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RAND Corp. study shows "empirical evidence" of steeper relative costs, stock impact, and flight from public markets after 404, but calls the findings "qualified."
Roy Harris, CFO.com | US
January 29, 2008
The California think-tank RAND Corp. spent last year quantifying the impact on small business of Sarbanes-Oxley Section 404. And in the areas of cost, negative stock-price reactions, and the tendency to exit public markets, its research showed that companies with less than $75 million market capitalization did indeed take a bigger hit.
Still, RAND recommends that the "evidence should be interpreted with caution." And it calls for further studies to test the effects in new ways.
The think-tank's main worries? Factors not related to Sarbox might render the findings faulty, and that in any event some of the impacts recorded so far may be fleeting. Indeed, the authors of the study "concluded that SOX has had a mixture of negative and positive effects on small firms, but which effects will prove more significant in the future is, as yet, unknown."
Nonetheless, the findings by RAND — an organization that's now diversified from defense projects into the public-interest and business realms — do seem instructive when considered with the caveats.
In the area of compliance costs, the study showed that firms with less than $75 million market capitalization "saw [audit] costs increase significantly after SOX, rising to 1.14 percent of 2004 revenues for firms filing internal-control reports." For 2003, the median audit fee as a percentage of revenue was nearly half that: 0.64 percent.
For the next size group, those with up to $250 million in market cap, the percentage of revenue spent on audit fees rose from 0.29 to 0.56. Firms not filing internal-control reports spent 0.79 percent of 2004 revenues on audit fees for the smallest market-cap group (less than $75 million), while the percentage was 0.39 for the next-largest group ($75 million to $250 million).
In its analysis, RAND said that its compliance-cost studies "provide ample evidence that SOX increased public firms' accounting and auditing expenditures, regardless of company size," and noted "that audit costs were disproportionately higher for small firms even before SOX passed . . . ." But, it said, "this disparity increased after SOX enactment, especially for small firms subject to SOX Section 404."
The studies are incorporated in the RAND book In the Name of Entrepreneurship? The Logic and Effects of Special Regulatory Treatment for Small Businesses, in which one chapter is dedicated to the topic: "Sarbanes-Oxley's Effect on Small Firms: What Is the Evidence?"
RAND did a number of studies on the affects of Sarbox on stock returns for companies overall, calling those results "mixed." But "almost all studies that did distinguish between large and small firms found that SOX sometimes reduced the latter's value."
In one of its studies, firms with less than $21 million in market cap and "with less independent boards and weaker internal controls performed more poorly than did similar firms with more independent boards and stronger internal controls." It added, "Another study examining the relation between firm size and returns found that SOX had a particularly negative effect on smaller and less actively traded firms."
While it has been intuitively understood that small firms were harder hit by Sarbox, RAND's study represents an early attempt to quantify that damage in various areas, even if though RAND isn't claiming the results are conclusive.
Likewise, the evidence that more small companies have exited the public markets because of Sarbox — deregistering their stock with the Securities and Exchange Commission for various reasons — presents problems.
"The research found that more firms, particularly smaller ones, left the public market after SOX enactment," with some of them going private. But that result "could be influenced by factors that have little to do with SOX," such as private investors responding to favorable markets by bidding up targets. "Similarly, the weakness of the public capital market at that time could have independently encouraged firms to go private."
An earlier 2006 RAND study — which like the 2007 study was sponsored by the Kauffman-RAND Institute for Entrepreneurship Public Policy — controlled for such factors by comparing post-SOX behavior of U.S. firms with that of non-U.S. firms. It found that the tendency of small public U.S. firms to go private "increased by 53 percent in the first year after SOX. However, this tendency did not last long: Acquisitions of small public firms by private ownership diminished to roughly pre-SOX levels by the second year."
In a final interpretation of how the results show a sharper small-firm Sarbox impact in all three areas, RAND said in the latest study that "the evidence offers qualified support for the view that SOX has had a negative effect on small firms . . ."
In addition to the concern that the results could be explained in a number of ways, it added two other reasons for caution: One is that "the studies have suggested that increased compliance costs may have had certain beneficial effects." For one thing, it said, "While it is clear that SOX requirements led some small firms to leave the public capital market, the exiting firms may have been opaque, risky, or prone to financial misstatements, and their departure may have positively affected the market's function."
It also noted that small firms remaining public may have "benefited more from SOX than the exiting firms lost because increased transparency raised investor confidence in them."
As a final note, RAND commented that these reviews are of "only the early post-SOX period, and it is important to learn whether the initial effects represented one-time or recurring effects." Therefore, it said, "the puzzle surrounding SOX's overall effect is far from being resolved. Additional empirical studies will almost certainly continue to inform the policy debate over the coming years."