Governance Institute—Finance Working

Paper No. 23/2003) (Sept. 2003), available at http://ssrn.com/abstract=441100 (“At this point,

SOX has probably helped to restore confidence in the U.S. corporate governance system.”); Floyd

Norris, Board Proposes Lighter Auditing of Internal Controls, N.Y. TIMES, Dec. 20, 2006, at C1

(noting that the stock market bottomed out at about the time efforts to pass SOX got underway

and has been on a sustained rise ever since); Dan Roberts, Corporate US Begins to Reflect

Sarbanes-Oxley: The Reform Process Has Entered Its Final Stages, FIN. TIMES, Nov. 29, 2004, at

7 (“If investors—presumably still scarred by past scandals—are indeed a reliable guide to new-

found corporate responsibility, then the [post-Sarbanes-Oxley] improvement is easy to measure:

the S&P 500 is up 50 per cent since its 2002 low.”). It is impossible to know the role of

Sarbanes-Oxley, but it is clear that the dot-com crash “never reached the depths hit in other

collapses, such as in the 1930s or the 1970s.” E.S. Browning, Ah, the 1990s—Four Years Ago,

the Pundits Peaked Along With Stocks; Where Are They Now?, WALL ST. J., Feb. 23, 2004, at C1.

60 See J. Bonasia, Firms Struggle with Sarbanes-Oxley Rules, INVESTOR’S BUS. DAILY, Apr.

13, 2005 (referencing a survey finding 60% of financial analysts are willing to pay a 10%

premium for shares of firms that can demonstrate solid compliance with SOX); Travis P. Holt &

Todd DeZoort, The Effects of Internal Audit Report Disclosure on Investor Confidence and

Investment Decisions 19 (Jan. 13, 2007) (unpublished manuscript), available at

http://ssrn.com/abstract=957055 (finding from experiment that investors value information about

internal audit reliability); David Nicklaus, Ease Stock Regulation, Just Not Too Much, ST. LOUIS

POST-DISPATCH, Dec. 10, 2006, at E1 (“[A]cademic studies have shown that even the

controversial Section 404 has its good side: Companies with strong internal controls get a higher

stock-market value than those whose controls are deficient.”).

61 ROBERT BENOIT, THE LORD AND BENOIT REPORT: DO THE BENEFITS OF 404 EXCEED THE



Corporations now complaining about SOX are also racking up record profits that were 88% higher in 2006 than in 2002.62 Although Wall Street has been howling about SOX 404, in 2006 and early 2007 the Dow Jones Industrial Average reached heights that were not touched even during the unsustainable frenzy of the dot-com boom.63 All major Wall Street investment banks reported record profits in 2006.64 Thus, it is extremely difficult to find any macro evidence to support assertions that SOX 404 has been throwing “buckets of sand into the gears of the market economy.”65 Rather, consider that in October 2002, “the dark days when the market was most nervous about the quality of financial reporting,”66 credit spreads for investment grade companies were 2.5 percentage points over Treasury rate, whereas by 2006 that spread had shrunk to 0.85%. The managing director of Moody’s Investors Services has stated that not all of that shrinkage can be “attribute[d] to 404, but if only 10 percent of that reduction is due to 404, put those numbers in your calculator and you get a benefit that is absolutely enormous.”67

B. Improving Corporate Governance

Studies often correlate improved corporate governance with better

performance by firms.68 A study of 2,500 international companies performed by GovernanceMetrics International concluded that SOX

COST? 3 (2006).

62 Matthew Goldstein, The Perils of Paulson, THE STREET.COM, Dec. 1, 2006,

http://www.thestreet.com/newsanalysis/businessinsurance/10325296.html?puc=_tscs

(“[C]orporations are spending a record sum on stock buybacks, an indication that business still

has plenty of cash to throw around despite higher regulatory costs. Over the first nine months of

[2006], corporations spent $325 billion on share buybacks, up 32% from [2005].”); Greg

MacSweeney, The Audacity, WALL STREET & TECH., Dec. 1, 2006, at 8 (noting that corporations

are screaming about SOX even though in 2006 corporate profits were setting records).

63 Gerard Baker, Markets Applaud as US Economy Walks Tightrope, TIMES (London), Oct.

31, 2006, at 52 (noting that the Dow Jones Industrial Average had recently set a new all-time

high).

64 See, e.g., David Wighton, Merrill Has Its ‘Most Successful Year,’ FIN. TIMES, Jan. 19,

2007, at 18 (noting that Merrill Lynch “joined Wall Street rivals by reporting record earnings” for

2006).

65 Steven Marlin, Gaining Strength from Sarbox—Sarbanes-Oxley Compliance May Be a

Burden, But It’s Helping Some Companies Improve Operations at Various Levels, INFORMATION

WEEK, Mar. 21, 2005, at 36 (quoting Sun Microsystems CEO Scott McNealy).

66 Helen Shaw, Can SOX 404 Be Measured?, CFO.COM, May 16, 2006,

http://cfo.com/article.cfm/6940147?f=search (quoting Gregory Jonas).

67 Id.

68 See, e.g., Prentice & Spence, supra note 10, at 1858-66 (citing numerous studies showing

that companies located in countries with higher corporate governance standards tend to perform

better than companies in countries with worse corporate governance and that, within nations,

firms with better corporate governance outperform their peer domestic firms with weaker

corporate governance).



reforms led to a 10% improvement in the corporate governance performance of U.S. companies versus their foreign counterparts.69 To this improvement Healy and Roberts attribute much of the U.S. stock market’s rebound from the 20% tumble it took in 2002 preceding SOX’s enactment.70 SOX 404’s contribution to this improvement cannot be precisely parsed out, but improved formal governance structures mean little if they do not create more reliable information upon which managers and investors can act.

C. Improving Liquidity

Jain and colleagues found empirical evidence that SOX improved

the liquidity of American capital markets both in the short-term and the long-term, suggesting “that these regulatory actions appear to be successful in restoring market participants’ confidence in corporate governance, financial reports, and audit functions.”71 In the fall of 2006, one observer noted that the U.S. markets were enjoying record liquidity and record foreign investment72 in part due to a flight to quality given the unprecedented transparency of U.S. public companies’ accounting.73 SOX 404 plays an important role in that increased transparency, as the next section indicates.

D. Improving Financial Reporting

Many believe that the SOX 404 “is working,”74 that its “accounting

69 Thomas Healey & Robert Steel, Sarbanes-Oxley Has Let Fresh Air Into Boardrooms, FIN.

TIMES (London), July 29, 2005, at 17.

70 Id.

71 Pankaj K. Jain, Jang-Chul Kim, & Zabihollah Rezaee, The Effect of The Sarbanes-Oxley

Act of 2002 on Market Liquidity 27 (Sept. 2006), 14th Annual Conference on Financial

Economics and Accounting, available at http://ssrn.com/abstract=488142.

72 In 2005, U.S. financial stock (equities, bonds, loans and deposits) stood at $51 trillion,

more than twice that of the next largest country (Japan). MCKINSEY REPORT, supra note 3, at 31.

73 Eleanor MacDonald, Senior Editor, Forbes, Kudlow & Co. (CNBC television broadcoast

Nov. 16, 2006) (“There’s record liquidity . . . and it’s a flight to quality as well into the US stock

markets with Sarbanes-Oxley. You haven’t seen such a transparent accounting ever in this

country.”).

74 See Tim Leech, Shock News—SOX is Working, GLOBAL RISK REGULATOR, Feb. 2005

(“[T]he real problem for SOX detractors is that it is working. There’s growing, irrefutable

evidence for this, despite SOX’s technical flaws and the need for improvement in some areas . . . .

Financial disclosures from US listed companies are more reliable. Profit management

gamesmanship has been curtailed. Chief financial officers and chief executives are far more

reluctant to push the limits of generally accepted accounting principles . . . . [A]udited financial

statements for US listed companies are now, on balance, more reliable than those being produced

for companies listed in London and on European exchanges. The financial statements of US



reforms have been a win,”75 and that it is a “godsend”76 for investors. The academic research provides important support for these conclusions.

1. Section 302

Most studies of Section 302 are strongly supportive of the impact

of internal control provisions.77 For example, Chang et al. found that bid-ask spreads decreased after 302 certifications,78 indicating that the certifications make disclosures more credible and reduce information asymmetry between owners and managers.79 Overall their evidence indicated that Section 302 “had a positive effect on the market value of certifying firms . . . consistent with the notion that certification improved investors’ confidence in corporate disclosures.”80

Hammersley and colleagues examined the market price and trading volume reactions to Section 302 disclosures of material internal control weaknesses, determining that on the day of the internal weakness disclosure, returns were significantly negative for disclosing firms.81 Thus, the Section 302 certifications provided investors “with much more timely information about the quality of a company’s internal

listed companies are now also generally more trustworthy than those of US private companies

and those in the public sector, the not-for-profit sector and for public companies in other countries

that have not yet adopted a SOX-like regime.”).

75 David Henry, Not Everyone Hates SarbOx, BUS. WK., Jan. 29, 2007, available at

http://www.businessweek.com/magazine/content/07_05/b40(1)9053.htm (quoting Donald J.

Peters, a portfolio manager at T. Rowe Price Group); see also Pearson & Mark, supra note 15, at

20 (concluding that “[i]mproved financial reporting is evident from companies adopting stronger

internal controls and producing more reliable financial statements . . . .”).

76 Henry, supra note 75.

77 In an early study, Bhattacharya et al. found that even before SOX was enacted the market

had already separated firms with good earnings transparency from those with bad so that the

SEC’s initial required certification by selected firms in August of 2002 was a “non-event,” and

“[t]he SEC order did not help the market’s ability to differentiate further between these two types

of firms.” Utpal Bhattacharya et al., Is CEO Certification of Earnings Numbers Value-Relevant?,

J. EMPIRICAL FIN. (forthcoming Sept. 2002) (working paper at 16), available at

http://ssrn.com/abstract=332621. However, most newer studies have reached much more positive

conclusions regarding the impact of Section 302. But see John E. McEnroe, Perceptions of the

Effect of Sarbanes-Oxley on Earnings Management Practices, 19 RES. ACCT. REG. (2006),

available at http://ssrn.com/abstract=947359 (abstract) (finding in a survey of CFOs of Fortune

500 firms and audit partners for the thirty three largest audit firms a perception that SOX

“reduced earnings management in only four of fifteen cases”).

78 Hsihui Chang et al., supra note 54, at 1.

79 Id. at 7.

80 Id. at 3.

81 Jacqueline S. Hammersley et al., Market Reactions to the Disclosure of Internal Control

Weaknesses and to the Characteristics of Those Weaknesses Under Section 302 of the Sarbanes

Oxley Act of 2002, 13 REV. ACCT. STUD. (forthcoming Mar. 2008) (working paper at 25),

available at http://ssrn.com/abstract=830848.



control system than was previously available.”82 Beneish et al. looked at stock returns and cost of capital effects

following Section 302 disclosures of internal control weaknesses; they discovered significantly negative abnormal returns as well as positive abnormal increases in implied cost of capital, indicating that “these disclosures inform investors about the financial reporting quality of disclosing firms.”83

Griffin and Lont found that investors responded positively to SEC certification requirements and recognized certification as a statistically significant event.84 Positive response was greater for firms with prior securities litigation, indicating that investor confidence increased after certification.85

Ashbaugh-Skaife et al. found that investors were using signals of internal control weaknesses from Section 302 reports to evaluate risks even before the first official disclosures of internal control deficiencies.86 Firms with poor internal controls had less reliable financial reporting, which created increased information risk for investors, resulting, in turn, in higher costs of capital.87 The authors concluded that “internal control risk matters to investors and firms reporting effective internal control or firms that remediate known internal control problems benefit from lower costs of equity beyond that predicted by other risk factors.”88

These and other89 early studies of Section 302 strongly indicate

82 Id. at 26.

83 Messod D. Beneish et al., Internal Control Weaknesses and Information Uncertainty 34-35

(May 2007), http://ssrn.com/abstract=896192. The authors’ results indicate that Section 404

disclosures do not provide additional information to investors. Id. at 2-4 (providing

explanations).

84 Paul A. Griffin & David H. Lont, Taking the Oath: Investor Response to SEC Certification,

1 J. CONTEMP. ACCT. & ECON. 27 (2005), available at http://ssrn.com/abstract=477586.

85 Id.

86 Hollis Ashbaugh-Skaife et al., The Effect of SOX Internal Control Deficiencies on Firm

Risk and Cost of Equity 2 (Feb. 28, 2007), http://ssrn.com/abstract=896760 [hereinafter

Ashbaugh-Skaife et al., Cost of Equity].

87 Id. at 1.

88 Id. at 38.

89 Hirtle, on the other hand, looked only at bank holding companies (BHCs) and found that

“BHCs subject to the SEC’s order experienced positive and statistically significant abnormal

returns from certification,” which would indicate that the certification provided valuable

information to investors. Beverly Hirtle, Stock Market Reaction to Financial Statement

Certification by Bank Holding Company CEOs, 38 J. MONEY CREDIT & BANKING 1263, 1264

(2006). Hirtle also found that “certification resulted in a lasting decline in uncertainty concerning

these banks’ future earnings streams, as the variance of analysts’ earnings forecasts for certifying

BHCs declined significantly in the year following certification.” Id.

Vermeer studied whether a voluntary disclosure system for CEO/CFO certification

effectively signals the credibility of their financial reporting and discovered that firms including

CEO/CFO certifications were less likely to practice income-increasing earnings management. He

concluded that his results showing lower earnings management for firms that voluntarily



that executive certifications provide valuable information to the capital markets in a timely fashion, boost investor confidence in the information they are receiving, and thereby enable firms with strong internal controls to reduce their capital costs significantly.

2. Section 404

Executive certification of financial statements is well and good, but

likely to be more meaningful to the markets if the process that produces the information going into them is monitored by sound internal controls that are themselves audited by reliable third parties.90 There is substantial empirical evidence that many firms, especially smaller ones, did not report their internal control deficiencies until SOX 404 audits began.91 Whereas the Internal Controls Subcommittee of the SEC’s Advisory Committee on Smaller Public Companies proposed exempting smaller companies from SOX 404 on grounds that other SOX provisions dealing with improved corporate governance might suffice to enforce proper establishment and evaluation of the firms’ internal controls,92 Bedard and colleagues’ recent empirical study indicated that without independent auditor attestation associated with full application of SOX 404, “corporate governance quality has little impact on internal control over financial reporting.”93 They concluded that SOX 404’s beneficial impact on internal controls supported the SEC’s plan to eventually require smaller firms to comply with its provisions, “[o]ur findings suggest that both SOX 404 and better corporate governance are associated with improved quality of financial reporting.”94

As with Section 302, most empirical studies of the impact of SOX

disclosed suggested that the mandatory certification of financial reports seems to enhance the

credibility of financial statements. Thomas E. Vermeer, Do CEO/CFO Certifications Provide a

Signal of Credible Financial Reporting?, 18 RES. ACCT. REG. 163, 173 (2005).

90 J. Efrim Boritz, Maintaining Quality Capital Markets Through Quality Information 28

(Apr. 2006), http://www.cica.ca/download.cfm?ci_id=34209&la_id=1&re_id=0.

91 Letter from Lynn E. Turner, Managing Director, Glass, Lewis & Co., LLC, to Jonathan G.

Katz, Secretary, Sec. & Exch. Comm’n 6 (Apr. 12, 2005), available at

http://www.sec.gov/news/press/4-497/leturner041205.pdf (noting that in the first years of SOX

the vast majority of CEOs and CFOs certified their financial controls as free of material

weaknesses, and only when outside audits commenced did the extent of internal control problems

become known); Lord & Benoit, Bridging the Sarbanes-Oxley Disclosure Control Gap 8-9

(2006), available at http://www.section404.org/pdf/Lord_Benoit_Report_1_.pdf [hereinafter

Lord & Benoit, Bridging] (noting that it was only after independent audits of internal controls

became required than many companies began self-reporting deficiencies under Section 302).

92 SEC. & EXCH. COMM’N, PRELIMINARY REPORT OF THE INTERNAL CONTROLS

SUBCOMMITTEE TO THE ADVISORY COMMITTEE ON SMALLER PUBLIC COMPANIES (2005).

93 Jean C. Bedard et al., Regulatory Intent and Political Reality: Corporate Governance and

Internal Controls in the Post-SOX World 4 (Mar. 2007), http://ssrn.com/abstract=954057.

94 Id. at 33.



404 find that the reports provide useful information that aids the capital markets. For example, De Franco et al. found that the market reacted negatively to corporate reports of internal control deficiencies, indicating that the investors did not previously have the information and that they deemed it economically significant.95 The authors concluded that investors used this information in directing their resources, thereby increasing capital market efficiency, as Congress and the SEC intended.96

Doyle and colleagues also studied section 302 and 404 reports, learning, consistent with Sections 302 and 404, that “the internal control environment is a fundamental element in the production of high quality accruals.”97 Such findings indicate that SOX’s mandated disclosures on company-level material weaknesses are “at least in part, appropriately identifying ‘poor quality’ firms—specifically, those with poor accruals quality.”98 More specifically, Doyle et al. found that poor internal controls in their subject population were positively correlated with three different measures of earnings management—discretionary accruals, average accruals quality, and historical restatements.99

Ashbaugh-Skaife and colleagues studied how internal controls affected the cost of equity capital,100 finding that firms with internal control deficiencies have higher idiosyncratic risk, higher systemic risk, and higher cost of equity capital. Importantly, when such firms then improved their internal controls and received an unqualified SOX 404 opinion, the market valued that information and their costs of capital decreased by 50 to 150 basis points.101

95 Gus De Franco et al., The Wealth Change and Redistribution Effects of Sarbanes-Oxley

Internal Control Disclosures 6 (Apr. 2005), http://ssrn.com/abstract=706701.

96 Id. The authors also found that small investors benefited more from the disclosure

requirement because prior to SOX, they had lacked access to information beyond financial

statements about the firms. Id. at 5. Additional protection of small investors was an unexpected

benefit of this SOX provision. Id. at 9.

97 Jeffrey Doyle et al., Accruals Quality and Internal Control over Financial Reporting, 82

ACCT. REV. 1141 (2007) (working paper at 30), available at http://ssrn.com/abstract=789985.

98 Id. at 31.

99 Id. at 2. This study did find that Section 302 reports were more strongly associated with

earnings management than Section 404 reports, perhaps because auditors were pickier and more

likely to highlight not only the significant internal control problems that management reported

voluntarily, but also more picayune problems that did not have significant impact on earnings

quality. Id. at 3.

100 Ashbaugh-Skaife et al., Cost of Equity, supra note 86.

101 Id. at 32-33. In a second study, Ashbaugh-Skaife and colleagues found that firms

displaying internal control problems show more evidence of earnings management than firms

with better internal controls. They also discovered that accrual quality generally improves if a

firm remedies its internal control deficiencies and an auditor verifies the remediation, concluding

that their findings were “consistent with the notion . . . that strong internal controls provide a

significant long-term benefit in improving the accuracy of financial reporting that leads to higher

quality information for firms’ external stakeholders.” Hollis Ashbaugh-Skaife et al., The Effect

of SOX Internal Control Deficiencies and Their Remediation on Accrual Quality 3 (July 23,



Bedard studied SOX 404 (and 302) to learn whether their requirements improved earnings quality, as measured by unexpected total and current accruals, finding that because of SOX 404’s formal internal control assessment process, firms improved their internal controls and/or auditors increased their audit effort, forcing management to improve earnings quality by reducing accruals. Bedard concluded “[o]verall, these results are consistent with an increase in the quality of earnings caused by the Sarbanes-Oxley internal control regulations.”102

These empirical studies and many others103 strongly indicate that together Sections 302 and 404 are providing investors in U.S. markets with the most reliable financial statements in history, which benefits issuers by reducing their capital costs and benefits investors by reducing their risk.104 Moreover, as Professor Nelson has reminded critics, while the costs of SOX 404 are high and immediate, the benefits are real and long-term.105

2007) (unpublished manuscript), available at http://ssrn.com/abstract=906474.

102 Jean Bédard, Sarbanes Oxley Internal Control Requirements and Earnings Quality 30

(Aug. 2006) (unpublished manuscript), available at http://ssrn.com/abstract=926271.

103 See, e.g., Eli Bartov & Daniel A. Cohen, Mechanisms to Meet/Beat Analyst Earnings

Expectations in the Pre- and Post-Sarbanes-Oxley Eras 27 (NYU Law & Economics Research

Paper Series, Working Paper No. 07-18) (Apr. 25, 2007), available at

http://ssrn.com/abstract=954857 (finding that SOX, although not necessarily sections 302 and

404, reduced earnings management via accounting tricks); Kam C. Chan et al., Earnings

Management and Return-Earnings Association of Firms Reporting Material Internal Control

Weaknesses Under Section 404 of the Sarbanes-Oxley Act 22-23 (Sept. 2006) (working paper on

file with author) (noting that prior studies suggest that poor internal control can lead to more

opportunities for earnings management, reporting findings providing “mild evidence” of this fact

and additional evidence that earnings management decreased after SOX 404 was implemented,

and concluding that “[s]ince the findings of ineffective internal controls by auditors under Section

404 may cause firms to improve their internal controls, Section 404 has the potential benefits of

reducing the opportunity of intentional and unintentional accounting errors and improving the

quality of reported earnings.”); Chan Li & Qian Wang, SOX 404 Assessments and Financial

Reporting Errors 5 (Aug. 2006), available at http://ssrn.com/abstract=926180 (finding that

auditors’ SOX 404 reports were “representationally faithful” in that they conveyed the

information that regulators wished them to convey and were useful predictors of future

misstatements, thereby providing “useful and timely information to investors”); see also Prentice

& Spence, supra note 10, at 1899-1907 (citing several other studies, including a few with contra

findings).

104 See Boritz, supra note 90, at 66 (“Together, these studies indicate that internal control

assessments are useful to capital market participants because they convey information that can

help them better assess information risk.”). Still, while SOX 404 reports often inform investors

regarding significant audit adjustments and related control problems that they would not

otherwise have known about, Moody’s Investors Services, supra note 57, at 5, it is disappointing

that a very high percentage of SOX 404 reports follow (rather than precede) financial

restatements or material audit adjustments. Id.

105 Mark W. Nelson, Ameliorating Conflicts of Interest in Auditing: Effects of Recent

Reforms on Auditors and Their Clients 8 (July 11, 2005) (unpublished manuscript), available at

http://ssrn.com/abstract=760884. See also Anindya Ghose, Information Disclosure and

Regulatory Compliance: Economic Issues and Research Directions 5 (July 2006) (unpublished



E. Improving Fraud Detection and Deterrence

Enron-era shareholders of defrauded companies lost more than

$300 billion,106 and one investor representative noted that “[i]nvestors lost more in Enron alone than [will be spent] for implementing [SOX 404] at all public companies.”107 In 2005 alone, Fannie Mae spent $800 million in consultants, accountants, lawyers, and tech support to clean up a mess made by poor internal controls that caused it to make $11 billion in accounting errors.108 If SOX 404 prevents just a few Enrons, WorldComs, or Fannie Maes by forcing corporate executives to take financial reporting seriously,109 by enabling detection of a financial fraud, by incentivizing gatekeepers to tend to their knitting, or by improving deterrence by making it more likely that fraud will be detected,110 SOX 404’s benefits might easily outweigh its substantial burdens.

Securities fraud not only reduces investors’ confidence and increases their monitoring costs, it also leads to misallocation of resources.111 WorldCom’s financial fraud, for example, caused the

manuscript), available at http://ssrn.com/abstract=921770 (noting that costs of 404 “are

quantifiable and immediate, whereas benefits are intangible and more difficult to quantify”).

106 See GLASS, LEWIS & CO., YELLOW CARD: INTERIM TREND ALERT 13 tbl.A2 appended to

Letter from Lynn E. Turner, Managing Dir., Glass, Lewis & Co., to Jonathan G. Katz, Sec., Sec.

& Exch. Comm’n (Apr. 20, 2005), available at http://www.sec.gov/news/press/4-

497/leturner041205.pdf.

107 Pamela A. MacLean, ‘SOX’ Inspires Backlash—and Benefits, NAT’L L.J., 1 (2005)

(quoting Barbara Roper of the Consumer Federation of America).

108 Richard Beales, Fannie To Spend $800m To Restate Earnings, FIN. TIMES, May 10, 2006,

at 29.

109 Many believe that the great increase in financial restatements immediately after SOX’s

passage is evidence that SOX induced corporate managers to take financial reporting seriously.

See Terence O’Hara, Excavations in Accounting; To Monitor Internal Controls, Firms Dig Ever

Deeper into Their Books, WASH. POST, Jan. 30, 2006, at D1 (quoting Kurt Schacht, managing

director of the Centre for Financial Market Integrity at the CFA Institute, as saying “[t]he general

consensus is [the restatements are] an indication of how well Sarbanes-Oxley is actually

working”).

110 After SOX, actors covered by SOX have improved their fraud detection, but nonetheless

account for only slightly more than 50% of the frauds detected. I.J. Alexander Dyck et al., Who

Blows the Whistle on Corporate Fraud? (Center for Research in Security Prices Working Paper

No. 618) (Feb. 2007), available at http://ssrn.com/abstract=891482.

111 Shane A. Johnson et al., Executive Compensation and Corporate Fraud 32 (Apr. 21 2005)

(unpublished manuscript), available at http://www.wlu.ca/documents/10886/tian.pdf; see also

Jere R. Francis, What Do We Know About Audit Quality?, 36 BRIT. ACCT. REV. 345, 361 (2004)

(noting that “when a corporate failure like Enron occurs there are enormous social and economic

consequences”).

Simple earnings management, which SOX 404 also helps minimize, also distorts capital

markets. See Pengjie Gao & Ronald E. Shrieves, Earnings Management and Executive

Compensation: A Case of Overdose of Option and Underdose of Salary? 2 (July 29, 2002)

(unpublished manuscript), available at http://ssrn.com/abstract=302843 (noting that earnings



company to misprice its products,112 make unnecessary investments in broadband capacity, pay bonuses to executives who had not earned them, and pay taxes on income that it did not earn.113 Investors bought WorldCom stock when the economy would have benefited from their investment dollars going elsewhere.

Worse still, WorldCom’s competitors, inaccurately believing that WorldCom’s strategy was succeeding, followed its lead by over-investing in broadband capacity, which ultimately led to a large oversupply and to layoffs of thousands of workers.114 Above and beyond the massive loss to WorldCom shareholders, the fraud caused its competitors’ investors to lose $7.8 billion115 and inflicted losses to social welfare of $49 billion, according to one study.116

The adverse economic impact of WorldCom’s fraudulent activity was typical for such schemes. Kedia and Philippon found that “[i]n equilibrium, [fraud firms] hire and invest too much, distorting the allocation of real resources. In short, it is not sufficient to merely misreport performance. Poor quality firms also have to mimic higher quality firms in their investment and hiring decisions.”117 The authors concluded that “the publicly traded firms that restated their earnings in 2000 and 2001 lost between 250,000 and 600,000 jobs . . . .”118 Again, if SOX 404 produces a meaningful improvement in corporate reporting, the benefits in improved allocation of resources could easily outweigh

management “distorts information flow and that its impact on stock returns is economically

significant”).

112 Gil Sadka, The Economic Consequences of Accounting Fraud in Product Markets: Theory

and a Case from the U.S. Telecommunications Industry (WorldCom) 26-27 (June 1, 2006)

(unpublished manuscript), available at http://ssrn.com/abstract=906153 (theorizing and finding

that managers committing financial fraud will make nonoptimal pricing decisions as well).

113 See Merle Erickson et al., How Much Will Firms Pay for Earnings That Do Not Exist?

Evidence of Taxes Paid on Allegedly Fraudulent Earnings, 79 ACCT. REV. 387, 389 (2004)

(finding that firms that restated their financials following SEC allegations of accounting fraud

from 1996 to 2002 paid $320 million in income taxes “as a result of overstating earnings by

approximately $3.36 billion”).

114 See Joshua Chaffin & Peter Thal Larsen, Called to Account, FIN. TIMES, Aug. 6, 2003, at

15 (“Spurred on by WorldCom’s apparent success, . . .[some competitors] made foolish

acquisitions [while o]thers wasted billions of dollars building networks to carry a wave of data

that did not arrive.”); James Surowiecki, SARBOXED In?, NEW YORKER, Dec. 12, 2005, at 46

(“WorldCom’s deception . . . led to the misallocation of billions of dollars in capital across an

entire industry, and rearranged the lives of tens of thousands of workers.”).

115 J. Gregory Sidak, The Failure of Good Intentions: The WorldCom Fraud and the Collapse

of American Telecommunications After Deregulation, 20 YALE J. ON REG. 207, 235 (2003).

116 Gil Sadka, The Economic Consequences of Accounting Fraud in Product Markets: Theory

and a Case from the U.S. Telecommunications Industry (WorldCom), 8 AM. L. & ECON. REV.

439, 463 (2006).

117 Simi Kedia & Thomas Philippon, The Economics of Fraudulent Accounting 2 (Jan. 2005)

(unpublished manuscript), available at http://ssrn.com/abstract=687225.

118 Id. at 4.



even extensive costs.119 In theory, SOX 404 should prevent and detect many misstatements,

some accidental and some fraudulent.120 But how much fraud will be prevented cannot be known with precision. SOX 404 has been compared to a metal detector at an airport—you know how much it costs, but you will never be able to measure how many airplanes it prevents from flying into buildings.

No major domestic corporate scandals have been uncovered since SOX was implemented, other than the options back-dating scandal that occurred almost exclusively before July 2002. Although SOX critics had predicted a huge explosion of SOX-driven litigation, once SOX 404 was largely implemented, class action securities filings began declining substantially. There were fewer suits in 2005 than in 2004,121 and from mid-2005 through 2006, filings dropped 40% below the prevailing 10-year average.122 The filings in 2006 were the lowest in more than a decade,123 and claimed only $198 billion in shareholder losses, as compared with an annual average over the previous ten years of $683 billion.124 Grundfest has suggested that a prime reason there are fewer fraud suits for smaller dollar amounts is that SOX has deterred fraud.125 Obviously, class action filing level is only the roughest indicator of the drop in actual fraud.126 It reflects non-SOX influences as well as the

119 Richard Breeden has noted (colorfully) that “[t]he cost of 404 in the aggregate from every

single public company is about one ten-millionth of the cost of executive compensation. I don’t

hear anybody saying we should get rid of executive compensation.” Glass, Lewis & Co., Getting

It Wrong the First Time 9 (March 2, 2006) (quoting a Reuters report on a Breeden speech).

120 See A Price Worth Paying?, supra note 9 (quoting Dennis Nally, chair of PwC, to the

effect that SOX should lead to “fewer incidents involving accounting fraud”); J. Robert Brown,

Jr., Criticizing the Critics: Sarbanes-Oxley and Quack Corporate Governance, 90 MARQ. L. REV.

309, 326 n.53 (2006) [hereinafter Brown, Criticizing] (suggesting that although “reforming

internal controls will not ‘prevent’ all fraud, . . . reducing the control of the CEO and CFO over

the finances by empowering the audit committee and accounting firms will prevent some

instances of it”); Nelson, supra note 105, at 8 (noting that improvement in internal controls

mandated by SOX 404 “should reduce the level of pre-audit misstatement that auditors must

detect and increase the amount of effort auditors expend on auditing. Sound controls and more

auditing should prevent and detect many misstatements”).

Critic Robert Clark concedes that SOX may deter or allow detection of some frauds but

gives several reasons why its impact may be modest. See Clark, supra note 16, at 29-30.

121 CORNERSTONE RESEARCH, SECURITIES CLASS ACTION CASE FILINGS 2006: A YEAR IN

REVIEW 3 (2007).

122 Id. at 1.

123 Id. at 3; see also TODD FOSTER ET AL., NERA ECON. CONSULTING, RECENT TRENDS IN

SHAREHOLDER CLASS ACTION LITIGATION: FILINGS PLUMMET, SETTLEMENTS SOAR 1 (2007)

(“2006 federal [securities fraud class action] filings are at the lowest level since 1996—a year that

was itself unusually low because many filings were moved to state courts in an attempt to bypass

the restrictions imposed by the 1995 passage of the [PSLRA].”).

124 Joseph A. Grundfest, The Class-Action Market, WALL ST. J., Feb. 7, 2007, at A15 (noting

that the $198 billion figure excludes claims from the one-time options back-dating cases).

125 Id.

126 This is especially so because the number of SEC enforcement actions rose substantially



impact of other provisions of SOX (increases in penalties for fraud, improved corporate governance,127 more generous SEC budget, etc.). Nonetheless, it seems unlikely that SOX 404 is unconnected to this large drop in fraud litigation. A significant reduction in securities fraud can produce benefits measured in the billions of dollars and dwarf even the most extravagant estimates of SOX 404’s implementation costs.128

Is there any evidence that SOX 404 is uncovering frauds? As it happens, yes. SOX 404, coupled with SOX 403, that required companies to report grants to executives within two business days (substantially narrowing the window for abuse),129 helped limit the opportunity that executives had to backdate stock options.130 Bernile et al. studied the market reaction to backdating and concluded that shareholders in 100 companies involved in the scandal had lost $100 billion to $250 billion in market value.131 Although the executives profited just a small percentage of that number, the authors noted that “[b]ecause options backdating is so blatantly wrong and corrupt, and the practice usually involves the company’s top executives, the agency costs of a publicly traded company increases dramatically on any news of such a scandal.”132 Even at the low end of the scale, avoided losses

during the period, although this was likely due in substantial part to an increase in resources

provided by SOX. GOV’T ACCOUNTABILITY OFFICE, FINANCIAL RESTATEMENTS: UPDATE OF

PUBLIC COMPANY TRENDS, MARKET IMPACTS, AND REGULATORY ENFORCEMENT ACTIVITIES 6

(2006). Still, the McKinsey Report attributes the decline, in part, to enactment of SOX.

MCKINSEY REPORT, supra note 3, at 74.

127 CORNERSTONE RESEARCH, supra note 121, at 9 (“[T]he lower number of filings and

associated market capitalization losses may in part be a result of improvements in corporate

governance following high profile filings such as Enron and WorldCom and the passage of the

Sarbanes-Oxley Act of 2002.”).

128 Id. at 1 (“If market capitalization losses are measured as of the last day of the class period,

typically the day on which the alleged fraud is disclosed (Disclosure Dollar Loss), the losses

decreased by 44 percent from $93 billion in 2005 to $52 billion in 2006. If market capitalization

losses are instead measured by the largest capitalization decline experienced during the class

period (Maximum Dollar Loss) then losses decreased by 19 percent from $362 billion in 2005 to

$294 billion in 2006. These dramatic declines are even starker when options backdating claims

are excluded from the sample on the theory that these cases are unlikely to be repeated.”).

129 See Fleischer, supra note 18, at 7.

130 See Jie Cai, Executive Stock Option Exercises: Good Timing or Backdating? 1 (Feb. 2007)

(unpublished manuscript), available at http://ssrn.com/abstract=951693 (noting that the price

pattern of stock options that indicates backdating weakened considerably after SOX was passed);

Fleischer, supra note 18, at 25 (“Sarbanes-Oxley stopped the [backdating] practice by limiting the

opportunity to backdate and implementing internal controls on the executive compensation

practice.”).

131 Gennaro Bernile et al., The Effect of the Options Backdating Scandal on the Stock-Price

Performance of 110 Accused Companies 11 (Simon School of Business, Working Paper No. FR

06-10, 2006) (Dec. 21, 2006), available at http://ssrn.com/abstract=952524.

132 Id. The authors go on to note

[i]ncreased agency costs means that the cost of equity capital will increase

significantly, as the marketplace discounts the increased riskiness of investing in the

stock of afflicted firms. This would explain why stock prices decline so much even



of $100 billion would likely pay for all SOX 404 audits for large public companies for a generation.

The tightening up of internal controls also enabled many companies to detect (or perhaps made it difficult for them to continue to conceal) illicit payments that violate the FCPA’s anti-bribery rules.133 By improving enforcement of FCPA antibribery provisions, SOX 404 should improve the allocation of assets in the global economy, ensuring that around the world, government contracts are more likely to go to the best qualified bidder, not the most flagrantly dishonest.134

Finally, HealthSouth’s CFO resigned in August of 2002 rather than sign the SOX 302 certification. That resignation led directly to the unraveling of HealthSouth’s multibillion dollar fraud.135

Overall, there is substantial evidence that SOX 404 has helped revive U.S. capital markets, reform corporate governance (which carries a broad range of benefits), and improve market liquidity, financial reporting accuracy, and fraud detection. The costs of implementing SOX 404 are very large in an absolute sense, but much more modest relative to potential benefits stemming from improved market efficiency, better asset allocation, and fraud avoidance. Perhaps for these reasons, a survey of directors recently indicated that “81 percent of senior executives reported SOX 404 compliance as a success and 76 percent of senior executives believe SOX 404 compliance has motivated improved internal controls.”136

III. THE INDICTMENTS AGAINST SOX 404

A law that has seemingly obtained its objectives, both short-term

(restore investor confidence) and long-term (improve financial transparency, market liquidity, corporate governance, and fraud prevention) will normally be considered a success, or at least receive the

though future cash flows are not much affected by options backdating. Agency costs

reduce stock prices by causing discount rates to increase, rather than affecting future

cash flows from operations.

Id. at 12.

133 See Michael T. Burr, Corporations Caught in Rising Tide of FCPA Enforcement, CORP.

LEGAL TIMES, Nov. 2005, at 22.

134 See Steven R. Salbu, Bribery in the Global Market: A Critical Analysis of the Foreign

Corrupt Practices Act, 54 WASH. & LEE. L. REV. 229, 249 (“The payment of bribes is wasteful

and inefficient and has been found to be associated with low economic growth . . . .”).

135 See Steven M. Salky & Adam L. Rosman, SOX on Trial, DEAL, June 6, 2005 (noting that

CFO Weston Smith initially resigned rather than sign the SEC-required certification in August

2002).

136 Sarbanes-Oxley at Four: Protecting Investors and Strengthening Markets, Hearing Before

the H. Comm. on Fin. Servs., 109th Cong. 2 (2006) (statement of Rep. Michael Oxley).



benefit of the doubt in that regard. Yet, SOX 404 has been barraged with denunciations since its inception. This section focuses upon the two primary categories of complaint: (a) the direct cost for companies that must implement and maintain its provisions, and (b) the indirect impact upon the competitiveness of U.S. securities markets.

A. Direct Costs of Implementation and Maintenance

Even plentiful benefits flowing from SOX 404 may not outweigh

its implementation and maintenance costs that have greatly exceeded the SEC’s original expectations.137 One commonly reported number is that the cost for implementing SOX in 2004 was $4.36 million for the average public company.138 Another study found SOX 404 costs average $4 million for large companies139 and $1.2 million for smaller firms.140 Although SOX 404 costs have been undeniably high, the figures reported in these surveys cannot necessarily be trusted because the respondents had every reason to exaggerate SOX’s costs.141 Certainly some of these expenses would have been incurred even in the absence of SOX because the Enron-era scandals highlighted widespread problems with public companies’ internal controls that simply had to be addressed.142 Some corporate managers have admitted that many internal control expenditures have been for improvements that firms had for years needed and wanted to make. Although SOX finally required

137 The SEC erred badly when it guessed that SOX would cost issuing firms only $91,000, on

average. Cone, supra note 58. Commissioner Atkins has admitted that the Commission

underestimated by a factor of 20. See Paul S. Atkins, Comm’r, Sec. & Exch. Comm’n, Speech by

SEC Commissioner: Remarks Before the Securities Regulation Institute (Jan. 19, 2006), available

at http://www.sec.gov/news/speech/spch011906psa.htm.

138 CCMR REPORT, supra note 4, at ES-5.

139 CRA Int’l, Inc., Sarbanes-Oxley Section 404 Costs and Implementation Issues: Spring

2006 Survey Update 10 (Apr. 17, 2006), http://www.s-

oxinternalcontrolinfo.com/pdfs/CRA_III.pdf.

140 The Trial of Sarbanes-Oxley; Regulating Business, 371 ECONOMIST 69 (Apr. 22, 2006). A

July 2004 survey of financial executives indicated that smaller firms would spend an extra $3

million to comply with SOX, and that firms with over $5 billion in revenue would spend an

average of $8 million. Fin. Executives Int’l, FEI Special Survey on Sarbanes-Oxley Section 404

Implementation (July 2004), http://www.404institute.com/docs/SOXSurveyJuly.pdf.

141 See Kara Scannell & David Reilly, SEC Seems Unwilling to Exempt Little Guys From

Internal Controls; There May Be a Saner Approach, WALL ST. J., Apr. 6, 2006, at C1 (quoting

Robert Kueppers, deputy chief executive of Deloitte & Touche LLP as saying “We’ve all seen

cost numbers that are overblown attributed to 404”).

142 See Jeremy Grant, Fears Over Cost of Company Inspections, FIN. TIMES (London), Nov. 7,

2006, at 31 (quoting Mark Olson, chair of the PCAOB as noting that there had been a “rising

expectation of an enhanced control environment” so that “[e]ven if there had not been 404 you

would still see more energy and more effort and therefore more cost directed towards enhanced

controls”).



those expenditures, it is unfair to attribute them wholly to SOX 404.143 One major component of the reported costs is the increase in

average audit fees, which among Fortune 1000 companies rose by an average of $2.3 million from 2003 to 2004.144 Publicly traded banks have claimed an increase in audit fees of seventy five percent.145 These are substantial increases, even though, looked at in the aggregate, auditing remains a bargain, “less than 1/10 of one percent of aggregate client sales.”146 Furthermore, there are many other causes of this increase in audit fees, including: (a) post-SOX, auditors are being more thorough because they are genuinely worried about being held accountable for their “screw-ups” as they might not have been for a while after passage of the PSLRA in 1995,147 (b) SOX’s provisions on non-audit services ended low-balling to attract consulting fees,148 and (c) Arthur Andersen’s demise reduced competition. Nonetheless, there is no doubt that SOX requires more auditing and therefore is responsible for a substantial part of the large increase in audit fees.149

However, even if one accepts the critics’ figures, that in 2005 public companies spent $6.1 billion to comply with SOX and attributes them all to SOX 404,150 this figure is only the tiniest fraction of public company revenues.151 Home Depot, which recently paid a failed CEO

143 See O’Hara, supra note 109, at D1 (quoting Kurt Schacht, managing director of the Centre

for Financial Market Integrity at the CFA Institute as saying “[w]hat you’re seeing in essence is

deferred maintenance, the fixing of internal controls that have been neglected”); Mark Trumbull,

Fraud Law Spurs Backlash, Then Buy-in, CHRISTIAN SCI. MONITOR, Apr. 7, 2006, at 3 (citing an

AMR Research survey in which 75% of executives indicated that “their investments in

compliance procedures would support other activities”).

144 Susan W. Eldridge & Burch T. Kealey, SOX Costs: Auditor Attestation Under Section 404,

at 2 (June 13, 2005), available at http://ssrn.com/abstract=743285.

145 Stephen V. Falanga, Sarbanes-Oxley Impact on Banks Under Review, METROPOLITAN

CORP. COUNS., Apr. 2006, at 16.

146 Francis, supra note 111, at 360.

147 After the PSLRA, the number of class action lawsuits filed annual against auditors went

from more than a hundred to fewer than ten. There is substantial evidence that audit quality

declined and “[t]he most plausible inference from this particular evidence is that the decline was

mainly a reaction to a reduction in the liability threat faced by auditors as a result of the Supreme

Court’s Central Bank decision . . . and the [PSLRA].” Langevoort, Social Construction, supra

note 2, at 9.

148 See Andras Marosi & Nadia Massoud, Why Do Firms Go Dark? 6 (2004) (unpublished

manuscript), available at http://ssrn.com/abstract=570421 (noting that SOX’s restrictions on

consulting has “reduced the potential for cross-subsidization of audit fees”); Dale R. Rietberg,

Note, Auditor Changes and Opinion Shopping—A Proposed Solution, 22 U. MICH. J.L. REFORM

211, 220 (1988) (quoting auditors explaining their motivation for low-balling).

149 See, e.g., Sharad Asthana et al., The Effect of Enron, Andersen, and Sarbanes-Oxley on the

Market for Audit Services 22-23 (June 2004), available at http://ssrn.com/abstract=560963.

150 Richard W. Rahn, Destructive Government, WASH. TIMES, June 16, 2005, at A18 (citing

the $6.1 billion figure as total SOX compliance costs for regulated firms in 2005); Richard W.

Rahn, Destructive Government, WASH. TIMES, June 16, 2005, at A18

151 See Cone, supra note 58 (noting that $8 million for a firm with at least $5 billion in

revenue is just a drop in the bucket). Still, the price tag for small firms is much higher on a



$210 million just to leave,152 has complained about the $1 million it must pay to support the PCAOB each year,153 even though this is but .0000012 of its annual revenue of $81.5 billion. 154 Put another way, SOX’s total costs are but an insignificant percentage of the $7 trillion the stock market lost between 2000 and 2002, but has regained since SOX was enacted. Much of that original decline was caused by corporate scandals of the type SOX 404 aims to prevent.155 SOX 404 costs are but a small percentage of the $70 billion that Enron shareholders lost, the $50 billion that Global Crossing shareholders lost, and the more than $100 billion that WorldCom shareholders lost, all due to fraud.156 These numbers suggest that if SOX 404 can prevent just one big fraud every decade or so, it can pay for itself.

Additionally, SOX 404 costs have generally come down substantially after initial implementation, which is more expensive than annual maintenance. A 2006 study found a 44% drop for larger companies and a 30% drop for smaller firms.157 Two important reasons for the decline are (a) software improvements making the internal control monitoring process more efficient, and (b) firms becoming a little more relaxed–for a time firms all overdid it because no CEO or auditor wanted to be the next headline in The Wall Street Journal.158

Costs will continue to decline because the SEC and PCAOB have (quite belatedly) begun to issue guidance aimed at reducing costs by

percentage basis, obviously. The Hackett Group’s chief research officer was recently quoted as

indicating that overall SOX compliance and auditing costs are 2.5% of revenue for big public

companies, and only 1.4% for “world class” operations. Lorraine Woellert, The SEC Opens Up

SarbOx, BUS.WK. ONLINE, Dec. 5, 2006,

http://businessweek.com/bwdaily/dnflash/content/dec2006/db20061205_761982.htm (quoting

Richard T. Roth).

152 Jay Bookman, Win-Win Gifts for CEO Losers, TIMES UNION (Albany, N.Y.), Jan. 8, 2007,

at A7 (noting that despite the fact that “Bob Nardelli was, by almost any measure, a failure at his

job,” he takes home a package of benefits worth $210 million after being pushed out as CEO of

Home Depot).

153 Brian Grow et al., The Debate Over Doing Good; Some Companies Are Taking a More

Strategic Tack on Social Responsibility. Should they?, BUS. WK., Aug. 15, 2005, at 76 (noting

the $1 million figure).

154 Roger Amsden, Gilford Lowe’s to Open Next Month, May Get Home Depot As a Neighbor

UNION LEADER (Manchester, N.H.), Dec. 2, 2006, at C1 (noting the annual revenue figure).

155 Edward Iwata, Enron’s Legacy: Scandal Marked Turning Point For Business World;

Impact Felt in Energy Trading, Lawsuits, Corporate Governance and Regulations, USA TODAY,

Jan. 30, 2006, at 4B (noting that “much of [the $7 trillion decline occurred] because of the

corporate scandals and the Sept. 11 attacks, say analysts, economists and scholars”).

156 See Thomas Kostigen, Cox Will Have to Walk Fine Line at SEC, MARKETWATCH, June 7,

2005.

157 Companies Start to Feel Less of a Pinch, ACCOUNTANT, Apr. 30, 2006, at 5 (reporting

results of study commissioned by the Big Four).

158 See Caroline McCarthy, Is Silicon Valley Strangled by SOX?, CNET NEWS.COM, Jan. 18,

2007, http://news.com.com/Is-Silicon-Valley-strangled-by-SOX/2100-1014_3-6151059.html

(quoting Accenture Partner Les S. Stone).



clarifying what they expect under SOX 404.159 Because what was required was unclear and corporate managers were risk-averse (and not unreasonably so), auditors exercised the whip hand and seemingly took advantage in order to replace the consulting revenues they lost because of Sarbanes-Oxley with 404 audit revenues.160 By clarifying the need for firms to focus on the kinds of internal processes that create the highest risks to the integrity of financial statements (and to skip trivial matters such as checking employee timesheets), the new guidelines should help to restore the proper balance between auditor and client, thereby continuing to reduce costs.161

All told, SOX 404’s costs should soon be a relatively minor concern for large public companies. However, its costs are potentially very burdensome for small firms,162 a fact that has created much controversy163 and induced the SEC to repeatedly postpone SOX 404’s application to smaller firms.164 Because of economies of scale, most

159 In December 2006, the SEC sent a strong signal that 404 audits should concentrate on

important matters and not trivia. See Norris, supra note 59, at 2 (noting that the purpose of the

reforms is to allow auditors to do less work and charge less money when assessing internal

controls). The SEC had attempted to give similar guidance a year previously, but it was generally

ignored. Id. In April of 2007, the Commission again threw its weight behind the finalizing of

new guidelines aimed at making SOX 404 audit guidelines clearer and cheaper to apply. Jeremy

Grant, SEC Pushes Clearer Sarbox Guide, FIN. TIMES (London), Apr. 5, 2007, at 21.

Observers had been calling for such guidance for some time. See Parveen P. Gupta & Tim

Leech, Making Sarbanes-Oxley 404 Work: Reducing Cost, Increasing Effectiveness, 3 INT’L J.

DISCLOSURE & GOVERNANCE 27, 46 (2006) (calling SOX 404 “a well-intended and necessary

piece of legislation that has, unfortunately, lost its way during its implementation”); David M.

Katz, Sarbox on Ice?, CFO.COM, Feb. 1, 2007,

http://www.cfo.com/article.cfm/8628974?f=search. (noting that even the SEC blames the PCAOB

for poor implementation of 404, especially delayed guidance as to what is expected in 404

audits),

160 As one consultant noted, “[i]f the external auditors said ‘we want you to run around the

building three times before you pay a bill’, the company being checked would do that. That’s

how absurd it got.” Jeremy Grant, SEC Looks to Add Clarity to Section 404, FIN. TIMES

(London), Dec. 14, 2006, at 19 [hereinafter Grant, Add Clarity] (quoting accounting consultant

Tony Zecca); see Langevoort, Social Construction, supra note 2, at 14 (noting that accountants,

lawyers, and consultants all engaged in rent-seeking post-SOX by pushing a broad interpretation

of its language and noting that “[t]he regulators are now backing off that breadth with remarkable

alacrity”).

161 Grant, Add Clarity, supra note 160, at 19 (citing SEC commissioner Paul Atkins).

162 Bryan and Lilien, for example, found that firms with material internal control weaknesses

tend to be smaller firms, and question whether the high cost of SOX for all firms can justify

improving the financial reporting of mostly small firms. Bryan & Lilien, supra note 27, at 25.

163 Malone writes that SOX “is almost perfectly designed to crush new business creation”

because the average annual cost of SOX compliance, which he estimates at $3.5 million, is

“pocket change” for a Fortune 500 company but the entire annual profit of a newly public firm.

Michael S. Malone, The Pump-and-Dump Economy, WALL ST. J., Dec. 21, 2006, at A16 (noting

that this is why small firms now are aiming less at going public and more at being acquired by

established firms).

164 At the time of the writing of this Article in early 2007, small firms are expected to comply

with 404 in their 10-Ks filed for fiscal years ending on or after December 15, 2007.



production, purchasing and other operational costs fall disproportionately on small firms, as do virtually all regulatory costs.165 Therefore, it is not surprising that SOX 404 compliance costs do as well.166

The SEC has carefully studied whether it should exempt small firms from SOX 404’s requirements.167 The strongest argument against exemption is that small firms tend to have the greatest problems maintaining effective internal controls168 and consequently are the ripest ground for financial fraud and internal misappropriation. Small-cap and microcap companies that many believe should be exempted from SOX 404 accounted for 59% of the financial restatements by public companies in 2005.169 In 2006, the number of restatements by large firms subject to SOX 404 fell by 20% while those among smaller firms not yet subject to SOX 404 rose by 42%.170 The most plausible difference for the divergence of these trends is that the larger firms’ internal controls are working better.171 Additionally, as noted earlier, if firms are not subject to SOX 404’s audit requirement, they are less likely to report material weaknesses that do exist.172

This controversy is reminiscent of an early FCPA debate. For example, in SEC v. World-Wide Coin Investments, Ltd.,173 the defendant firm argued that it was too small to be able to afford FCPA-mandated internal accounting controls. The court rejected the defense, pointing out that the firm was a prime example of why every company, no matter

165 See Victor Godinez, Small Firms See Minimal Job Growth, DALLAS MORNING NEWS, Jan.

15, 2006, at 4D (“[E]conomies of scale don’t just apply to things such as buying concrete or

office supplies. Small firms are also at a disadvantage compared with larger firms when it comes

to the cost of complying with federal regulations . . . .”).

166 See The U.S. Handtool and Cutlery Manufacturing Industry is Fairly Concentrated with

the 50 Largest Companies Holding More than 65 Percent of the Market, BUS. WIRE, Mar. 20,

2006 (“Large companies have economies of scale in purchasing and production.”).

167 See Larry E. Ribstein, Sarbanes-Oxley After Three Years 20 (Ill. Law & Econ. Working

Paper Series, Working Paper No. LE05-016 2005) (June 20, 2005), available at

http://ssrn.com/abstract=746884 (noting that the SEC delayed application of SOX 404 to small

firms, held a roundtable on implementing SOX 404, and established an advisory committee to

study SOX 404’s effects on small firms).

168 Bedard et al., supra note 93, at 18 (citing studies finding that “smaller, more complex

companies who are financially weaker and experience changes are more prone to disclose

material weaknesses”); Glass, Lewis & Co., Getting It Wrong, supra note 119, at 1 (noting that

“the smallest companies are where strong internal controls arguably are needed most, because

they are where the risk of restatement is the highest”); Lord & Benoit, Bridging, supra note 91, at

3 (finding in empirical study that “[t]he highest rates of material weaknesses in Section 404

internal controls over financial reporting will be SmallCap and MicroCap companies with

revenue below $250 million”).

169 Scannell & Reilly, supra note 141, at C1 (quoting report by Glass, Lewis & Co.).

170 David Reilly, Restatements Still Bedevil Firms, WALL ST. J., Feb. 12, 2007, at C7.

171 Id. (quoting Mark Cheffers, CEO of AuditAnalytics, author of the study).

172 Bedard et al., supra note 93, at 20.

173 567 F. Supp. 724 (N.D. Ga. 1983).



how small, needs effective internal accounting controls, because it was the lack of such controls that had allowed the individual defendants to run the firm into the ground.174 Today, poor controls disadvantage small firms in numerous ways, including making it difficult to recruit high quality employees175 and to attract investors.176 Many small firms fail because of poor internal controls.177

A strong riposte to the claim of small firm vulnerability to fraud is that investors should realize that there are greater risks of all types in investing in smaller companies and therefore the SEC should not worry as much about providing protection from misstatements when regulating small firms as it does when regulating large firms.178

Furthermore, there are empirical studies indicating that some benefits from regulation accrue primarily to large public companies and that for smaller firms costs may outweigh benefits. For example, Chhaochharia and Grinstein found that SOX’s requirement of completely independent audit committee membership substantially benefited large and medium-sized firms, but not smaller firms.179 Bruno and Claessens, also studying primarily board independence, found “evidence that strong corporate governance practices pay off less for small companies, maybe because strong corporate governance practices involve costs in terms of monitoring, time and resources which offset the benefits.”180 Although neither of these studies involved SOX 404,

174 Id. at 751-52. Internal controls at the firm were virtually nonexistent. The vault was left

open and unguarded all day. Rare coins were left unattended. There was no separation of duties;

one employee could appraise a coin, purchase that coin with a company check, count the coin into

inventory, value it for inventory purposes and then sell it, all without review from any other

employee. Unbonded employees were allowed to take large amounts of inventory off premises

without giving a receipt. Purchase orders were so poorly documented that the cost of inventory

could not be determined. All employees had access to presigned checks and there were no dollar

amount limitations on employees’ authority to write checks. Approximately $1.7 million in

checks were written to the CEO, his affiliates, or cash without supporting documentation about of

their purpose. Id. at 738-40. Small wonder the firm failed.

175 Hating Higgs, ECONOMIST, Mar. 15, 2003, at 79 (quoting executive search firm officer as

saying that it is harder for small firms “to recruit high-quality non-executives, because they often

have weaker financial controls,” among other problems).

176 See Carl Mortished, Flotations, TIMES (London), Dec. 30, 1997, at 22 (noting that “[m]ost

small companies are deservedly small. They are rotten investments because of their weak

managements, small markets, and bad financial controls.”).

177 Larry E. Rittenberg et al., Internal Control Guidance: Not Just a Small Matter, J. ACCT.,

Mar. 2007, at 46.

178 See Aegis J. Frumento, SOX: One Size Doesn’t Fit All, CORP. COMPLIANCE &

REGULATORY NEWSLETTER, May 5, 2006.

179 Vidhi Chhaochharia & Yaniv Grinstein, Corporate Governance and Firm Value: The

Impact of the 2002 Governance Rules, 62 J. FIN. 1789, 1810 (2007).

180 Valentina G. Bruno & Stijn Claessens, Corporate Governance and Regulation: Can There

Be Too Much of a Good Thing? 4 (World Bank Policy Research, Working Paper No. 4140, 2007)

(Oct. 2007), available at http://ssrn.cm/abstract=956329 (finding that the benefits of strong

corporate governance benefit primarily large firms and firms heavily dependent on outside



both make it eminently plausible that although effective internal controls likely produce benefits for firms of all sizes, costs could exceed benefits for small firms.

Many believe that the biggest mistake the SEC has made in the post-SOX era is its failure (at this writing, at least)181 to exempt smaller public companies from SOX 404.182 There is at least some indirect empirical support for the argument, although at the moment the debate is inconclusive. The SEC has studied this issuer closer than any other SOX-related question facing it, but clearly it must continue its due diligence, paying particular attention to the empirical evidence as it is uncovered. It is an intensely difficult issue because there is no doubt that SOX 404’s costs disproportionately burden small firms, yet studies show that in the absence of an audit, small firms are much less likely to report internal control deficiencies.183 Also, as noted, Bedard and his colleagues concluded that improvements in corporate governance and external audit of controls were needed to improve the financial reporting of small firms.184

Overall, it is probably impossible at this time to determine whether SOX 404’s benefits outweigh its costs, 185 but there is strong evidence of concrete benefits in the form of greater investor confidence, greater market liquidity, more accurate corporate reporting, fewer restatements, lower capital costs, and improved fraud detection and prevention.

financing).

181 In a December 2006 release, the SEC granted non-accelerated filers with less than $75

million in market cap until December 15, 2007 to file a Section 404 Management Report and a

year beyond that to file a 404 Auditor’s Attestation. Internal Control Over Financial Reporting,

Exchange Act Release Nos. 33-8760, 34-54942 (Dec. 15 2006), available at

http://www.sec.gov/rules/final/2006/33-8760.pdf.

182 See Problems With SOX: SEC Should Lighten Burden and Exempt Small Businesses, FIN.

TIMES (London), May 19, 2006, at 14 (noting that the SEC’s “most pressing concern [in coming

months] must be to address the incentive for the big four accounting firms to pile ever greater

disclosure requirements on companies’ internal controls”).

183 Some claim that the cost of SOX 404 compliance for even very small firms will be

$900,000 per year. Marie Leone, 404 Makes an IPO: Mission Impossible, CFO.COM, May 9,

2006, http://cfo.com/article.cfm/6908122?f=search. If that number is anywhere near correct, it is

obvious that the SEC and PCAOB must exempt these firms from SOX compliance. On the other

hand, COSO has issued guidelines for small firms aimed at reducing 404 compliance costs for

them, consistent with the SEC and PCAOB’s December 2006 attempts to bring down costs.

Consulting firm Lord & Benoit claims that it recently implemented controls in a small firm

consistent with the new COSO guidelines for less than $25,000. If small firms can install

controls for somewhere near that dollar figure, then 404 should soon be of minor concern to small

firms as it is becoming for large public firms. First SOX Compliance Firm to Use COSO for

Smaller Companies, BUS. WIRE, Oct. 25, 2006.

184 See supra notes 92-93 and accompanying text.

185 Adam C. Pritchard, The Irrational Auditor and Irrational Liability 3 (John M. Olin Ctr. for

Law & Econ. Working Paper Series, Paper No. 57, 2005), available at

http://law.bepress.com/umichlwps/olin/art57 (“Are investors receiving better, more accurate

information? Almost certainly. Is it worth the cost? We don’t know.”).



There is also enough evidence regarding the burden SOX 404 places upon small firms that the matter must, at a minimum, remain the subject of additional study.

B. Impact upon the Competitiveness of U.S. Securities Markets

Beyond direct costs, the most urgent complaint about SOX 404 is

its impact on the competitiveness of U.S. securities markets. Because the U.S. share of global stock market activity in 2005 was about 50%, slightly higher than the 47% figure of a decade before,186 these complaints should be closely scrutinized. Even according to its critics, SOX 404 is not the sole or perhaps even primary part of Sarbanes-Oxley allegedly causing competitiveness problems, and there are also numerous non-legal factors adversely affecting the U.S. securities industry that no rollbacks of any portion of SOX could impact. As a final introductory point, over the last decade foreign capital markets have gained on U.S. markets by some measures187 while their governments increased rather than decreased the stringency of their securities regulation.188 In other words, foreign markets have been gaining competitively by imitating U.S. capital market regulation.

1. Discouraging IPOs

a. Is SOX 404 Reducing the Number of U.S. Firms Going Public?

SOX 404 is widely blamed for reducing the number of U.S. firms

going public. The number of IPOs has been trending downward in the U.S., but it is unclear that this is a long-term situation. IPO trends wax and wane. There were more U.S. IPOs in 2006 than in 2005, and the

186 CCMR REPORT, supra note 4, at ES-2.

187 See id. at ES-3 (noting that a study of trading volume for cross-listed stocks from 1980-

2001 found a gradual shift to a much higher percentage in home markets, concluding that “[t]he

historical competitive advantage of liquidity that has been a feature of the U.S. market has

diminished”).

188 European markets apparently learned their lesson. Pagano and colleagues found that from

1986 to 1997, U.S. markets did much better than European markets at attracting foreign cross-

listings because “the United States offers lower trading costs, tighter accounting standards, and

better shareholder protection than most European countries.” Marco Pagano et al., The

Geography of Equity Listing: Why Do Companies List Abroad?, 57 J. FIN. 2651, 2685 (2002).

Over the last decade or so, European countries have raised accounting standards, improved

corporate governance, and strengthened securities regulation. Robert A. Prentice, The

Inevitability of a Strong SEC, 91 CORNELL L. REV. 775, 832-38 (2006) [hereinafter Prentice,

Strong SEC] (summarizing world-wide emulation of American securities standards).



number rose especially late in the year.189 In November of 2006, just as the CCMR was issuing its report decrying SOX’s impact on America’s share of IPOs, 32 companies from around the world raised $8 billion in the best single month for the U.S. market in more than five years.190 This may be just a blip, but that seems unlikely since stock market flotation hit a seven-year high in the first quarter of 2007191 and Silicon Valley IPOs appear set to explode.192

A recent survey of CFOs of companies found that the main reason for remaining private is to preserve decision-making control and ownership and that only 19% cited Sarbanes-Oxley as deterring going public.193 Furthermore, SOX critics tend to ignore other factors contributing to the recent trend of reduced IPOs. For example, many investors remember how much they lost investing in IPOs during the dot-com boom and are understandably reluctant to get back in the game that investment banks stacked in favor of their elite clients before SOX was passed.194 Also, Wall Street tends to ignore how its own high underwriting fees retard IPO activity.195

Additionally, part of the drop-off in IPOs is due to the burgeoning private equity sector.196 The founder of Home Depot has stated that had the burdens of SOX been around earlier, it is possible that Home Depot would never have happened.197 This is possible, but there is so much venture capital, private equity, and hedge fund money floating around in the economy, not to mention low interest rates, that it seems unlikely that too many truly promising business ideas will go wanting for

189 Cone, supra note 58 (noting that IPOs were on the rise in 2006).

190 Anuj Gangahar, U.S. Records Best Month for IPOs in Five Years, FIN. TIMES (London),

Dec. 1, 2006, at 15.

191 Anuj Gangahar, New York Sees Flurry of Listings, FT.COM, May 17, 2007,

http://www.ft.com/cms/s/ac68d01e-04bf-11dc-80ed-000b5df10621.html.

192 See Michael V. Copeland, 1 Setting Sail: A Tech IPO Armada, BUS. 2.0 (Mar. 2007)

(“Judging by the number of companies that have already filed or indicated that they might, 2007

is shaping up to be the biggest year for initial public offerings in the tech world since the end of

the dotcom bubble in 2000.”).

193 James C. Brau & Stanley E. Fawcett, Initial Public Offerings: An Analysis of Theory and

Practice, 61 J. FIN. 399, 423, 425 (2006). But see MCKINSEY REPORT, supra note 3, at 17, 77

(indicating in a survey-based report that business people in general have concerns about many

competitive factors, including perceived unfairness and unpredictability of U.S. legal system and

regulatory burdens, including SOX, proposed capital requirements of U.S. implementation of

Basel II accord, and requirement for foreign companies listing in U.S. to conform to U.S.

accounting standards).

194 Dale A. Oesterle, The High Cost of IPOs Depresses Venture Capital in the United States 1

(Moritz Coll. of Law Pub. Law & Legal Theory Working Paper Series, Paper No. 75, 2006)

(Aug. 2006), available at http://ssrn.com/abstract=923572.

195 Id. (noting that U.S. IPO markets “would be more active if IPOs were not so expensive”).

196 Cone, supra note 58 (noting that an abundance of private equity means that many firms can

find capital without going public that they couldn’t have found in previous years).

197 See John Berlau, A Nobel Prize for Pinpointing U.S. Greatness, INVESTOR’S BUS. DAILY,

Oct. 11, 2006, at A13 (quoting Home Depot co-founder Bernie Marcus).



funds.198 Venture capital firms have long been the driving force behind many IPOs, but they have learned that public offerings are no longer necessary in order to cash out. It is often easier “to recoup their entire investment by selling to another private-equity firm, rather than the small portion they typically sell in an IPO.”199 That said, small businesses benefit by having as many different ways to access capital as possible, and SOX’s costs seem definitely to have dampened the IPO route for small companies, although the impact is very difficult to measure.

b. Are More U.S. Firms Going Public Abroad?

The evidence here is also mixed. In 2006, Napo Pharmaceuticals

became the first U.S. company to go public on the London Stock Exchange’s Main Market, and SOX’s costs may have been a primary reason why.200 Additionally, a couple of large publicly traded private equity vehicles, such as KKR’s $5 billion fund raised through Euronext, held offerings abroad in large part to avoid U.S. regulatory burdens, such as SOX 404.201

On the other hand, even in 2000 at the zenith of the dot-com boom, six U.S.-domiciled companies chose to hold their IPOs abroad,202 so this is not a new phenomenon. While many have complained that U.S. firms are now going public on the mostly-unregulated Alternative Investment Market (AIM) in London, most of these firms have been so small that they could neither have attracted the interest of U.S. underwriters and investors nor met even pre-SOX listing requirements.203 Those firms that are larger may, depending on their

198 See Kevin Allison, Internet, Energy and Healthcare Attract VCs, FT.COM, Jan. 22, 2007,

http://search.ft.com/search?queryText=internet+healthcare+attract+vcs&x=0&y=0&aje=true&dse

=&dsz= (then click on article link) (“The amount of money poured into US start-ups [in 2006] hit

its highest level in five years . . . .”); Susan Harrigan, Out of the Public Eye, NEWSDAY (N.Y.),

Oct. 3, 2006, at A47 (noting that “a number of experts think the [going private] trend has less to

do with new laws and regulations than it does with a flood of cash that has become available” in

private equity funds recently); Steven Syre, Market Cops Taking Heat, BOSTON GLOBE, Nov. 30,

2006, at D1 (“[T]he world is swimming in capital, but the stock market may not always be the

best way for small companies to connect with investors.”).

199 Greg Ip et al., Trade Winds: In Call to Deregulate Business, a Global Twist, WALL ST. J.,

Jan. 25, 2007, at A1.

200 Eric Pan, Why the World No Longer Puts Its Stock in Us 5 (Benjamin N. Cardozo School

of Law, Jacob Burns Institute for Advanced Legal Studies, Working Paper No. 176, 2006) (Dec.

13, 2006), available at http://ssrn.com/abstract=951705.

201 Kathryn Tully, The Hunt for Liquidity Hits a Dry Patch, FIN. TIMES, Nov. 7, 2006, at 11.

202 MARIA PINELLI & JOSEPH A. MUSCAT, GLOBAL CAPITAL MARKET TRENDS 4 (Ernst &

Young 2007).

203 As of March 2006, only twenty nine of AIM’s 2,220 listed companies were based in the

U.S. and only seven of them were also dual-listed or otherwise trading in the U.S., indicating that



number of shareholders, still be subject to SOX 404’s requirements even if they list in London, making it clear that SOX 404 is not the driving force behind their decision.204

c. Are Foreign Firms Refusing to Go Public in the U.S.?

SOX 404 critics emphasize that in 2005, only one of the largest

twenty five global IPOs occurred in New York.205 Are the costs of SOX 404 significantly to blame in this regard? Probably not. Clearly, SOX cannot be saddled with the entire blame for this IPO trend for the simple reason that the U.S. share of global IPOs began declining long before SOX was enacted.206 Indeed, the U.S. portion of the global IPO market declined from about “60% to 8% from 1996 to 2001 and then increased after SOX to about 15%.”207

Many other factors are well recognized as contributing to the lagging U.S. share of IPOs, including, importantly, a weaker U.S. dollar.208 Also, there has been a tremendous increase in investment opportunities abroad which has led activity to go where the money is, which is no longer exclusively (or nearly so) New York.209 Additionally, U.S. investment banks have expanded around the world and taken IPO business with them. They have exported financial technology and deal techniques to European and Asian markets, allowing companies on those continents to follow a natural inclination

the other twenty two probably could not meet U.S. standards. Charles D. Niemeier, American

Competitiveness in International Capital Markets (Sept. 30, 2006), available at

http://www.pcaobus.org/News_and_Events/Events/2006/Speech/09-30_Niemeier.aspx.

204 CCMR REPORT, supra note 4, at ES-3 (noting that this fact makes it clear that “there are

many considerations that interact in complex ways when companies decide where to raise new

capital”).

205 John Gapper, The Big Apple’s Glory Days Have Passed, FIN. TIMES (London), Nov. 27,

2006, at 17 (citing Ernst & Young global map of total IPO activity). Overall, the US claimed

27% of total global value versus 42% for Europe, the Middle East and Africa, and 31% in Asia.

Id.

206 Jeremy Grant et al., The Cost of Compliance: As Listings Go Elsewhere, U.S. Regulators

Take a Fresh Look, FIN. TIMES (London), Nov. 20, 2006, at 15 [hereinafter Grant, Cost of

Compliance].

207 Posting of Jack Ciesielski to AAO Weblog, Counter-Conventional Wisdom on SOX 404

Costs, http://www.accountingobserver.com/Default.aspx?tabid=54 (Oct. 6, 2006 06:42 EST)

(referencing speech by PCAOB’s Niemeier); John C. Coffee, Fear of the U.S. Market, 29 NAT’L

L.J. 13, 13 (2006). On the other hand, looking just at IPOs over $1 billion, U.S. exchanges

attracted 57% of such offerings in 2001, but only 16% in the first ten months of 2006.

MCKINSEY REPORT, supra note 3, at 43.

208 Gapper, supra note 205, at 17.

209 Id. (noting that these two factors have led Americans to hold $3.1 trillion in foreign

equities in 2005 as compared to only $700 billion in 1995). See also Ip et al., supra note 199, at

A1 (“Trading across borders has become simpler, cutting the prestige and usefulness of a big-

country listing . . . .”).



to do things locally.210 “The rest of the world is getting better at this type of activity,”211 and a major reason is the export of technology, skill, and personnel by U.S. investment banks. When the Chinese ICBC bank went public in October 2006, it debuted simultaneously on the Hong Kong and Shanghai exchanges. New York got none of the business, but western investment banks, including Merrill Lynch and Credit Suisse took home most of the $500 million in underwriting fees.212

A 2006 study by Ernst & Young put all these factors in perspective. It found that 90% of all companies go public in their home country.213 This is largely due to the gradual development of stock markets around the world as well as the home bias, and cannot have been caused by SOX 404, because by 2000, 94% of global IPOs already occurred domestically.214 Because of this home bias, only 77 of the 767 companies that went public globally in the first half of 2006 chose to conduct their IPO abroad. One-third of those that did go abroad (twenty five) listed regionally.215 Most of the rest were either special cases or listed on London’s AIM, and, as noted earlier, the latter were typically too small to attract the interest of U.S. underwriters or U.S. investors.216 Therefore, the Ernst & Young study concluded that there were only seventeen of these foreign offerings that were actually “in play.” Of those competitive opportunities, eleven did list on a U.S. exchange.217 This 65% success rate compares favorably to the 73% success rate in 2000 at the height of the dot-com boom,218 indicating a small but negligible SOX impact.

Most of the recent large global IPOs involved privatization of state-owned firms in China, Russia, and France.219 Political and cultural

210 Sergei Sarkissian & Michael J. Schill, The Overseas Listing Decision: New Evidence of

Proximity Preference, 17 REV. FIN. STUD. 769 (2004), available at

http://ssrn.com/abstract=267103 (finding that geographic, economic, cultural, and industrial

proximity plays the dominant role in choice of overseas listing venue).

211 Grant et al., supra note 206, at 15 (quoting Timothy Geithner, president of the Federal

Reserve Bank of New York, noting that IPO activity is also hurt by restrictive U.S. visa

practices).

212 MCKINSEY REPORT, supra note 3, at 49.

213 PINELLI & MUSCAT, supra note 202, at 1.

214 Id. From 1961 to 1982, Germany averaged less than one IPO per year, yet saw 158 in

1999. Jay R. Ritter, Differences Between European and American IPO Markets, 9 EUR. FIN.

MGMT. 421, 422 (2003). Because most of those IPOs will stay home, it is no wonder that

European IPO activity has been rising faster than U.S. activity. Indeed, because of such trends,

European IPO activity [excluding the U.K.] exceeded U.S. IPO activity for probably the first time

in history in 2000, before SOX. Id. at 426.

215 PINELLI & MUSCAT, supra note 202, at 3.

216 Id.

217 Id.

218 Id..

219 Because most major U.S. firms are already public, most of the large global IPOs have

involved foreign state-owned enterprises. MCKINSEY REPORT, supra note 3, at 44.



trends push such firms to list locally if their markets are adequate to the task (which increasingly they are).220 Furthermore, the Chinese and Russian firms had such accounting, internal control, and governance issues that they likely could not have held an IPO in the U.S. even under the pre-SOX rules.221

Furthermore, U.S. underwriting fees are nearly twice as high as those charged abroad, running 6.5-7% versus 3-4% in Europe and even less in Asia.222 Due to globalization and development of markets abroad “more companies will choose not to trek halfway around the world to raise money—especially when fees in London are half that of the United States.”223 Wall Street tries to minimize the importance of the fee differential,224 but this is difficult to fully credit. ICBC’s offering, which generated $500 million in fees in Asia, might well have cost twice as much in New York where fees are generally twice as high. This half a billion dollar savings would pay the SOX 404 costs of an average large public company for a century or so. It is, therefore, difficult to believe that SOX 404 is deterring foreign IPOs, yet the higher fees charged by U.S. investment banks are not.

Furthermore, a recent survey found that 36% of foreigners indicated that they would not come to the U.S. for fear of being detained by customs officials for hours (or worse) at the airport, 40% indicated that they had given up trying to obtain visas to visit the U.S., and over half said that it was “unreasonably inconvenient” to obtain a U.S. visa in their home country.225 Because foreign CEOs now “actively avoid” the U.S. because of such problems,226 it is no wonder that New York’s share of global IPOs is declining.

SOX is, at most, only one of a multitude of factors that have reduced Wall Street’s share of global IPOs.227 Even Glen Hubbard,

220 Niemeier, supra note 203. See also MCKINSEY REPORT, supra note 3, at 46 (“The big

western European IPOs do not, however, appear to be truly geographically mobile, due to a

combination of political sensitivities and market depth: each of the 10 largest IPOs of 2005

involving western European companies took place on the issuer’s home market.”).

221 Greg MacSweeney, The Audacity, WALL. STREET & TECH., Dec. 1, 2006, at 8 (noting that

Rosneft, a Russian firm that held a $10.4 billion IPO in 2006 had such problems, including six of

its nine directors being Russian government officials).

222 See Alan Murray, Fees May Be Costing Wall Street Its Edge in Global IPO Market, WALL

ST. J., Aug. 2, 2006, at A2 (citing these numbers).

223 Jenny Anderson, About Those Fears of Wall Street’s Decline, N.Y. TIMES, Jan. 26, 2007, at

C6; see also Ip et al., supra note 199, at A1 (“Stock markets around the world have become better

and deeper, encouraging companies to seek IPOs in their home market.”).

224 MCKINSEY REPORT, supra note 3, at 45 (citing survey evidence that underwriting fees are

not an important factor in deciding where to list). This seems difficult to completely credit.

225 Id. at 68 (citing a Discovery America Partnership survey).

226 Id. at 69.

227 Ip et al., supra note 199, at A1 (“Taken alone, the cost of regulation can’t explain what’s

happening to U.S. financial markets . . . .”).



who ramrodded the CCMR report, admits that there is no “smoking gun” to indicate that SOX or other domestic factors are primarily behind the sinking U.S. share of the capital markets business.228 Probably for that reason, the CCMR report ultimately did not recommend any major changes in SOX 404.229 Nor did the McKinsey report commissioned by Mayor Bloomberg and Senator Schumer.230 Nor did the Chamber of Commerce report.231 Notably, there was a resurgence of foreign IPOs in the U.S. in 2006,232 involving the highest percentage of foreign IPOs in the U.S. in two decades.233 And in 2007, Chinese IPOs in the U.S. are expected to triple.234

d. A Race to the Bottom?

All things being equal, it is in Wall Street’s, New York’s, and the

USA’s best interests to have Wall Street dominate underwriting of

228 Id. The authors observe that the best Hubbard can do is point to some evidence that “the

premium earned by companies . . . [from listing on American exchanges] has shrunk faster than

that for shares in emerging-market companies.” Id. From this Hubbard concludes that the costs

of meeting U.S. requirements is exceeding the benefits, but it doesn’t necessarily mean that at all.

As developed nations adopt U.S.-style securities regulation, as they are all doing, there is no

doubt that their companies can begin to reap the benefits of vigorous securities regulation at

home. They will, of course, also have more costs there as their home countries’ regulations

converge upon the U.S. model. When they can get the benefits of investor confidence and lower

financing costs that come with regulation, then they may stay home to enjoy the lower investment

banking fees.

Ip et al. note that “[t]he EU, Canada, Mexico, Australia, Hong Kong, Brazil, the U.K., and

Germany have to varying degrees beefed up standards for audit committees. This means many

companies won’t escape tighter regulation by avoiding the U.S.” Id. “Pretty soon the vast

majority of Sarbanes-Oxley will be applicable either at the European level or at the national levels

[in the EU] . . . The regulatory costs are in the process of converging.” Id. (quoting Andrew

Bernstein, lawyer at Clearly Gottlieb in Paris).

229 All that the CCMR Report recommended regarding SOX 404 was (a) a redefinition of

material weakness, (b) more guidance from the PCAOB and SEC (c) multi-year rotational testing

permitted within an annual attestation, (d) continued study of the costs and benefits of 404 for

small companies, and (e) to exempt foreign companies subject to equivalent home country

requirements. CCMR REPORT, supra note 4, at ES-19-21. There are sensible suggestions for

minor adjustments and hardly indicative of a conclusion that SOX 404 is causing any major

problems.

230 MCKINSEY REPORT, supra note 3, at 19-20. The report’s recommendations had virtually

nothing to say about SOX beyond suggesting that clearer guidance for implementation should be

given, and that small domestic and foreign issuers be allowed to opt out.

231 CHAMBER REPORT, supra note 5, at 146. The report’s recommendations largely ignored

SOX except for recommending that the SEC be given more flexibility in implementing its

provisions.

232 CHAMBER REPORT, supra note 5, at 18.

233 Jeremy Grant, SEC Chief Rejects Easing of Sarbanes-Oxley Rules, FIN. TIMES (London),

Mar. 15, 2007, at 8.

234 Jamil Abderlini, New York Proves an Attractive Destination, FIN. TIMES (London), May

11, 2007, at 27.



public offerings. However, deregulation for deregulation’s sake as part of a regulatory “race to the bottom” would surely damage the worldwide capital markets. Even if SOX 404 were a primary driver of the adverse IPO trends, its repeal or substantial reworking would not necessarily be justified. SOX critics wrongly assume that if SOX 404 is causing firms to choose to not to go public, it is because those controlling the firms are making choices in the best interests of the firms. That is not necessarily the case

“Theory predicts that where private benefits of control are larger, entrepreneurs should be more reluctant to go public,”235 and that may account for the observable trends. By making firms more transparent and making it more difficult for top executives and major shareholders of firms to profit at the expense of minority shareholders, SOX 404 performs a beneficial service. If some U.S. firms are not going public because their internal controls are a mess and the insiders wish to avoid SOX 404 scrutiny, that may well be a good thing (except for the investment banks that want the underwriting fees).236

Evidence of self-serving actions by insiders in making such decisions is substantial. Empirical evidence indicates that just before IPOs occur, top officers are more likely to manipulate discretionary accruals to beautify the financial statements if they intend to sell their own shares in an “attempt to maximize their personal wealth at the expense of other investors.”237 Managers implementing IPOs tend to install anti-takeover provisions238 and adopt corporate governance schemes that do not fully protect shareholders,239 even though these actions reduce the amount investors are willing to pay for the shares. Furthermore, studies indicate that when parent managers would personally benefit by entrenching the managers of companies that they spin off, they are much more likely to include takeover defenses in the spinoff’s management structure.240 Although this reduces the amount of money the firm can raise through the spinoff, managers seem to

235 Alexander Dyck & Luigi Zingales, Private Benefits of Control: An International

Comparison, 59 J. FIN. 537, 538 (2004).

236 Cone, supra note 58 (noting that if some firms are not going public because their controls

are in a shambles that could be a SOX success).

237 See Masako Darrough & Srinivasan Rangan, Do Insiders Manipulate Earnings When They

Sell Their Shares in an Initial Public Offering?, 43 J. ACCT. RES. 1, 31 (2005).

238 Robert Daines & Michael D. Klausner, Agents Protecting Agents: An Empirical Study of

Takeover Defenses in Spinoffs (Stanford Law and Economics Olin, Working Paper No. 299,

2004) (Dec. 16, 2004), available at http://ssrn.com/abstract=637001 (finding that anti-takeover

provisions are common in IPOs and that they are explained by management entrenchment).

239 See Gretchen Morgenson, New Stocks, Same Old Problems, N.Y. TIMES, Jan. 23, 2005, §

3, at 1 (citing study by Linda R. Killian).

240 Daines & Klausner, supra note 238 (finding also that this entrenchment reduces share

value in the parent).



conclude that the personal benefits of control that they can garner make it worthwhile.

In IPOs, those who control the issuer often leave up to 40% or more of the money the firm could raise on the table by allowing underwriters to underprice the offering.241 Tellingly, they are most likely to do so in situations where their share of the overall take is relatively small and when their families and friends are part of “directed share programs” and thereby are enabled to buy shares at the low IPO price.242 Thus, the evidence makes it clear that those who manage firms going public “even at the time of the initial public offering do not maximize firm value,”243 and a primary motivation is their desire to continue to exploit the benefits of control.

In sum, the people who decide whether and where to have an IPO are heavily influenced, consciously or otherwise, by what is in their own personal best interests. If they are avoiding U.S. public markets because of SOX 404, it is not at all a given that it is because SOX 404 is not in the best interests of their firms. More importantly, what SOX in general does is ask individual firms to bear burdens so that the entire capital markets can thrive. These considerations militate in favor of the U.S. urging foreign countries to raise their standards (as they have been doing) rather than lowering U.S. standards.

2. Encouraging U.S. Firms to Go Private or “Go Dark”

a. Are More U.S. Companies Going Private or Going Dark Because of SOX 404?

In no other nation in the world does the general public participate

as widely in the capital markets as in the United States.244 Rigorous securities regulation has made that substantial participation possible, so if SOX 404’s new provisions are contributing to a contraction of that

241 Alexander Ljungqvist, IPO Underpricing, in HANDBOOK IN CORPORATE FINANCE:

EMPIRICAL CORPORATE FINANCE (B. Espen Eckbo ed., forthcoming), available at

http://ssrn.com/abstract=609422 (noting that IPO underpricing averaged “21% in the 1960s, 12%

in the 1970s, 16% in the 1980s, 21% in the 1990s, and 40% in the four years since 2000”). Part

of officers’ motivation for leaving millions on the table in the recent dot-com boom may have

been the payoffs they received in the form of opportunities for personal allocations of other hot

IPO shares offered by the underwriters they chose to take their firms public. See A Cartel-Buster;

Google’s IPO, ECONOMIST, May 8, 2004 (“[I]nstitutional shareholders and corporate bosses were

plied with IPO allocations in return for inflated commissions and future favours.”).

242 See Alexander Ljungqvist & William J. Wilhelm, Jr., IPO Pricing in the Dot-com Bubble,

58 J. FIN. 723, 751-52 (2003).

243 Stephen J. Choi & Andrew T. Guzman, Choice and Federal Intervention in Corporate

Law, 87 VA. L. REV. 961, 985 (2001).

244 Niemeier, supra note 203.



public participation, it is a cause for concern. The number of companies going private rose from 143 in 2001 to

245 in 2004.245 The number of companies “going dark” (ceasing to file with the SEC, but continuing to trade in the OTC market) has also risen.246 The increased cost of being public caused by SOX, and particularly SOX 404, is no doubt contributing both to the going private trend247 and to the increased tendency of firms to go dark.248

Still, other factors also seem to be playing a substantial role. Some firms may have gone private after SOX as a reaction to the huge drop in stock prices of public corporations following the Enron-era debacle249 because cost of shares is the most important variable in these transactions.250 Now there is also more private capital available than ever before in history, so that companies that once would have had to tap the public markets for capital can now access plentiful private equity funds.251

Furthermore, many high-tech firms seem to have gone public during the dot-com boom simply because holding IPOs was all the rage. Going public was a branding event for high-tech companies that wished the consumer markets to take their products seriously.252 Many firms simply discovered in due time that they were a poor fit for the public

245 Graham, SEC Mulls, supra note 58, at A01 (citing GAO report). See also CCMR REPORT,

supra note 4, at 74 (noting that going private transactions topped 25% of public takeovers in the

last three years).

246 Marosi & Massoud, supra note 148, at 2

247 See, e.g., Stanley Block, The Latest Movement to Going Private: An Empirical Study, 14 J.

APPLIED FIN. 36 (2004) (surveying firms that went private between January 2001 and July 2003

and concluding that the cost of being public was the top reason smaller firms went private); Ellen

Engel et al., The Sarbanes-Oxley Act and Firms’ Going-Private Decisions 23 (May 2004),

available at http://ssrn.com/abstract=546626 (finding that the quarterly frequency of going

private increased “modestly” after SOX was enacted); Nancy Mohan & Carl R. Chen, The Impact

of Sarbanes-Oxley Act on Firms Going Private 19 RES. ACCT. REGULATION (2006), available at

http://ssrn.com/abstract=947358 (finding in study of 147 companies that went private between

June 13, 2000 and Oct. 3, 2003 that a small group of firms went private with characteristics

consistent with the contention that SOX drove them private due to heavy monitoring costs).

248 See SEC Witnesses Worry About Future of Small Public Companies Under Sarbanes Oxley

404, FIN. WIRE, June 20, 2005.

249 William J. Carney, The Costs of Being Public After Sarbanes-Oxley: The Irony of “Going

Private,” 55 EMORY L.J. 141, 153-58 (2006) (attributing various forms of going private

transactions to SEC compliance costs, fueled substantially by SOX, but noting “[o]ne of the

difficulties with the data is that it doesn’t discriminate between companies that go private simply

because stock prices have declined drastically in some segments of the stock market and those

that find the increasing costs of remaining public a sufficient motivation”).

250 See Brown, Criticizing, supra note 120, at 325 (making this point and noting that share

prices for U.S. public companies collapsed well before SOX was enacted).

251 Cone, supra note 58 (noting that an abundance of private equity means that many firms can

find capital without going public that they couldn’t have found in previous years).

252 Brian Garrity & George Moriarty, New Tech Trend; A Private Equity Deal Before the IPO,

INVESTMENT DEALERS, Feb. 8, 1999.



markets.253 As noted earlier, if small firms lack effective internal controls, they do not necessarily belong in the public equity markets and it is just as well that SOX 404 sparked their departure.254 Studies of the going private phenomenon indicate that most firms that have gone private had little trading volume anyway; those that have stayed listed are trading at a healthy rate.255

Overall, the “going private” trend is occurring worldwide and therefore cannot be traced exclusively, or even substantially, to SOX 404.256 Globally, more than $150 billion worth of companies were taken private in 2006 “with New York and London’s stock markets taking the brunt.”257 Admittedly, the NYSE was hit harder than the LSE, but it is quite possible that American capital markets are simply farther along this private equity curve than are European or Asian markets as evidenced by the fact that private equity deals rose 41% in Europe in 2006.258

The same mix of factors in the going private decisions also appears in the going dark cases. The trend of more firms going dark predated SOX.259 Studies show that SOX expenses are but one of many reasons why firms go dark.260 Overall, SOX’s impact on the going-private/going dark phenomenon “has probably been overstated.”261

253 Ehud Kamar et al., Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-

Country Analysis 3 (U.S.C. Center in Law, Economics and Organization Research Paper No.

C06-5, 2006) (Aug. 2006), available at http://ssrn.com/abstract=901769 (finding that the

tendency of firms to go private in response to SOX diminished substantially after SOX’s first

year, indicating that some firms had simply been a poor fit with the public reporting system and

noting that the burden to these firms, which tended to be small, might be outweighed by benefits

SOX brought to the reporting system as a whole).

254 Cone, supra note 58, (noting that if some firms are not going public because their controls

are in a shambles that could be a SOX success story).

255 Ip et al., supra note 199, at A1.

256 John Green, The Paradox Behind the Invasion of the Privateers, FIN. TIMES (London), Feb.

13, 2007, at 13 (nothing that “the astonishing global pace of private equity’s onslaught.”); Ip et

al., supra note 199, at A1 (“[P]rivate-equity buyouts are a global phenomenon, not a uniquely

American one.”).

257 Peter Smith & Norma Cohen, Value Delisting Wave Hits London, FIN. TIMES (London),

Jan. 2, 2007, at 1.

258 The Barbarians Back at the Gate, SUNDAY BUS. (London), Feb. 3, 2007.

259 U.S. GOV’T. ACCOUNTABILITY OFFICE, GAO-06-361, CONSIDERATION OF KEY

PRINCIPLES NEEDED IN ADDRESSING IMPLEMENTATION FOR SMALLER PUBLIC COMPANIES 22

(2006), available at http://ww.gao.gov/mew.items/d06361.pdf.

260 Christian Leuz et al., Why Do Firms Go Dark? Causes and Economic Consequences of

Voluntary SEC Deregistrations 31-33 (AFA Meeting Paper 2006), available at


261 Ip et al., supra note 199, at A1 (quoting David Rubinstein, managing director of private-

equity firm Carlyle Group).



b. Race to the Bottom?

As with IPOs, we must ask why? Why are managers of some

American companies deciding to withdraw from the scrutiny of the market? Any conclusion that they are doing so in the best interests of the firm and its shareholders “assumes the market is relatively efficient, which is not necessarily safe for the smallest companies. An alternative hypothesis is that company insiders value the private benefits of control lost under SOX, which they regain by a going-private or going-dark transaction of dubious fairness.”262 After all, the decision to go private or go dark, like the decision whether to go public, is functionally made by the insiders, and there is all manner of empirical academic evidence that suggests such transactions are often mechanisms for disadvantaging outside investors.

When companies go private, there is a stark conflict of interest as insiders negotiate to buy out the same outsiders to whom they owe a fiduciary duty. Managers of these companies frequently use accounting gimmicks to artificially depress reported performance just before taking the company private in an effort to reduce the purchase price.263 Unsurprisingly, “when management is the buyer, it pays, on average, thirty percent less than an outside bidder.”264 After companies go private, they often restructure by selling off unproductive assets, gaining quick profits. CEOs who plan to buy their own companies tend to wait until after they buy control to restructure rather than gaining that benefit for the outside shareholders while the firms are still public.265

If going private were about the advantages of private ownership over public ownership, most firms that go private would stay private; however, this is not the case, suggesting “that management buyouts are often simply an opportunity for insiders to pick up assets on the cheap and flip them a few years later for fantastic sums.”266 Similar manipulation attends analogous open-market repurchases by public companies, especially when the CEO owns a larger portion of the firm’s

262 Langevoort, Social Construction, supra note 2, at 42.

263 See, e.g., Susan E. Perry & Thomas H. Williams, Earnings Management Preceding

Management Buyout Offers, 18 J. ACCT. & ECON. 157, 158, 178 (1994) (finding evidence that

management tends to manage earnings downward prior to going-private transactions and noting

that “[e]arnings management is of interest because it concerns the potential illegal or unethical

transfers of wealth [from publish shareholders to insiders].”); see also Surowiecki, supra note

114, at 46 (referencing studies).

264 James Surowiecki, Private Lies, NEW YORKER, Aug. 28, 2006, at 28 (citing study of

buyouts in recent two-year period).

265 Id. (citing U.K. study).

266 Id. at 28.



stock.267 Thus, plentiful evidence suggests that agency problems are substantial contributors to going private decisions.

Turning to going dark transactions, Leuz and his colleagues found that firms go dark in response to poor future prospects, financial distress, and increased SOX compliance costs. The firms that tend to go dark are small, do not gain substantial benefits from being public, have weak accounting, and suffer significant agency problems.268 In other words, part of the reason firms go dark is that their managers wish to protect their private control benefits and decrease outside scrutiny.269 If firms are better off going dark than living under SOX, their stock price should rise upon the going private announcement. Instead, the market realizes that going dark increases insiders’ opportunities to garner private benefits and it tends to react adversely to going dark decisions.270

Leuz et al. note that their findings suggest

that SOX has not only increased reporting costs, but also that its provisions ‘work’ in the sense that they appear to have stronger effects on firms with agency problems and poor quality accounting. However, given that firms can deregister and leave the SEC reporting system, the effects may not be the intended ones.”271

This finding may raise the ultimate question: Is the system better off or worse off with these companies out of the public markets? Any adverse effects on the overall reporting system from firms that go dark is likely to be minor, given the small size of the firms that do so.272 The companies that go private will have a larger impact. But is SOX 404’s

267 Gong et al. recently studied open market repurchases and discovered a tendency to manage

earnings downward before repurchases, so that shares can be repurchased at a bargain and post-

repurchase performance can be made to look better. The more shares managers repurchase and

the more shares the CEO owns, the greater the negative earnings management before repurchase.

See Guojin Gong et al., Earnings Management and Firm Performance Following Open-Market

Repurchases 38-39 (Nov. 2006), available at http://ssrn.com/abstract=943887 (noting that

findings are “consistent with the notion that managers have greater incentives to deflate earnings

when the potential benefits from downward earnings management are greater”).

268 See Leuz et al., supra note 260, at 31-33.

269 See J. Robert Brown, Jr., In Defense of Management Buyouts, 65 TUL. L. REV. 57, 59

(1990) (noting that LBOs, MBOs, and similar transactions may be a mechanism used by

management to escape the judgment of the market).

270 Leuz et al., supra note 260, at 31-33; see also James S. Linck et al., The Effects and

Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards 7 (Feb. 14, 2007),

available at http://ssrn.com/abstract=902665 (“[M]arkets react more negatively to going-dark

decisions during the post-SOX period, suggesting that investors value the stringent disclosure

requirements under SOX.”); Marosi & Massoud, supra note 148, at 6-9 (also finding significant

negative cumulative abnormal returns upon going dark announcement, as well as that firms with

greater inside ownership are more likely to go dark and that SOX audit costs have been one of

several forces driving decisions to go dark).

271 Leuz et al., supra note 260, at 33.

272 Id.



contribution to this trend necessarily a bad thing, given that private investors such as private equity funds, hedge funds, and other sophisticated investors may be able to exert more effective control over such managers than are public shareholders?273 Public shareholders are more protected from fraud and manipulation under SOX, but they lose some investment opportunities. If they wish to invest in firms that have gone private or gone dark, they will have to do so through sophisticated investment entities, such as mutual funds.274 This is relatively easily done.275

3. Discouraging Foreign Firms from Listing in the U.S., and

Encouraging U.S. Firms to List Abroad.

a. Is SOX 404 Encouraging Some Foreign Issuers to Delist from U.S. Stock Exchanges and Discouraging Others from Listing in the First

Place?

The discussion in this section will obviously overlap with the

earlier discussions, for seasoned firms’ listing decisions are affected by the same factors as private firms’ going public decisions, and the same pressures might influence a firm to change its listing to a foreign exchange rather than to go private.

Leon notes that capitalization on U.S. exchanges and foreign exchanges grew at nearly the same rate from 1997 to 2002, but from 2002 to 2005, market capitalization on U.S. exchanges grew only slightly more than 50% while non-U.S. exchanges more than doubled.276 Also, there is evidence that many foreign firms would have liked to delist from the U.S. because of SOX’s costs and regulations, but have been unable to do so because of restrictions on delisting that were greatly eased in March 2007.277 Wall Street supports this move on

273 See Jenny Davey, Private Equity Faces Its Critics, SUNDAY TIMES (London), Feb. 18,

2007, at 10 (quoting Ian Armitage of HgCapital as claiming that “[t]he discipline of private equity

makes companies fitter, leaner and better able to compete”).

274 See Eleanor Laise, Hedge Funds Beckon Small Investors—As a Major Private-Money

Management Firm Goes Public, Individuals Face 'Alternative' Choices of Varying Risk, WALL

ST. J., Feb. 14, 2007, at D1 (noting that “[n]ew vehicles are giving small investors access to hedge

funds and private equity”).

275 Perhaps too easily, but that is another article. To the extent that SOX 404 burdens smaller

companies, they may choose to stay public or to go private. Going private takes them out of the

transparent public markets that SOX seeks to preserve. Hedge funds and private equity funds can

buy interests in those companies and protect themselves, but if unsophisticated investors use the

new vehicles to invest in the private funds, then they are investing outside the protective envelope

that SOX seeks to preserve for them.

276 See Leon, supra note 8, at 38.

277 Termination of a Foreign Private Issuer’s Registration of a Class of Securities Under 12(g),



grounds that the difficulty of delisting has discouraged foreign firms from listing in the U.S. in the first place. Can these trends be pinned primarily on SOX 404? Surveys of CEOs and conclusions of observers provide strong support for that conclusion,278 but other factors seem important as well.

Until relatively recently, foreign firms listed in the U.S. because that is where the money was, and only U.S. exchanges could confer a large reputational benefit upon listing firms.279 Now, there is a huge amount of capital available abroad, especially in Asia, meaning that today companies need not come to the U.S. in order to access large pools of money.280 The simple fact is that capital markets overseas are growing and will continue to do so, and repealing SOX will not change that fact.281

Indeed, the trend away from U.S. hegemony began more than fifteen years ago.282 The SEC’s promulgation of Rule 144A,283 that

Exchange Act Release No. 34-55540, 72 Fed. Reg. 16,934 (Apr. 5, 2007).

278 Arturo Bris et al., A Breakdown of the Valuation Effects of International Cross-Listing 1

(Aug. 2006), available at http://ssrn.com/abstract=868485 (suggesting that the costs of SOX for

foreign firms outweighs benefits coming from listing on American exchanges); Carney, supra

note 249, at 152-53 (listing foreign issuers that did not list in the U.S. in part because of SOX’s

burdens); Leon, supra note 8, at 36-37 (arguing that “the perceived taxing burden of SOX on

listed companies” is one factor responsible for these trends); Geoffrey P. Smith, A Look at the

Impact of Sarbanes-Oxley on Cross-Listed Firms 23 (Jan. 12, 2007), available at

http://ssrn.com/abstract=931051 (finding that post-SOX there was “a significant decrease in the

number of new cross-listings on US stock exchanges”); Georg Stadtmann & Markus F.

Wissmann, Sox Around the World—Konsequenzen fur Risikomanagement und –berichterstattung

deutscher Emittenten (2006), available at http://ssrn.com/abstraact=858884 (finding in a survey

that “the introduction of SOX made the U.S. financial market less attractive to currently cross-

listed foreign companies as well as potential new foreign issuers”).

279 Carolyn Pritchard, CCB Considers Shunning NYSE, MARKETWATCH, Jan. 24, 2005

(quoting an unnamed Hong Kong investment banker).

280 See Francesco Guerrera & Andrei Postelnicu, A Not So Foreign Exchange: China Shuns

the West as a Location for Its Big Corporate Share Offers SECURITIES MARKETS: Flotation

Decisions Made in Asia Will Help Determine the Standing of New York and London as Equity

Centres and the Valuations Accorded in Mergers Between Bourses, Write Francesco Guerrera

and Andrei Postelnicu, FIN. TIMES (London), Nov. 18, 2005, at 17 (noting that the fact that China

Construction Bank had recently raised $9.2 billion in a Hong Kong IPO indicates that there is

little reason for firms to list in the U.S. just to access giant pools of capital). Also, “[m]ost

European and Asian economies have lower capital markets penetration—equity and bond

financing compared with GDP—than the US economy, suggesting that they have significantly

more room to grow.” MCKINSEY REPORT, supra note 3, at 40.

281 See Gillian Tett & David Wighton, NY Unable to Regain Lost Business, Says Top Banker,

FIN. TIMES (London), Jan. 26, 2007, at 1 (noting that many complain of overregulation, but admit

that foreign markets are growing in a way that will cost New York some of its share of finance

business).

282 See Pan, supra note 200, at 2 (“[M]ore than 15 years ago—long before Sarbanes-Oxley—

as foreign companies took advantage of new ways to raise money from US investors without

becoming US public companies and foreign and US companies discovered that certain non-US

markets offered deep pools of capital that could satisfy their capital-raising needs without having

to go to the United States.”).

283 17 C.F.R. § 240.144A (2006).



allowed institutional investors to buy securities in foreign firms without the firms having to register with the SEC, played a big role. As early as the late 1990s, well before SOX, it was rare for any public offering to be done in Europe without a Rule 144A piece, making Rule 144A the most popular route for foreign companies wishing to sell shares in the U.S.284

Additionally, it is easier today than ever before for Americans to invest in foreign securities. By the late 1990s, the use of ADRs by foreign firms had already decreased. Many firms had done an IPO in the U.S. with substantial success, but within a few years their percentage of shares held by U.S. investors in ADRs had dropped substantially. It was not that U.S. investors had lost interest in foreign firms; rather, their ownership had switched from the ADRs to shares owned directly through the issuer’s home market.285 This is part of a long-term trend: in 2005 U.S. investors held $2.97 trillion in foreign equity securities, compared to just $197.6 billion in 1990.286

Furthermore, there has been a growing competition among world exchanges,287 and the NYSE has lost its near-monopoly position by “resisting new technology and preserving outmoded trading arrangements.”288 The LSE has prospered at the expense of American (and other) exchanges in part because speed has become the most important facet in exchange competition and the LSE has well positioned itself to compete in this aspect.289 Also, the integration of markets in Europe has made it a much more attractive competitor for the U.S. than it had been before, meaning that attempts to put the blame for New York’s loss of market share on SOX and U.S. litigiousness is “too narrow” an explanation.290 The bad reputation that the excesses of

284 Howell E. Jackson & Eric J. Pan, Regulatory Competition in International Securities

Markets: Evidence from Europe in 1999—Part I, 56 BUS. LAW. 653, 681 (2001); see also

MCKINSEY REPORT, supra note 3, at 48 (noting that in 2005 “foreign companies raised 16 times

as much equity in Rule 144A transactions as they did on public US markets”).

285 See Pan, supra note 200, at 8.

286 SEC. INDUS. ASSOC., SECURITIES INDUSTRY FACT BOOK 2006, at 81 (2006).

287 See Mary Kissel & Laura Santini, Global Stock Exchanges Vie for a Slice of China’s IPO

Pie, WALL ST. J., Dec. 2, 2004, at C1 (noting that there are now more exchanges to compete for

IPOs).

288 John Kay, A Giant’s Strength is Valuable—If Not Used Like a Giant, FIN. TIMES, Nov. 28,

2006, at 13. The McKinsey Report commissioned by Mayor Bloomberg and Senator Schumer

admits that “technology, trading markets, and communication infrastructures are evolving to

make real-time interactions and transactions possible and affordable from virtually anywhere,

thus reducing some of the benefits of physical co-location in major financial centers such as New

York.” MCKINSEY REPORT, supra note 3, at 11.

289 Norma Cohen, Chief Hails Twin Reasons for Exchange’s Pre-Eminence, FIN. TIMES

(London), Nov. 9, 2006, at 14 (noting also that London had eclipsed both the US and the

Continent in breadth and scope of business, and that it has a “benign regulatory . . .

environment”).

290 Josef Ackermann, Europe Has to Storm Its Cross-Border Financial Barriers, FIN. TIMES



the American markets created during the dot-com boom further exacerbated the loss of relative position in conferring prestige.291 Because they have adopted U.S.-style securities regulation, even the maturing Asian stock markets can now come reasonably close to matching U.S. markets for endowing prestige upon listing companies.292 Multiple other non-404 factors are important here, including the increase in analyst coverage in European markets.293

Because of the development of markets around the globe, since 2000, foreign listings on London’s Main Market have declined 23%, the Deutsche Boerse is down 58%, and Tokyo has dropped 39%.294 It is difficult to see how a repeal of SOX 404 would have a substantial impact on the trends Wall Street currently decries, for “according to the data, it does not appear as though the bogeyman of tough US disclosure regulations is to blame for the relative decline in popularity of US exchanges.”295 The trends are real, but SOX 404 appears to be far from the primary driver.

b. Does SOX 404 Encourage U.S. Firms to List Abroad?

According to Leon, “[t]he incidence of domestic firms listing on

foreign exchanges grew from 1 in 1990 to 12 in 1996 then pulled back to 2 in 2002 and rose to 18 in 2005.”296 It is obviously difficult to draw firm conclusions from this uneven trend, but again there is substantial circumstantial evidence that SOX 404 is encouraging very small U.S.

(London), Jan. 26, 2007, at 17.

291 See Murray, supra note 222, at A2 (“There’s also a cyclical aspect to the IPO business

that’s not working in the U.S.’s favor right now. The U.S. is still suffering an overhang from the

wild days of 1999 and 2000, when any 30-year-old with a Web site could take his or her company

public. After that financial orgy, it’s no surprise that the market has become more skeptical of

IPOs.”); see also Leon, supra note 8, at 36-37 (noting that equities lost their appeal in part due to

the dot-com scandals).

292 See Guerrera & Postelnicu, supra note 280, at 17 (quoting Robert Morse, chief executive of

Citigroup’s corporate and investment bank in Asia as saying that “Asian markets have matured to

a point where the prestige of a US listing has lost a bit of its lustre”); Pan, supra note 200, at 11-

12 (noting that as a result of improvements in Europe’s securities regulatory systems, “the

European Union has developed a robust regulatory environment that rivals the US system,

providing less benefit to foreign companies coming to the United States and more reasons for US

investors to consider going to Europe”).

293 Pan, supra note 200, at 12.

294 Ip et al., supra note 199, at A1. The Tokyo Stock Exchange had 125 foreign listings in

1990 and only 25 at the end of 2006. Michiyo Nakamoto & Ben White, Citigroup Looks at

Listing on Tokyo Exchange, FIN. TIMES (London), Feb. 20, 2007, at 17.

295 Norma Cohen & Peter Smith, Upsurge in IPOs and Private Deals, FIN. TIMES (London),

Jan. 2, 2007, at 19.

296 Leon, supra note 8, at 40.



firms to list on AIM. 297 These small firms view the AIM market as an alternative to private financing rather than to taking their firms public,298 so this migration does not cost the U.S. many IPOs,299 or much underwriting revenue.300

Piotroski and Srinivasan recently found very little evidence of foreign firms avoiding the NYSE in favor of listing on the LSE’s Main Market, but did find significant evidence that smaller and less profitable firms, primarily from developed markets, were more likely than before SOX to choose London’s AIM over NASDAQ.301 These small firms, many of which would not have attracted the interest of investment banks in the U.S. or been able to go public even under pre-SOX rules,302 took an estimated $26 billion in market capitalization to AIM and away from NASDAQ. Interestingly, the authors modeled where foreign firms would likely list based on firm-specific, industry, and home country attributes, and discovered a small set of firms that post-SOX listed in the U.S. when the model predicted that they would have listed in the U.K., bringing $34.8 billion in market capitalization to the U.S.303 These numbers, demonstrating an apparent comparative advantage for U.S. markets, result primarily from the fact that the average firm that lists on NASDAQ has more than twice the market capitalization, more than five times the total assets, and 25 times the profits of the average AIM-listed firm.304 They note: “[m]oreover, nearly all of these firms are domiciled in emerging markets, consistent with large, high quality firms from countries with weak institutions now deciding to capture the enhanced bonding/reputation benefits of a U.S. listing following the

297 The CCMR concluded that four factors were responsible for the loss of U.S. capital market

competitiveness. CCMR REPORT, supra note 4, at ES-4. The first three had nothing to do with

SOX—(a) an increase in integrity and trust of foreign capital markets deriving from their

adoption of U.S.-style disclosure requirements, (b) a relative increase in the liquidity of foreign

capital markets, and (c) improvements in technology making it easier for U.S. investors to invest

abroad. The fourth factor, differences in legal rules, includes SOX 404, no doubt, but a plethora

of other rules must be involved as well. See id. at 4-5.

298 Lynn Cowan, Small U.S. Firms Take AIM in London, WALL ST. J., Apr. 17, 2006, at C5.

299 Furthermore, there is evidence that some firms that have listed abroad may return to the

U.S. where bigger deal sizes can justify additional compliance costs. Kathryn Tully, The Hunt

for Liquidity Hits a Dry Patch, FIN. TIMES (London), Nov. 7, 2006, at 11 (noting that greater

liquidity in the U.S. will likely ultimately outweigh extra compliance costs).

300 See MCKINSEY REPORT, supra note 3, at 51 (noting that the U.S. firms that list on AIM are

so tiny that “the potential loss in financial revenues for the US from this shift to London is limited

- at least in the short term”).

301 Joseph D. Piotroski & Suraj Srinivasan, The Sarbanes-Oxley Act and the Flow of

International Listings 5 (Apr. 2007), available at http://ssrn.com/abstract=956987.

302 See supra note 202 and accompanying text.

303 Piotroski & Srinivasan, supra note 301, at 6. The authors observe that “[w]hether the

[economic] gains associated with these new emerging market listings outweigh the benefits

forfeited by the loss of small firms from primarily developed economies is a question for future

research.” Id. at 7.

304 Id.



enactment of Sarbanes-Oxley.”305

c. Race to the Bottom?

Even if SOX 404 costs did explain a material portion of the trend

of foreign firms to list at home rather than in the U.S. and the smaller trend for U.S. firms to list abroad, pulling the plug on SOX 404 would not necessarily be a logical course of action.306 Substantial empirical research indicates that poor protection of minority investors explains why it is often difficult for non-U.S. firms to efficiently and effectively raise equity capital and why their equity is valued less by investors.307 Investors are sensibly reluctant to invest in firms located in countries where they are particularly subject to exploitation by those who control the firm—either large shareholders or managers.

Firms from countries that, compared to the U.S., do not provide strong protection for outside investors may explore the advantages of cross-listing on U.S. exchanges. By listing on the NYSE, for example, foreign firms can “bond” themselves to investors, promising to live up to high disclosure and governance standards and thereby to forfeit opportunities to expropriate wealth from minority shareholders.308 Naturally, such firms benefit particularly if they come from jurisdictions with weak investor protection. Thus, empirical studies have indicated that a corporation in a weak investor protection jurisdiction that cross-lists in the U.S. where investor protection standards are higher will

305 Id. at 6.

306 It makes more sense for the U.S. to keep standards high to continue to attract high-quality

listing firms and to allow lower-quality firms to list abroad if they wish. Coffee notes:

[I]f U.S. regulators were to listen to the siren call of those who favor reduced

regulation (and less deterrence), they might unintentionally both increase the cost of

capital in the United States and reduce the bonding premium that attracts current cross-

listing firms. Ironically, this could result in reducing the incentive for ambitious firms

with high quality governance to list in the U.S., while decreasing the barrier to firms

with controlling shareholders intent on enjoying the private benefits of control. That

would be perverse.

John C. Coffee, Jr., Law and the Market: The Impact of Enforcement 69 (Columbia Law Sch.

Working Paper Series, Working Paper No. 304, 2007) (Nov. 7, 2007), available at

http://ssrn.com/abstract=967482 [hereinafter Coffee, Impact].

307 See, e.g., Rafael La Porta et al., Investor Protection and Corporate Governance, 58 J. FIN.

ECON. 3, 24 (2000) (“Empirically, strong investor protection is associated with effective corporate

governance, as reflected in valuable and broad financial markets, dispersed ownership of shares,

and efficient allocation of capital across firms.”).

308 See, e.g., John C. Coffee, Jr., Racing Towards the Top?: The Impact of Cross-Listings and

Stock Market Competition on International Corporate Governance, 102 COLUM. L. REV. 1757

(2002); Rene M. Stultz, Globalization, Corporate Finance, and the Cost of Capital, 12 J.

APPLIED CORP. FIN. 3 (1999).



experience significant positive stock price reactions,309 enjoy higher valuation (up to 37%),310 receive increased beneficial scrutiny from financial analysts,311 benefit from lower costs of capital,312 have a better information environment,313 gain more access to external finance,314

309 See Stephen R. Foerster & G. Andrew Karolyi, The Effects of Market Segmentation and

Investor Recognition on Asset Prices: Evidence from Foreign Stocks Listing in the United States,

54 J. FIN. 981, 1008 (1999) (finding positive, permanent market reactions for Asian firms that list

the shares in the U.S.); Darius P. Miller, The Market Reaction to International Cross-Listings:

Evidence from Depositary Receipts, 51 J. FIN. ECON. 103, 121-22 (1999) (“[F]oreign firms that

enter US capital markets to raise new equity capital in a public offering experience a positive

change in shareholder wealth . . . [and that] dual listing can mitigate barriers to capital flows,

resulting in a higher share price and a lower cost of capital.”).

310 See, e.g., Craig Doidge et al., Why Are Foreign Firms Listed in the U.S. Worth More?, 71

J. FIN. ECON. 205, 206 (2004) [hereinafter Doidge et al., Worth More].

311 See, e.g., H. Kent Baker et al., International Cross-Listing and Visibility, 37 J. FIN. &

QUANTITATIVE ANALYSIS 495, 516-18 (2002) (finding that firms that list on the NYSE and LSE

receive broader analyst following); Mark H. Lang et al., ADRs, Analysts, and Accuracy: Does

Cross Listing in the United States Improve a Firm’s Information Environment and Increase

Market Value?, 41 J. ACCT. RES. 317, 342 (2003) (finding that cross-listing increases analyst

following and forecast accuracy and thereby leads to higher valuation).

312 See, e.g., Vihang R. Errunza & Darius P. Miller, Market Segmentation and the Cost of

Capital in International Equity Markets, 35 J. FIN. & QUANTITATIVE ANALYSIS 577, 598 (2000)

(finding that firms in their sample that cross-list enjoyed a 42% decline in cost of capital); Luzi

Hail & Christian Leuz, Cost of Capital Growth Expectations Around U.S. Cross-Listings 36 (Eur.

Corp. Governance Inst., Finance Working Paper No. 46/2004, 2006) (Oct. 2006), available at

http://ssrn.com/abstract=549922 (“[S]trong evidence that cross-listings on U.S. exchanges are

associated with a significant decrease in firms’ cost of equity capital . . . of about 70 to 120 basis

points [if listing on the exchanges], followed by OTC listings with about 30 to 70 basis points.”);

Pagano et al., supra note 188, at 2686 (noting that to the extent that the advantages of American

markets—more liquidity, better accounting standards, more shareholder rights’ protection—

“translate in a lower cost of equity capital,” they may attract listings by companies needed to raise

large amounts of equity).

The CCMR notes the difference in cost of capital advantage in U.S. markets, states that it

has declined in recent years relative to developed markets, and surmises that “[e]xcessive

regulatory costs and risk of litigation are the most likely causes.” CCMR REPORT, supra note 4,

at 38. Given the link between disclosure and antifraud protection on the one hand and lower

capital costs on the other, and given the fact that developed markets over the last decade have

raised their level of regulation toward U.S. standards, it would seem more logical to attribute the

narrowing of the gap to the actions of the foreign markets in emulating U.S. regulation. “As

foreign markets continue to align their securities regulations closer to U.S. standards, investors

become more confident in allocating capital to these areas.” CHAMBER REPORT, supra note 5, at

36.

On the other hand, Litvak’s study does find that the listing premium for foreign companies

subject to SOX declined more than the listing premium for foreign cross-listing firms not subject

to SOX. See Kate Litvak, Sarbanes-Oxley and the Cross-Listing Premium,105 MICH. L. REV.

1857 (2007). However, Coffee responds that the data “show that this decline preceded Sarbanes-

Oxley, and listing premia are again increasing [post-SOX].” Coffee, Impact, supra note 306, at

20, 57.

313 See Warren Bailey et al., The Economic Consequences of Increased Disclosure: Evidence

from International Cross-Listings, 81 J. FIN. ECON. 175, 208-09 (2006) (finding that absolute

return and volume reactions to earnings announcements typically increase significantly once a

foreign firm cross-lists in the U.S.).

314 See, e.g., Karl V. Lins et al., Do Non-U.S. Firms Issue Equity on U.S. Stock Exchanges to

Relax Capital Constraints?, 40 J. FIN. & QUANTITATIVE ANALYSIS 109, 131-132 (2005) (finding



exhibit lower voting premiums,315 perform better during economic downturns,316 and be more likely to replace ineffective CEOs.317 These benefits are not costless, but they flow naturally from being subject to more vigorous securities regulation.318

Empirical evidence indicates that cross-listing firms do not get as big a boost if they do U.S. private placements or other offerings that do not require as much disclosure;319 nor do they benefit as much if they list on the LSE, which has lower standards than the NYSE.320

that cross-listing firms “tend to increase their access of external international capital markets

following a U.S. listing and . . . the increases in capital access are more pronounced for emerging

market firms”); William A. Reese, Jr. & Michael S. Weisbach, Protection of Minority

Shareholder Interests, Cross-Listings in the United States, and Subsequent Equity Offerings, 66 J.

FIN. ECON. 65, 102 (2002) (finding that “firms from countries with weak shareholder protection

appear to cross-list, among other reasons, for the purpose of voluntarily bonding themselves to

US securities and market regulations, allowing them to raise capital more easily at home and

elsewhere outside the US”).

315 See Craig Doidge, U.S. Cross-Listings and the Private Benefits of Control: Evidence from

Dual-Class Firms, 72 J. FIN. ECON. 519, 550 (2004) [hereinafter Doidge, Private Benefits]

(finding evidence that cross-listing in the U.S. improves the protection afforded to minority

investors and decreases the private benefits of control as measured by the difference (on average,

43%) in how investors value otherwise identical voting and non-voting shares).

316 Todd Mitton, A Cross-Firm Analysis of the Impact of Corporate Governance on the East

Asian Financial Crisis, 64 J. FIN. ECON. 215 (2002) (finding that Asian firms that had high levels

of disclosure because they listed in the United States (or relied upon Big Six accounting firms)

performed better during the East Asian financial crisis of the late 1990s).

317 Ugur Lel & Darius P. Miller, International Cross-listing, Firm Performance and Top

Management Turnover: A Test of the Bonding Hypothesis 31 (FRB Int’l Fin. Discussion Paper

No. 877, 2006) (Sept. 2004), available at http://ssrn.com/abstract=926606 (“[C]ross-listed firms

are more likely to shed poorly performing CEOs than non-cross-listed firms.”).

318 “It’s magical, in a way. People pay enormous amounts of money for completely intangible

rights. Internationally, this magic is pretty rare. It does not appear in unregulated markets.”

Bernard S. Black, Information Asymmetry, the Internet, and Securities Offerings, 2 J. SMALL &

EMERGING BUS. L. 91, 92-93 (1998); see also Erik Berglöf & Stijn Claessens, Enforcement and

Corporate Governance 29 (World Bank Policy Research Working Paper No. 3409, 2004) (Sept.

2004), available at http://ssrn.com/abstract=625286 (surveying the empirical literature and

concluding that “[o]nly a combination of strong investor rights and an efficient judicial system

leads to well-developed financial markets.”); Prentice, Strong SEC, supra note 188, at 775

(making the non-empirical argument for robust securities regulation).

319 See Hail & Leuz, supra note 312, at 36 (finding that cross-listing firms’ cost of equity goes

up if they do private placements in the U.S., but goes down if they list on the OTC and down

substantially more if they cross-list on U.S. stock exchanges); Darius P. Miller, The Market

Reaction to International Cross-Listings: Evidence from Depositary Receipts, 51 J. FIN. ECON.

103, 121 (1999) (“[F]oreign firms that enter US capital markets to raise new equity capital in a

public offering experience a positive change in shareholder wealth [but that t]hose in a private

offering experience a negative change in shareholder wealth.”).

320 Lel & Miller, supra note 317, at 31 (finding that cross-listing firms benefiting from

increased removal of ineffective CEOs gain the most by listing on major U.S. exchanges such as

the NYSE, and less if they list on the OTC, do private placements in the U.S., or list on the LSE).

The differences might well be even greater if the SEC did not give so many passes to foreign

companies, exempting them from various restrictions applicable to American firms and not

enforcing securities rules against them as aggressively as against domestic firms. See, e.g., Amir

N. Licht, Cross-Listing and Corporate Governance: Bonding or Avoiding? 4 CHI. J. INT’L L. 141,

151 (2003), available at http://ssrn.com/abstract=382660 [hereinafter Licht, Cross-Listing]



The benefits of cross-listing, particularly on U.S. exchanges—higher stock price, cheaper capital, more analyst attention, and the rest—seem overwhelming, yet only 10% of eligible foreign firms cross-list on U.S. exchanges.321 Why do the 10% cross-list? When foreign firms explain their decisions to cross-list, their answers have little to do with bonding their reputation to investors by improving disclosure and governance practices,322 although this happens. Their motive is to access capital.323 The disclosure requirements that create the benefits detailed above are actually considered obstacles by many managers and controlling shareholders who make the cross-listing decisions.324 Well before SOX was passed, foreign firms that raised money by listing on U.S. exchanges could enjoy a 2.47% lower cost of capital than if they raised funds in the U.S. using the less transparent Rule 144A;325 yet, as noted above, many more chose to go the 144A route, forfeiting firm benefit in order to retain private benefit for the controllers.326

A major reason why 90% of eligible firms forgo the obvious and substantial benefits their firms can derive from cross-listing on a U.S. exchange is that those who control foreign firms have personal interests

(noting certain exchange exemptions for foreign firms that the SEC has approved); Jordan I.

Siegel, Can Foreign Firms Bond Themselves Effectively by Renting U.S. Securities Laws? (AFA

2003 Washington, DC Meetings) (March 10, 2004), available at http://ssrn.com/abstract=308481

(arguing that procedural obstacles also make private enforcement of U.S. securities laws by

foreign investors problematic). Obviously, the costs of SOX to foreign firms may be exaggerated

in light of this evidence. See Piotroski & Srinivasan, supra note 301, at 9-12.

321 See Doidge et al., Worth More, supra note 310, at 206.

322 The reasons they give include (a) business reasons such as increased visibility or

facilitating a U.S. acquisition; (b) financial reasons, such as better price and liquidity; (c) industry

specific reasons such as the fact that competitors have also listed; and (d) expansion of U.S.

shareholder base because that is where the money is. James A. Fanto & Roberta S. Karmel, A

Report on the Attitudes of Foreign Companies Regarding a U.S. Listing, 3 STAN. J. L. BUS. &

FIN. 51, 63-66 (1997).

323 Lins et al., supra note 314, at 132; Frederick Tung, From Monopolists to Markets?: A

Political Economy of Issuer Choice in International Securities Regulation, 2002 WIS. L. REV.

1363, 1397 (2002).

324 See Licht, Cross-Listing, supra note 320, at 156 (“[T]he surveys consistently indicate that

if increased disclosure levels under U.S. regulations play any role, then this role is definitely a

negative one.”); G. Andrew Karolyi, Why Do Companies List Abroad? A Survey of the Evidence

and Its Managerial Implications, 7 N.Y. UNIV. SALOMON BROTHERS CENTER MONOGRAPH No.

1 (1998) [hereinafter Karolyi, Why List] (finding that “stringent disclosure requirements are the

most important impediment to cross-border listings”).

325 Hail & Leuz, supra note 312, at 49.

326 See Craig Doidge et al., Private Benefits of Control, Ownership, and the Cross-Listing

Decision (Dice Center, Finance Working Paper No. 77/2005, 2006) (Apr. 2006),

http://ssrn.com/abstract=668424 [hereinafter Doidge et al., Ownership] (finding that more

concentrated control by insiders seeking to preserve private benefits “make it less likely that a

[foreign] firm will have a U.S. exchange listing, but not less likely that it will have other U.S.

listings such as Rule 144a private placement or a Level 1 over-the-counter (OTC) listing, or a

listing on the London stock exchange” because the non-U.S. exchange alternatives place fewer

constraints on insiders).



that diverge from the interests of the firm as a whole and from those of minority shareholders.327 They naturally prefer less supervision, disclosure, accountability, and liability, not more,328 even though these are the very features of cross-listing that create value for the firm.329 For example, studies show that while managers of firms that cross-list in the U.S. can manage earnings more than U.S. firms,330 they cannot manage them as much as other firms in their home country.331 Because of the self-interest of the controllers of these foreign firms, the general trend is for cross-listed companies to choose destination nations with lower, not higher, accounting standards than their origin countries.332 This phenomenon is unsurprising given its consistency with the evidence that when managers of American companies choose to list their companies’ shares on exchanges they often act on private information to benefit themselves before both exchange listings and delistings.333

Stock exchanges know who makes the listing decisions and what their motives are, and therefore often cater to them in the absence of

327 See Doidge et al., Worth More, supra note 310, at 235 (finding substantial evidence

consistent with the notion that only when insiders gain substantial personal advantages from

cross-listing do they do so in light of the limitations that cross-listing places on their ability to

extract private benefits from the firm); Doidge et al., Ownership, supra note 326, at 36 (reporting

results from cross-national study finding “that firms controlled by their top managers and their

families are less likely to have a U.S. listing” and concluding that their “results support the view

that a desire to either consume private benefits of control, or to retain the option to consume

private benefits, deters the controlling shareholders of many non-U.S. firms from listing in the

U.S”); Amir N. Licht, Legal Plug-Ins: Cultural Distance, Cross-Listing, and Corporate

Governance Reform, 22 BERKELEY J. INT’L L. 195, 204 (2004) [hereinafter Licht, Plug-Ins]

(citing sources).

328 Allen Ferrell, The Case for Mandatory Disclosure in Securities Regulation Around the

World 16 (Harvard Law & Economics Discussion Paper No. 492, 2004) (Sept. 2004), available at

http://ssrn.com/abstract=631221; Amir N. Licht, David’s Dilemma: A Case Study of Securities

Regulation in a Small Open Market, 2 THEORETICAL INQ. L. 673, 682 (2001) (“[M]anagers

would prefer to list on a market without a duty to disclose executive compensation with a

personal breakdown; controlling shareholders would prefer to list on a market with lax disclosure

and approval requirements regarding interested party transactions; and insiders in general might

prefer to list on a market with a lenient anti-insider trading regime or weak enforcement.”).

329 Evidence from many empirical studies supports the conclusion that “insiders may take

advantage of cross-listings to derive private benefits.” Licht, Legal Plug-Ins, supra note 327, at

206 (citing several studies).

330 Mark Lang et al., Earnings Management and Cross Listing: Are Reconciled Earnings

Comparable to US Earnings?, 42 J. ACCT. & ECON. 255, 281 (2006) (finding that “accounting

data for [non-U.S.] cross-listed firms show more evidence of earnings management, less evidence

of timely loss recognition and a lower association with share price” as compared to U.S. firms).

331 Christian Leuz, Cross Listing, Bonding and Firms’ Reporting Incentives: A Discussion of

Lang, Raedy and Wilson (2006), 42 J. ACCT. & ECON. 285, 297 (2006) (“[C]ross-listed firms

engage in less earnings management than non-cross-listed firms, despite the fact that they manage

earnings more than U.S. firms.”).

332 Licht, Cross-Listing, supra note 320, at 158.

333 Gwendolyn P. Webb, Evidence of Managerial Timing: The Case of Exchange Listings, 22

J. FIN. RES. 247 (1999).



regulatory pressure.334 For example, in the early 1990s, the NYSE weakened its listing standards by eliminating the one-share, one-vote rule rather than delist a prominent company, General Motors.335 There are numerous recent examples of various stock exchanges around the world competing for business by lowering listing standards.336 But this lowering of standards is a short-term strategy that inevitably undermines the investing environment. As Coffee notes, “[t]he ironic bottom line here could be that the policies that maximize the private wealth of the exchanges could minimize social wealth for the nation.”337

Today, managers of U.S. firms who benefit personally from less supervision and less liability are leading the charge toward repeal of SOX 404 and other Enron-era reforms. Consistent with its short-term self-interest, Wall Street is joining in. This highlights the potential for an unwise regulatory “race to the bottom.” Pan notes:

To the extent direct purchases abroad become more common and institutional investor purchases continue to grow, a greater share of the US investor base will be buying shares of companies that do not meet any of the US securities law requirements. Information will be disclosed in a [sic] unfamiliar manner, financial information may be prepared in accordance with weak accounting standards, and fraud and liability protections may be absent. The SEC therefore faces its own competitive pressure—over-regulate and investors and issuers will move offshore; under-regulate and investors and markets may be harmed.338

SOX’s only clear impact in the listings arena has been to nudge many very small firms away from NASDAQ and to the AIM Market in London. But the SEC should generally resist pressure for deregulation to lure these firms to New York, because AIM’s standards have been so low that “[y]our child’s lemonade stand would probably have a shot at being listed.”339 AIM has been criticized for being less than diligent in policing fraud among its listing companies.340 There has been an

334 This is certainly not a universal rule. No exchange in the U.S. seems unduly tempted at the

current time to lower its listing standards to compete with London’s AIM. Indeed, NASDAQ

went the other direction by raising its standards on the new NASDAQ Global Market

335 Bernard S. Black, Is Corporate Law Trivial?: A Political and Economic Analysis, 84 NW.

U. L. REV. 542, 558 (1990); see also Karen Richardson, How NYSE, Nasdaq Listings Confer

Value, WALL ST. J., Jan. 8, 2007, at C3 (providing recent evidence that to preserve listings

exchanges often do not enforce their standards).

336 Robert A. Prentice, Regulatory Competition in Securities Law: A Dream (That Should Be)

Deferred, 66 OHIO ST. L.J. 1155, 1198-1200 (2005) (giving many specific examples).

337 Coffee, Impact, supra note 306, at 19.

338 Pan, supra note 200, at 14.

339 Anderson, supra note 223, at C6 (“[S]maller companies are listing in London because there

is a market there [the AIM] that boasts of having virtually no regulation, a benchmark the United

States should not lower itself to meet.”).

340 See Richard Fletcher, Torex Profit Warning Sparks Inquiry, DAILY TEL. (London), Jan. 27,



accelerating number of delistings on AIM and most of its stocks are not liquid at all; the average daily trading volume per company on AIM is only 2% of NASDAQ. 341

Already important investors are complaining of the adverse impact that some overseas listings are having on the standards and reputation of London as a financial center.342 Problems at AIM have forced the LSE to change its rules to increase regulation; soon firms that list on AIM “will face inspections from the London Stock Exchange, and in a move with echoes of Sarbanes-Oxley, they will have to attest in writing that the company is ‘suitable’ to be listed on AIM.”343 Increased disclosure is also on the horizon.344 Foreign firms that wish to be included in key indices will have to publicly pledge to uphold UK standards of corporate governance and investor protection.345 The FSA has recently imposed heavy fines on a bank, an insurance company, and two securities firms for poor internal controls.346 As London raises its standards in response to AIM’s and other problems, it is a poor time to urge the SEC to lower U.S. standards.

Hostak et al. recently studied the foreign firms that had voluntarily delisted from U.S. stock exchanges, finding that they were firms with weaker corporate governance.347 When these firms delist, their stock price suffers on home markets, suggesting that investors believe the

2007, at 31 (noting that problems with Torex Software have people questioning the reputation of

this lightly-regulated market); Andrew Hill, Some Subtle Brand Management Is Needed, FIN.

TIMES (London), Feb. 27, 2007, at 20 (noting that some sophisticated investors are concerned that

London’s “light touch’ may become perceived as a “soft touch” to the detriment of the London

brand); Ros Snowdon, Market Accused of Being Open to Fraud, YORKSHIRE POST, Feb. 15, 2006

(“The AIM market was slammed for being negligent and open to fraud yesterday by angry

shareholders in Langbar, the company in the middle of a £365m fraud investigation.”).

341 MCKINSEY REPORT, supra note 3, at 52.

342 Francesco Guerrera & Chrystia Freeland, Ross Raps Aim For 'Dangerous' Standards, FIN.

TIMES (London), Apr. 20, 2007, at 1 (noting criticisms of U.S. billionaire Wilbur Ross); James

Mackintosh, FSA to Act on Foreign IPO Concerns, FIN. TIMES (London), Apr. 5, 2007, at 1; see

also James Mackintosh, FSA Ditches ‘Light’ Hedge Fund Regime, FIN. TIMES (London), Apr. 5,

2007, at 19 (noting that the FSA in London was, in the face of investor outcry, scrapping a “light-

touch” regulatory regime aimed at attracting hedge fund listings).

343 Jenny Anderson, About Those Fears of Wall Street’s Decline, N.Y. TIMES, Jan. 26, 2007, at

C6.

344 Balls Gives LSE Rivals an Equal Tax Break, DAILY MAIL (London), Feb. 21, 2007, at 79

(noting that the LSE had introduced a number of regulatory changes for AIM, including an

enhanced disclosure regime).

345 Joanna Chung, Rigors of the Road to a London IPO, FIN. TIMES (London), May 14, 2007,

at 21.

346 Chris Hughes, FSA Fines Bank for Lax Fraud Controls, FIN. TIMES (London), May 11,

2007, at 20 (citing 350,000 pound fine assessed to BNP Paribas Private Bank); Matt Williams,

Bank Called to Account for Fraud, BIRMINGHAM POST, May 11, 2007, at 19 (noting fines against

Kyte, Nationwide Building Society, and Capita Group).

347 Peter Hostak et al., An Examination of the Impact of the Sarbanes-Oxley Act on the

Attractiveness of US Capital Markets for Foreign Firms 19 (Apr. 30, 2007), available at




motive for delisting is not to avoid SOX’s implementation costs in order to benefit the firm, but to protect the ability of managers and controlling shareholders to maintain private benefits.348 The authors conclude that “our finding that, on average, SOX is driving away firms with weaker corporate governance suggests that SOX is not adversely affecting the competitiveness of US exchanges.”349 Marosi and Massoud did a similar study and also found that “foreign firms are exiting U.S. markets so as to avoid enhanced corporate governance controls associated with” SOX, consistent with a managerial opportunism hypothesis rather than a SOX-is-costly hypothesis.350

Even the McKinsey report explicitly chose not to recommend lowering U.S. listing requirements to compete with the AIM market.351 Allowing regulatory arbitrage by shaky firms with poor internal controls is questionable policy.352 The only good news in such a scenario is that the threatened race toward the bottom that SOX critics seek to ignite is starting from a higher point up the slope than was previously the case because European and Asian nations have all adopted many important aspects of U.S.-style securities regulation over the last fifteen years.353

IV. CHANGING NORMS AND BEHAVIORS

SOX 404 clearly has fewer costs and more benefits than commonly

348 Id. at 3, 31.

349 Id. at 5.

350 Andras Marosi & Nadia Massoud, “You Can Enter But You Cannot Leave. . .”—U.S.

Securities Markets and Foreign Firms 25 (Nov. 2006), available at


351 MCKINSEY REPORT, supra note 3, at 51. However, the Pink Sheets is opening a new

listing category to compete with AIM, which will eliminate any regulatory reason for small

American firms to go to AIM. It is called “OUTCQX” and is aimed at providing a category

between SEC-regulated exchanges and the layer of “crap companies” commonly found on the

Pink Sheets. Jeremy Grant, In the Pink for a Lighter Regulatory Touch, FIN. TIMES (London),

Apr. 26, 2007, at 43.

352 Regarding the NYSE’s then-proposed (now impending) merger with Euronext, plaintiffs’

attorney and frequent commentator Jacob Zamansky argued that

[t]he most unfortunate outcome of the merger, should it go through, is a real

possibility that the deal could effectively weaken regulation and listing standards

worldwide and undermine recent advances in the US. The merger will most likely give

less-than-pristine US companies a chance to play the game of regulatory arbitrage,

shifting to national exchanges in Europe to escape tough US regulations.

Jacob Zamansky, How an Exchange Merger Can Create Big Losers, FIN. TIMES (London), Aug.

24, 2006, at 9.

353 See Prentice, Strong SEC, supra note 188, at 832-38. When nations think in the short term,

they tend to lower regulatory standards to compete for listings, as London has done with AIM in

recent years. When they think in the long term, they tend to create conditions that will be inviting

to investors and that typically involve raising regulatory standards as London is just now starting

to do with AIM.



represented. Some of the costs are relatively easy to quantify; most of the benefits are not. Many other costs and benefits could be addressed, but like those already mentioned they would not be susceptible to precise empirical calculation. For example, many corporate executives have complained that the time they must devote to SOX compliance is time when they cannot be thinking the big thoughts, mapping corporate strategy, implementing strategic plans, etc.354 In addition, many firms claim that SOX costs have required them to cut budgets or staff in important areas of their business.355 Both claims are likely true, but difficult to verify and impossible to accurately quantify.

On the other side of the ledger, SOX 404 implementation not only benefits the capital markets generally by producing more accurate financial statements, but can also help the implementing companies themselves in the long run by enabling them to know when they are wasting money on duplicate systems, suffering insider theft, persistently losing money in divisions that were assumed profitable, and so forth.356 Also, experts indicate that SOX 404 compliance can produce many supply chain-related benefits that thus far “have been downplayed, understated, or simply overlooked by critics of [404].”357 Still, no one has successfully put a calculator to the cumulative dollar value of these benefits.

Although it remains impossible to confidently determine which weighs heavier in its side of the scale—SOX 404’s costs or its benefits358—what can be confidently said is that SOX’s long-term

354 See Carney, supra note 249, at 147 (noting that the opportunity costs of SOX will not

show up directly in income statements but will be real nonetheless); Tom Kirchmaier & Mariano

Selvaggi, The Dark Side of ‘Good’ Corporate Governance: Compliance—Fuelled Book-Cooking

Activities (FMC Discussion Paper No. 559) (Apr. 2006), available at

http://ssrn.com/abstract=895362 (theorizing that SOX’s strict reporting rules may lead to “[t]op

executives [being] judged primarily on the basis of financial metrics as opposed to long-term

fit.”); Alix Nyberg Stuart, Sticker Shock, CFO MAG., Sept. 1, 2003,

http://www.cfo.com/article.cfm/3010299/c_3046597?f=singlepage (citing a survey indicating that

“executives say the focus on compliance has also left them frazzled, with less time to mull

strategic decisions . . .”).

355 See Foley & Lardner Fourth Annual Sarbanes-Oxley Study Reveals Slight Reductions in

Cost of Being Public in 2005, PR NEWSWIRE US, June 15, 2006 (citing survey indicating that

one-third of companies claimed such cuts). One-third of one survey’s respondents claimed that

they had delayed or canceled projects as a result of SOX. See Stuart, supra note 354.

356 See, e.g., Trumbull, supra note 143, at 3 (noting that for some companies “grudging

reluctance has given way to acceptance [of SOX 404] and even the view that the rigorous new

accounting standards entail benefits as well as costs . . . .”).

357 Mark Barratt et al., Sarbanes-Oxley: Is It Good for Your Supply Chain?, SUPPLY CHAIN

MGMT. REV., Nov. 1, 2006, at 34 (noting that the benefits are long-term and difficult to measure,

but definitely exist).

358 See Brown, Criticizing, supra note 120, at 335 (“The permanent effects of SOX may

eventually become clear enough and susceptible to isolation to permit assessment. That day has

not yet arrived.”); Langevoort, Social Construction, supra note 2, at 13 (“[T]here is no good

scientific mechanism for quantifying [SOX’s] benefits or costs, much less netting them out.”).



benefits are much more likely to outweigh its long-term costs if it is not de-legitimized by criticism uninformed by the best empirical evidence. The problem at Enron and most of the companies involved in the massive frauds of the dot-com boom had much to do with corporate culture.359 Although Enron had a paper code of ethics, its true code was easily inferred from its behavior—we are smarter and more innovative than anyone else and the normal rules do not apply to us. The CFO’s office was expected to produce attractive numbers rather than accurate numbers. The tax department was charged with being a profit center, rather than with paying the accurate, if minimum, amounts of taxes owed.360 Little good can come from such a poisonous corporate culture.361

One of the most important questions in corporate America over the next few years will be whether SOX 404 can influence people’s beliefs as well as actions. Changes in the law can alter not only behavior but also beliefs as to what behavior is appropriate.362 Passage of the original securities acts back in the 1930s improved financial morality on Wall Street by informing securities professionals about the standard society was going to (and should) hold them to.363 Insider trading legislation in the 1980s had a similar impact regarding people’s

359 See generally Robert Prentice, Enron: A Brief Behavioral Autopsy, 40 AM. BUS. L.J. 417

(2003).

360 See Victor Fleischer, Options Backdating, Tax Shelters, and Corporate Culture 2 (2006),

available at http://ssrn.com/abstract=939914.

361 See generally Stephan Meier, A Survey of Economic Theories and Field Evidence on Pro-

Social Behavior 13-18 (Federal Reserve Bank of Boston Working Paper No. 06-6) (Jan. 2006),

available at http://ssrn.com/abstract=917187 (noting the strong influence institutional culture can

have upon individual conduct).

362 See, e.g., Robert Cooter, Expressive Law and Economics, 27 J. LEGAL STUD. 585, 607

(1998) (“Law provides an instrument for changing social norms by expressing commitments.”);

Mark Kelman, Consumption Theory, Production Theory, and Ideology in the Coase Theorem, 52

S. CAL. L. REV. 669, 695 (1979) (“[P]erhaps society learns what to value in part through the legal

system’s descriptions of our protected spheres.”); Richard H. Pildes, The Unintended Cultural

Consequences of Public Policy: A Comment on the Symposium, 89 MICH. L. REV. 936, 938-39

(1991) (noting that law has cultural consequences); Eric A. Posner, Law, Economics, and

Inefficient Norms, 144 U. PA. L. REV. 1697, 1731 (1996) (“[L]aws inevitably strengthen or

weaken social norms by signaling an official stance toward them . . . .”); ERIC A. POSNER, LAW

AND SOCIAL NORMS 33 (2000) (observing that legal changes can alter both people’s behavior and

beliefs); Jeffrey J. Rachlinski, The Limits of Social Norms, 74 CHI.-KENT L. REV. 1537, 1538

(2000) (“[C]hanges in law can influence social norms. For example, passing a law against

smoking in public places had a dramatic effect on smokers, not because of the formal penalty for

public smoking (which is hardly ever imposed) but because it empowered nonsmokers to levy

social sanctions on smokers.”); Steven Shavell, Law versus Morality as Regulators of Conduct 4

AM. L. & ECON. REV. 227, 254 (2002) (“[L]egal rules can affect our moral beliefs, as well as the

operation of the moral sanctions.”).

363 JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET: A HISTORY OF THE

SECURITIES AND EXCHANGE COMMISSION AND MODERN CORPORATE FINANCE 178-79 (rev. ed.

1995) (noting long-term impact of the SEC’s “revolution in financial morality” accomplished in

the 1930s).



perceptions of the legitimacy of that practice.364 More important than the law, however, are perceptions of the law,

for people’s beliefs regarding the morality of behavior depend even more upon their peers’ views than upon the law’s stance regarding that behavior.365 One theory is that legislation changes what people believe about approval patterns in their society and because people value approval, their new beliefs affect their behavior.366

Thus, while disclosure in general tends to reduce fraud by changing the internal dynamics of the firm,367 the more targeted question is whether SOX 404 can actually help alter corporate norms and cultures. If it can, then SOX can have a much greater and longer-lasting impact on the evolution of capital markets in America than if it is unfairly discredited. Edelman et al. indicate that compliance programs can help instill in firms the values represented by legislation, enabling consistent social norms to evolve.368 Edelman’s research has indicated that regarding corporate implementation of equal employment opportunity regulations, “compliance programs create the opportunity for social norms to take deeper root inside the organization, competing with (though probably never fully displacing) narrower conceptions of the firm’s self-interest.”369

SOX 404 could help create a culture of compliance, of dedication to disclosing accurate numbers rather than just desired numbers.370 This

364 THOMAS DONALDSON & THOMAS W. DUNFEE, TIES THAT BIND: A SOCIAL CONTRACTS

APPROACH TO BUSINESS ETHICS 95-96 (1999).

365 See Dan M. Kahan, Gentle Nudges vs. Hard Shoves: Solving the Sticky Norms Problem, 67

U. CHI. L. REV. 607, 614 (2000) (citing Harold G. Grasmick & Donald E. Green, Legal

Punishment, Social Disapproval and Internalization as Inhibitors of Illegal Behavior, 71 J. CRIM.

L. & CRIMINOLOGY 325 (1980)).

366 Richard H. McAdams, An Attitudinal Theory of Expressive Law, 79 OR. L. REV. 339, 389

(2000).

367 ,Victor Fleischer, Options Backdating, Tax Shelters, and Corporate Culture 27-28 (Colo.

Law Sch. Legal Stud. Research Paper Series, Paper No. 06-38, 2006) (Oct. 24, 2006), available

at http://ssrn.com/abstract=939914 (citing Michael D. Guttentag et al., Brandeis’ Policeman:

Results from a Laboratory Experiment on How to Prevent Corporate Fraud, at 7 (unpublished

manuscript)).

368 See, e.g., Lauren B. Edelman et al., The Endogeneity of Legal Regulation: Grievance

Procedures as Rational Myth, 105 AM. J. SOC. 406 (1999) [hereinafter Edelman et al.,

Endogeneity]; Lauren B. Edelman, Legal Ambiguity and Symbolic Structures: Organizational

Mediation of Civil Rights Law, 97 AM. J. SOC. 1531, 1567-69 (1992) (suggesting that

organizations’ responses to legal requirements may help shape legal and societal expectations

about what constitutes compliance and to advance compliance even when political pressures

subside); Lauren B. Edelman et al., Legal Ambiguity and the Politics of Compliance: Affirmative

Action Officers’ Dilemma, 13 L. & POL’Y 73 (1991).

369 Langevoort, Internal Controls, supra note 7, at 26, (citing Edelman et al., Endogeneity,

supra note 368 and related papers).

370 Langevoort, Internal Controls, supra note 7, at 27 (“Sarbanes-Oxley will have some

positive pay-off in terms of corporate transparency and accountability generally, in addition to the

specific improvements in the quality of financial reporting.”).



seems to have already happened in one area. Based on anecdotal evidence and survey responses, Morse has concluded that SOX’s changes, including SOX 404, have helped to create a new compliance norm in the tax field.371 SOX 404 helps reduce tax tomfoolery by making the tax planning process more transparent, in part because the SOX 404 audit addresses the substantive correctness of tax positions.372 Morse concludes that SOX 404 “appears to provide some synergies with respect to the regulation of tax planning”373 which has helped replace a culture of aggressive tax shirking with a culture of tax compliance.

SOX has the potential to create a similar culture of compliance in corporate financial reporting. On the other hand, as Kahan has noted, if the law tries to change accepted norms too significantly, this “hard shove” may well be self-defeating where a “gentle nudge” might have worked.374 Kahan argues that if a condemnatory law that is greatly out of sync with established norms is enacted, officials will refrain from enforcing it and the drop in probability of punishment may result in less deterrence in toto.375

A problem for SOX is that businesses that oppose regulation have the incentive and resources to keep up a drumbeat of opposition to SOX 404 in the press that may undermine its legitimacy in the eyes of the public and the participants in the securities markets, thereby subverting its effectiveness. Dunfee and Donaldson note that “[l]aw, particularly when it is perceived as legitimate by members of a community, may have a major impact on what is considered to be correct behavior.”376 Langevoort agrees, noting that “absent unusually high rates of detection and prosecution, compliance decisions are based at least as much on the perceived legitimacy of the law and prevailing norms in local context as any deliberate risk calculation.”377 If critics succeed in convincing

371 Susan Morse, The How and Why of the New Public Corporation Tax Shelter Compliance

Norm 1-2 (May 15, 2006), available at http://ssrn.com/abstract=905746 (citing as three reasons

why tax compliance has increased in the U.S. recently: (a) the expansion and increased

transparency of the tax decisionmaking process within firms, caused largely by SOX innovations,

including Section 404; (b) increased top-down ethical compliance caused by liability worries on

behalf of officers and gatekeepers; (c) the clear and consistent government message that labels tax

shelters as impermissible).

372 Id. at 5; see also id. at 17 (noting that under SOX 404, auditors “demand more information

about tax planning [than they did before SOX]”).

373 Id. at 14. The interrelationship between Section 404 and tax compliance is particularly

strong because “over 200 material weaknesses and 31% of adverse internal control opinions were

tax related in 2005.” Id. at 15-16 (citing Allen Shoulders, Practical Approaches to Improving

Tax Control Effectiveness, 2006 TNT 80-37 (Apr. 18, 2006)).

374 See Kahan, supra note 365, at 609.

375 See id. at 619.

376 DONALDSON & DUNFEE, supra note 364, at 95 (emphasis added).

377 Langevoort, Social Construction, supra note 2, at 2 (emphasis added) (citing TOM R.



capital market participants that SOX is “quack corporate governance”378 or a “debacle,”379 they will undermine SOX’s legitimacy and thereby make it much more likely that in the long run its overall benefits will be exceeded by its costs.

CONCLUSION

Faith in U.S. capital markets has been substantially restored

following the bursting of the dot-com bubble and the exposure of a scandalous corporate culture at many major corporations. Sarbanes-Oxley and its section 404 helped enable that resurrection.

The commonly perceived burdens of SOX 404, including implementation costs and impact on U.S. capital markets, are real but have been overstated while its real benefits are often overlooked. Considerable empirical academic evidence indicates that SOX 404 has improved the accuracy of financial reporting, improved liquidity and corporate governance, and helped disclose some frauds and discourage others.

That said, it is impossible at this point in time to accurately weigh SOX’s total benefits against its total costs. None of the scores of academic studies cited in this article purports to settle definitively the question of whether SOX in general or SOX 404 in particular have been, on balance, beneficial. Therefore, what must continue to occur is a careful, reasoned study of SOX’s provisions and their impact.380

While there is substantial reason to believe that SOX has improved the economy and brought various concrete benefits to the capital

TYLER, WHY PEOPLE OBEY THE LAW (2006); IAN AYRES & JOHN BRAITHEWAITE, RESPONSIVE

REGULATION: THE DEREGULATION DEBATE (1992); Neil Gunningham et al., Social License and

Environmental Protection: Why Businesses Go Beyond Compliance, 29 L. & SOC. INQUIRY 307

(2004)).

378 Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate

Governance, 114 YALE L.J. 1521 (2005).

379 HENRY N. BUTLER & LARRY E. RIBSTEIN, THE SARBANES-OXLEY DEBACLE: WHAT

WE’VE LEARNED; HOW TO FIX IT (2006).

380 It is interesting that in 1996, the GAO issued a report noting that the SEC had not been

aggressive in enforcing the FCPA’s internal accounting control provisions, noting that the

Commission “has not been convinced of the merits of reporting on internal controls.”

ACCOUNTING & INFO. MGMT. DIV., U.S. GEN. ACCOUNTING OFFICE, AIMD/GAO 96-98A, THE

ACCOUNTING PROFESSION—MAJOR ISSUES: PROGRESS AND CONCERNS 12 (1996), cited in

Letter from Lynn E. Turner, Managing Dir., Glass, Lewis & Co., to Jonathan G. Katz, Sec’y, Sec.

& Exch. Comm’n 3 (Apr. 12, 2005). The GAO presciently stated its expectation that “audits will

be expanded to include internal control reporting, either because of market demand or systemic

crisis.” Id. The GAO had the better view regarding internal controls then, which may be part of

the reason that the SEC has not knuckled under to intense political pressure to waive SOX 404

requirements for small and foreign issuers but instead continues to study these difficult issues.



markets, if its detractors succeed, commercial actors in the U.S. will ultimately view SOX, and especially SOX 404, as illegitimate. This eventuality would blunt SOX’s positive impact upon beliefs, norms, and practices in the U.S. capital markets and its potential to create and sustain a culture of compliance and integrity will be seriously damaged. If that happens, it becomes much more likely that SOX’s costs will ultimately exceed its benefits than if SOX 404 is viewed as a legitimate, though somewhat flawed, attempt to restore integrity to the U.S. capital markets. And the current evidence indicates that is much closer to the truth.

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