State of Innovation

Patents and Innovation Economics

Sarbanes Oxley – The Medicine is worse than the Disease: Part 2

None of these securities laws were able to prevent the stock market decline of 2000.  Sarbanes Oxley was passed in 2002 in reaction to several corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, and WorldCom.  The legislation set new or enhanced standards for all U.S. public company boards, management, and public accounting firms.  The act contains 11 titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law.

According to John Cogan, Jr., professor of Law and Economics and Harvard:

The primary goal of the Sarbanes Oxley Act was to fix auditing of U.S. public companies, consistent with its full, official name: the Public Company Accounting Reform and Investor Protection Act of 2002.  By consensus, auditing had been working poorly, and increasingly so.  The most important, and most promising, part of SarbanesOxley was the creation of a unique, quasi-public institution to oversee and regulate auditing, the Public Company Accounting Oversight Board (PCAOB).  In controversial section 404, the law also created new disclosure-based incentives for firms to spend money on internal controls, above increases that would have occurred after the corporate scandals of the early 2000s.[1]

The alleged benefits of Sarbanes Banes Oxley, in exchange for the costs of auditing, included:

“Investors will face a lower risk of losses from fraud and theft, and benefit from more reliable financial reporting, greater transparency, and accountability.  Public companies will pay a lower cost of capital, and the economy will benefit because of a better allocation of resources and faster growth.”[2]

When Sarbanes Oxley was passed, the SEC (Securities and Exchange Commission) estimated the cost of compliance would be $91,000.00 per year for each public company.  The most recent estimates for the cost of compliance are between $4.0 million and $5.0 million per year for publicly traded companies.  The United States has over 18,000 public companies, which means the U.S. spends around $80 Billion a year to comply with Sarbanes Oxley.  How much is $80 Billion a year?  It is roughly equal to IBM’s revenues per year, and about the cost of the auto industry bailout.

Is the cost of this law worth its incredible price?  Has Sarbanes Oxley achieved its goal of protecting investors from fraud?  Sarbanes Oxley has cost the U.S. economy at least $400 billion since it passage.  This is just the direct costs and does not include the opportunity costs, which are most likely substantially higher.  The stock market has been flat or declining since its passage.  As a result, it is hard to argue that this legislation increased shareholder value.  The banking scandals of 2008 & 2009 that included Bear Sterns, Lehman Brothers, American International Group (AIG), Merrill Lynch, and the Bernie Madoff fraud make it impossible to suggest that Sarbanes Oxley has protected investors from fraud.

Sources report that 100 to 200 publicly owned companies per year, including big names such as Dunkin’ Donuts and Neiman Marcus, have chosen to buy out their stockholders and revert to private ownership since Sarbanes Oxley was passed.  Many U.S. private firms are putting off initial public offerings, and more foreign companies are choosing to list on the Tokyo, London or other foreign exchanges rather than on the U.S. stock exchanges.

Sarbanes Oxley has essentially killed off the public market as an exit strategy for technology start-up companies, thereby reducing investment in innovative start-up companies.  In the second quarter of 2008, there were no public offerings of Silicon Valley venture capital-backed companies, a phenomenon not seen since 1978.  At $4-5 million per year for a company to go public and comply with Sarbanes Oxley, a company must have earnings of about $100 million and sales of around $1 billion.  Given these astronomical hurdles to an IPO (Initial Public Offer), it is not surprising that start-up companies no longer consider an IPO a realistic exit strategy.  By closing off the public market to start-up companies, the amount of risk capital available (e.g., venture capital) has declined precipitously.


Sarbanes Oxley is very expensive: including enormous direct and indirect costs to our economy and to innovation.  It has not met its goals of improving the quality of auditing or preventing fraud.  Nor have any of the benefits of these costs materialized.  Public companies have not experienced lower capital costs, investors have not been protected from fraud and there has not been faster economic growth due to more efficient allocation of resources.  The effects of this law include fewer public companies, fewer companies going public, more companies choosing to go public in foreign markets, absurdly high auditing expenses and a significant decrease in risk capital.

Interestingly, a number of econometric studies of the effectiveness of the SEC and securities laws before and after Sarbanes Oxley have shown no net effect on investor returns.[3] According to Liu et al. “we find that the conditional mean and variance of monthly total real stock returns were no different

during 1940-2007 than during 1871-1925.  Consequently, recent claims by high ranking government officials that stock market “stabilization” requires increased federal regulation implies greater faith in this method of protecting investors than is supported by the evidence.”[4] What these studies do not account for is the lost opportunity costs due to all the securities laws.  At least in the case of Sarbanes Oxley, the opportunity costs most likely far outweigh the direct costs.

Since the public market is not an option for innovative start-up companies, why don’t risk capital investors and company founders just obtain their return on investment through dividends and salary or alternatively, sell out to another public company?  Selling out to another public or private company has been the major exit strategy for most start-ups in the last decade (2000-2009).  The problem with this solution the limited number of companies that can purchase start-ups and generally these companies want to pay for the start-up with their stock.  Only when companies that believe their stock is well valued are likely to engage in acquisitions.  Because Sarbanes Oxley limits the number of companies in the public market, it limits public stocks that investors can purchase to mature, slower growing companies.  As a result, most public companies’ valuation by the market is not high and the amount of money they can pay for a start-up is correspondingly lower.

There are three reasons why dividends and salary are not good substitutes for going public: 1) taxes are higher on dividends and salary than on capital gains, 2) this requires pulling cash out of a company that needs the cash to grow, and 3) the timeframe to obtain the return is ten years or longer than a public offering.  Taxes on dividends and salary are at least double the taxes on capital gains.  Also, the founders and investors are only taxed when they sell their stock.  They may never sell all of their stock, further reducing the tax burden.

When a start-up goes public it infuses money into the company allowing it to grow faster.  The investors and founders can use the companies stock as money instead of withdrawing cash from the company.  Since the stock is now publicly traded, the founders can be confident that if they need cash they can sell some of their stock at that time.  This reduces their propensity to sell the stock immediately.  Venture capital firms can use the stock to pay off their investors or hold, confident that if they need cash they can sell some of their stock at that time.  The company can use its stock to purchase other start-ups.

If the founders and investors are limited to salary and dividends for their return and assuming the company would have a ten times multiple on earnings, it would take at least ten years for the founders and investors to obtain the same return.  When you add in the additional taxes for salary and dividends compared to going public and the time value of money, it would probably take even longer than ten years to obtain the same return.  This would slow the company’s growth by starving it for capital.

How should we reform securities laws to encourage innovation?  First, we should repeal Sarbanes Oxley.  In the 1990s the U.S. was the innovation leader of the world, state and federal tax revenues were burgeoning, and the stock market was booming.  This was the result of a thriving technology start-up ecosystem.  Then we passed Sarbanes Oxley and the stock market is down, the U.S. is no longer innovating and federal and state budgets are bleeding.  Sarbanes Oxley is a direct attack on the technology start-up ecosystem, starving it for capital.

Since there is no evidence for the efficacy of securities laws, the regulatory burden of these laws should be drastically reduced.  Regulation should be limited to requiring quarterly financial statements.  The goal of securities laws should not be to create “perfect competition” among investors.  Perfect competition is the enemy of innovation, resulting in investor apathy over which stocks they buy.  Ultimately, the question is whether the U.S going to choose the path of France after the Mississippi Company collapse and renounce innovation or the path of England after the South Sea bubble and embrace innovation?

[1] Cogan, Jr., John,  ”The Goals and Promise of the Sarbanes–Oxley Act” Journal of Economic Perspectives, Volume 21, Number 1, Winter 2007, p. 91.


[2] Ibid. p. 92.

[3] Liu, Tung, Santoni, Gary J., Stone, Courtenay C.,   Federal Securities Regulations and Stock Market Returns.  This paper surveys several papers that have studied the effects of securities laws all of which show no meaningful change in investor outcomes.

[4] Ibid. p. 21.

June 18, 2009 - Posted by dbhalling | -Economics, -History, -Legal, Innovation | , , , , , , | 1 Comment

1 Comment »

  1. I completely agree SOX has gone too far. Clearly an over-reaction. And the effect has been to not only create a huge cost, particularly on emerging companies. But it’s also effectively put accountants and lawyers in the gatekeeper mode for emerging companies. While accountants and lawyers are clearly an important part of our business system, putting them in charge of the funnel for innovation based emerging companies isn’t exactly a winning idea.

    I’m not sure we can completely blame SOX for the IPO drought. But it’s clearly creating some draconian unintended consequences beyond fiscal oversight.

    Comment by Patrick Bultema | June 19, 2009 | Reply

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