To Be or Not to Be Public: The Impact of SOX
Rosenthal, Leonard, Gleason, Kimberly C., Madura, Jeff, Quarterly Journal of Finance and Accounting
In the midst of the greatest economic/market meltdown since the Great Depression, the U.S. government has enacted a number of new laws/regulations to address the problems that played a role in the current crisis. Some commentators and others say that we should avoid rushing to put new rules in place as was done with the passage of the Sarbanes-Oxley Act (SOX) of 2002--which was passed on the heels of several major financial frauds which came to light in 2001 and early 2002. SOX is the most dramatic piece of legislation relating to shareholders and corporations since the 1930s.
The Sarbanes-Oxley Act, signed by President Bush on July 30, 2002, contains provisions that are intended to ensure more accurate disclosure of financial information to investors. The Act:
1. Empowers a public company accounting oversight board to inspect accounting firms. The accounting firms are charged an annual fee, and are assessed by the board every one to three years. (Section 1)
2. Allows public accounting firms to offer non-audit consulting services to an audit client only if the client's audit committee pre-approves the non-audit services to be rendered before the audit begins. (Subsection 201)
3. Prevents a public accounting firm from auditing a client firm whose CEO, CFO, or other employees with similar job descriptions were employed by the audit firm within one year prior to the audit. (Subsection 206)
4. Requires that the firm uses an independent audit committee, which consists of only outside board members, and one of those members must be a financial expert. (Subsection 301, Subsection 407)
5. Requires that firms with at least $75 million in assets that file 10-Ks improve their internal control systems (this provision was implemented as of November 15, 2004). (1, 2) (Subsection 404)
6. Requires that the CEO and CFO of firms that are of at least a specified size level certify that the audited financial statements are accurate, and holds them accountable for their verification. (Subsection 302)
7. Requires more timely and enhanced disclosure of the financial statements, (especially for off-balance sheet items). (Subsection 401)
8. Specifies major fines or imprisonment for employees who mislead investors or hide evidence. (Sections 8, 9 and 11)
9. Provides for the forfeiture of bonuses if financial statements are restated. (Subsection 304)
10. Eliminates personal loans. (Subsection 402)
All provisions listed above are intended to prevent fraudulent financial reporting, and increase the transparency of publicly-traded firms. However, some critics argue that SOX imposes a large penalty on publicly-traded firms by increasing the cost of disclosure. As a result of SOX provisions, publicly-traded firms are subject to larger audit fees, and higher costs of maintaining the required internal financial controls. Consequently, its provisions may have motivated firms to go private rather than incur the explicit and implicit costs of complying with the law's requirements. We investigate this issue by examining whether SOX affected the propensity of firms to go private, and the effect of SOX on valuation of firms going private.
Our study contributes to the literature in the following ways. First, we use a more focused definition of going private than previous related studies (discussed shortly), in which we examine firms whose shares no longer trade in any market and which no longer provide publicly available financial information. Therefore, we exclude firms that deregister ("go dark"). We think that our definition of going private provides the cleanest way to assess whether SOX encourages public firms to go private. Second, our sample is extended through 2005 so that we can assess a longer time period following SOX. This is relevant because of shift in the possible increased incentive to go private since SOX and the possible extra reward (valuation effect) for firms that have gone private since SOX. …