State of Innovation

Patents and Innovation Economics

More Evidence on the Damage Caused by SOX

Professor Stephen Bainbridge of UCLA law school has written a paper entitled “Corporate Governance and U.S. Capital Market Competiveness.”   Professor Bainbridge clearly shows that U.S. corporate governance is not the problem, regulation is.  The paper shows “that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis.”  The effectiveness of this corporate governance is never evaluated after it is passed.  A number of econometric studies have shown that investors have not profited at all from securities regulation.[1] The article clearly shows that “U.S. capital markets steadily became less competitive globally throughout the decade.”  This is consistent with the analysis in my book, The Decline and Fall of the American Entrepreneur.

Startlingly, the article shows,

In the 1990s, the number of foreign issuers listed on the NYSE roughly quadrupled, with NASDAQ experiencing similar growth, while London and the other major European exchanges were losing market share. Since 2000, however, the situation appears to have reversed. Using global IPOs as an indicator of the relative competitiveness of capital markets, for example, there was a dramatic decline in the U.S.’ market share 48% to 8% between 2000 and 2006.

This change was clearly due to changes in the regulatory environment in this decade.

U.S. corporate governance regime was well above average in the global picture. Even when the fallout from the bubble (technology bubble) was taken into account, returns on the U.S. stock market equaled or exceeded those of its global competitors during five time periods going back as far as 1982. Likewise, U.S. productivity exceeded that of its major Western competitors. In general, the trend with respect to major corporate governance practices had been towards enhanced management efficiency and accountability. Pay for performance compensation schemes, takeovers, restructurings, increased reliance on independent directors, and improved board of director processes all tended to more effectively align management and shareholder interests. (Emphasis Added)

According to the article “SOX is viewed both domestically and internationally as stifling innovation.”  It also shows that the cost of SOX was order of magnitude greater than originally estimated.

The SEC estimated that the average cost of complying with § 404 would be approximately $91,000.36 In fact, however, a 2005 survey put the direct cost of complying with § 404 in its first year at $7.3 million for large accelerated filers and $1.5 million for accelerated filers. “First-year implementation costs for larger companies were thus eighty times greater than the SEC had estimated, and sixteen times greater than estimated for smaller companies.”

So how has this affected public companies financials?

Both the recurring nature and disproportionate impact of these costs is confirmed by a recent study of the impact SOX had on the operating profitability of a sample of 1428 firms. Average cash flows declined by 1.3% post-SOX. Costs ranged from $6 million for small firms to $ 39 million for large firms. These costs were not limited to one-time first year implementation expenses. Instead, substantial costs and reduced profits recurred throughout the four year study period. In the aggregate, the sample firms lost about $75 billion over that period.

SOX has also had a major impact on venture capital and technology startups.

Start-up companies opted for financing from private-equity firms, rather than using an IPO to raise money from the capital markets. Because going public is an important venture capital exit strategy, partially closing the exit could impede start-up financing, and therefore make it harder to get ideas off the ground.

I have shown in my book that the inability to go public has had a significant deleterious effect on technology startup companies.

The evidence that SOX and the new financial reform bill are damaging our economy and not provided any of the promised benefits is overwhelming.  However, it appears that the short term political advantage is outweighing the interests of the country.

[1] 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.


January 30, 2011 - Posted by dbhalling | -Economics, Innovation

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