The Sarbanes-Oxley Act and Corporate Investment: New Evidence from a Natural Experiment*

Ana Albuquerque Julie L. Zhu Boston University Boston University

CATÓLICA-LISBON Business & Economics juliezhu@bu.edu albuquea@bu.edu

May 2012 Abstract Prior studies conclude that one of the economic costs of complying with the Sarbanes-Oxley Act (SOX) is lower corporate investment. U.S. firms with a public float above $75 million during 2002-2004 had to comply with Section 404 of SOX, whereas firms with a smaller public float in each of those three years could delay compliance until at least 2007. Using this setting as a natural quasi-experiment to isolate the effects that were uniquely due to Section 404 of SOX, we compare investment activities for the two groups of firms around the $75 million threshold. In contrast to prior studies, we do not find a reduction in investment for firms that had to comply with SOX relative to those that could delay compliance. Our results challenge the conventional wisdom that SOX caused firms to decrease corporate investment. JEL Classifications: K0, G2, O5. Keywords: SOX, Section 404, investment, regulation, natural experiment.

* We gratefully acknowledge the financial support of Boston University and CATÓLICA-LISBON Business & Economics. We thank Rui Albuquerque, Elizabeth Demers, Miguel Ferreira, Francesca Franco, Gilles Hilary, Krish Menon, Steven Monahan, George Papadakis, Jun Qian, Brian Quinn, Scott Richardson, Eddie Riedl, Irem Tuna, Rodrigo Verdi and Paul Zarowin for comments and suggestions. This work has also benefited from the comments of workshop participants at the 2011 EAA annual meeting, Boston University, INSEAD and London Business School. The research leading to these results has received funding from the European Union Seventh Framework Programme (FP7/2007-2013) under grant agreement n° PCOFUND-GA-2009-246542 2.

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The Sarbanes-Oxley Act and Corporate Investment: New Evidence from a Natural Experiment

May 2012 Abstract Prior studies conclude that one of the economic costs of complying with the Sarbanes-Oxley Act (SOX) is lower corporate investment. U.S. firms with a public float above $75 million during 2002-2004 had to comply with Section 404 of SOX, whereas firms with a smaller public float in each of those three years could delay compliance until at least 2007. Using this setting as a natural quasi-experiment to isolate the effects that were uniquely due to Section 404 of SOX, we compare investment activities for the two groups of firms around the $75 million threshold. In contrast to prior studies, we do not find a reduction in investment for firms that had to comply with SOX relative to those that could delay compliance. Our results challenge the conventional wisdom that SOX caused firms to decrease corporate investment. JEL Classifications: K0, G2, O5. Keywords: SOX, Section 404, investment, regulation, natural experiment.

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“The benefits of the Sarbanes–Oxley act are by their nature difficult to isolate, which doesn’t mean they aren’t real and substantial. Given the corporate scandals of the early 2000s, and the awareness of this behavior by investors and other market participants, the chances are good that public and private enforcement and manager behavior would have changed even had Sarbanes–Oxley not been enacted.” Coates (2007, p. 106) 1. Introduction

The passage of the Sarbanes-Oxley Act (SOX) in 2002 by the U.S. Congress resulted in the

most significant change in securities regulation since the Securities Act of 1933. In response to a

string of high-profile corporate scandals, the main goal of SOX was to strengthen corporate

governance while improving disclosure quality and transparency. An unintended consequence, as

some argue, is a reduction in investment activities that generate profits for shareholders and produce

long-term economic growth (Brady, 2007). A year after enactment, William Donaldson, former

chairman of the Securities Exchange Commission (SEC), stated that SOX would lead to a “loss of

risk-taking zeal” due to a “huge preoccupation with the dangers and risks of making the slightest

mistake.” Several recent studies suggest that compliance with SOX caused companies to decrease

investment (see Litvak, 2008; Shadab, 2008; Bargeron, Lehn, and Zutter, 2010; and Kang, Liu, and

Qi, 2010). However, Leuz (2007) cautions about attributing these findings to SOX, pointing out that

changes in market conditions and other concurrent events may have been at work and that it is crucial

to find a control group—comparable U.S. firms that are not affected by SOX— to isolate the effects

of SOX (see also Coates, 2007; Ball, 2009; and Hochberg, Sapienza, and Vissing-Jorgensen, 2009).

In this paper, we use a quasi-natural experiment to isolate the impact of SOX on corporate investment

by comparing two groups of similar U.S. firms that are affected differently by the legislation.

Arguably the most demanding requirement of SOX is Section 404 (hereafter SOX404), which

mandates that a firm’s annual report filing include a “management report,” in which management

evaluates the firm’s internal control system on financial reporting and discloses any “material

weakness” found. The management report must be personally certified by the chief executive officer

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(CEO) and chief financial officer (CFO) and the company’s auditor needs to attest to management’s

assessment of the firm’s internal controls.1,2 Prior studies suggest compliance with Section 404 as a

reason for companies to avoid risky investments that could compromise the internal control systems

(e.g., Bargeron et al., 2010).3

However, the extent to which SOX404 has dampened corporations’ investment activities is

debatable. First, a stream of literature suggests that SOX may have a positive impact on corporate

investment by lowering firms’ cost of capital. For example, Coffee (2007) points out that, as a result

of SOX404, investors benefit from more reliable financial statements, greater transparency, and

greater accountability, all of which can lead to a lower cost of capital.4 Ashbaugh-Skaife, Collins,

Kinney, and LaFond (2009) show that increases in the effectiveness of internal controls yield

decreases in the firm’s cost of equity, providing evidence that SOX404 reduces the information

asymmetry between a firm and its investors. Hochberg et al. (2009) also find evidence suggesting that

the improved disclosure due to SOX was perceived as beneficial to investors. Using a sample of

European firms that cross-list in the U.S., Arping and Sautner (2011) show that firms’ level of

transparency increased after having to comply with SOX. !

Second, it has long been argued that security laws in general and mandatory disclosure

requirements in particular are inconsequential (Stigler, 1964), because firms can evade the

requirements by disclosing boiler-plate statements and by taking advantage of loopholes and 1 The SEC’s final rule on management’s report on internal control over financial reporting and certification of disclosures following Section 404 can be found at http://www.sec.gov/rules/final/33-8238.htm#iiid. 2 Note that some certifications pursuant to Section 302 of SOX were amended to conform to the requirement under Section 404. See as examples, Section 302(a)(4)(A), Section 302(a)(4)(B), and Section 302(a)(4)(C). 3 Bargeron et al. (2010) mention two other measures of SOX that could have led to a decrease in investment: the increased role of independent directors and increased liabilities and penalties faced by officers and directors. However, the former had already been imposed by the New York Stock Exchange and NASDAQ corporate rules and became effective for fiscal year 2003, before SOX. In the robustness section, we control for the percentage of independent directors on firm’s board of directors and find similar results. As for the latter, Ball (2009) questions its effectiveness in deterring accounting fraud because these penalties also existed before SOX. We thus focus on the most demanding requirement of SOX, Section 404. 4 Leuz and Verrecchia (2000) find evidence of decreased cost of capital for firms that increase their level of (voluntary) disclosure.

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deficiencies in the regulations and in the enforcement process. Specifically, even though the

certification requirements of SOX404 can, in theory, generate significant civil and criminal liabilities

for CEOs and CFOs, in practice, only officers who certify financial statements knowing them to be

materially misleading are in a position to face liability—and may escape any punishment, depending

on other factors.5 In addition, officers can protect themselves through directors’ and officers’ liability

insurance to cover damages or defense costs resulting from a lawsuit for alleged wrongful acts while

acting in their capacity as directors and officers for the organization.6

Third, Ball (2009, page 314) questions the effectiveness of the new legislation regarding the

expanded liability of officers and directors because, prior to SOX, CEOs and CFOs were already

required to sign and attest to the veracity of financial statements and faced heavy penalties for

knowingly attesting to false certification (see also Coffee, 2007; Coates, 2007).

Given the importance of investment to the growth of firms and of the economy in general, it is

important to ascertain whether or not SOX has negatively affected firms’ main activities.

Unfortunately, uniquely identifying the impact of SOX404 on corporate investment during a period

characterized by other significant events—including the burst of the tech bubble in 2000/2001, the

recession following 9/11, new NYSE and NASDAQ rules, and the Enron and WorldCom scandals—

is a challenge for researchers. These events alone could have caused firms to become more cautious

5 Corporate officers who rely in “good faith” on reports from subordinates or from outside auditors and accountants are not likely to be subject to civil or criminal liability themselves. As a result of this “reliance defense,” very few cases in which plaintiffs bring actions against defendant corporate officers proceed beyond a motion to dismiss in the very early stages of litigation. In the vast majority of cases where plaintiffs allege violations pursuant to §302, the motions are dismissed. Only two motions appear to have survived the motion-to-dismiss stage as of May 2011: (1) Bear Stearns Securities Derivative Litigation, 2011 U.S. Dist. LEXIS 6026, dated Jan. 19, 2011, and (2) LDK Solar Securities Derivative Litigation, 584 F. Supp. 2d 1230; 2008 U.S. Dist. LEXIS 42425, dated May 29, 2008. Although neither of these cases has been adjudicated to a final judgment, they did survive early dismissal. We thank Brian Quinn, Assistant Professor of Law at Boston College, for providing us with this information. 6 Cases in which directors of a company are required to personally pay for their misconduct are also rare (e.g., Davidoff, 2011).

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in their investment decisions as Coates (2007) suggests. The key is to find a control group of firms

that were not affected by SOX404, but were subject to the same concurrent events.

In this paper, we use a quasi-natural experiment to isolate the impact of SOX on corporate

investment by comparing two groups of similar U.S. firms that were affected differently by the

legislation. SOX required firms with a public float above $75 million in 2002 to comply with Section

404 in 2004, while firms with a public float below $75 million in 2002, 2003, and 2004 could delay

compliance until the end of 2007.7 Specifically, we compare a sample of small firms with public

float just above $75 million (the “filers”) to firms with public float just below this threshold (the

“control group”) to benchmark the changes in investment made by similar firms forced to comply

with SOX404. In addition, the specific threshold of $75 million used to define Section 404 in 2002

was not known prior to 2002 and is not related to firm characteristics, which lowers the risk

associated with manipulation of—or endogeneity in—the public float as of 2002 (see Ilieve, 2010).

This allows for a difference-in-difference research design, which should mitigate potential biases

from unobservable factors that might be correlated with investment. If SOX404 caused firms to

engage in less risk-taking behavior, as suggested by prior studies, we expect the level of investment

for filers to drop in the post-SOX period relative to that of the control group. But if the change in

risk-taking behavior is due to the general economic conditions or if filers are able to enjoy greater

transparency and lower cost of capital due to SOX, then the level of investment for filers would not

drop—and might even increase—in the post-SOX period compared to that of the control group.

Using a sample of approximately 440 unique firms for the sample period of 1994 through

2006, we first find that post-SOX investment by filers falls from the pre-SOX levels; the magnitude

7 Securities and Exchange Act Rule 12b-2 defines “public float” as the aggregate market value of the issuer's outstanding voting and non-voting common equity held by non-affiliates. An “affiliate” is a person who, directly or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with the person specified. The term “control” means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.

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of the reduction is similar to that documented in earlier studies of firms larger than those in our study.

However, post-SOX investment by the control group also dropped over the same period, and we do

not find that filers reduced their investment significantly more than the control group did. Moreover,

we show that the decrease in investment for both groups starts in 1999, not in 2003 when SOX

became effective. These results are consistent with both filer firms and control firms reducing

investment to adjust to a business and legal environment that had gone through substantial changes

prior to the introduction of SOX.

In addition, we use an instrumental variables approach to examine investment activities in

2004, the first year of SOX compliance, when the difference between the two groups should be most

pronounced. Specifically, we use firms’ public float in 2002, along with stock returns and stock

return volatilities, to instrument firms’ compliance status in 2004 (i.e., whether a firm becomes a filer

or not).8 We find that the filers invest more after SOX than firms in the control group do, which

suggests that filers may actually have benefited from the increased disclosures mandated by SOX404.

Our results thus are inconsistent with the hypothesis that Section 404 of SOX reduces investment for

firms that had to comply.

We then explore whether the impact of SOX404 varies cross-sectionally for our sample firms.

First, we test whether our findings are limited to small firms; we do not find that the impact of

SOX404 on large firms’ investment is statistically different from that on small firms in our sample.

Second, we examine large-scale acquisition, an activity considered to have adverse effects on a firm’s

internal control system, and do not find that filers make fewer acquisitions than control group firms

do after SOX. Third, we analyze whether investment decreased significantly more for firms with a

higher percentage of insider holdings, as these firms would presumably be more concerned about the

potential liability costs associated with risky investments that could compromise internal controls. 8 Gao, Wu, and Zimmerman (2009) show evidence that firms take actions to avoid complying with SOX.

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We find that filers with a higher percentage of insider ownership (measured before SOX) decrease

investment less, not more, in the post-SOX period than filers with lower levels of insider holdings.

We only find evidence of a negative impact of Section 404 on investment for filers with material

internal-control weaknesses (58 firms—or 15.9 percent—of our filers), possibly due to the fact that

these firms had to reallocate investment capital to fix their internal control systems. Our results are

also robust to controlling for other concurrent corporate governance events, such as the new New

York Stock Exchange (NYSE) and Nasdaq exchange listing requirements regarding the number of

independent directors. Overall, these results cast doubt that SOX increased the level of risk-aversion

among executives and directors.

This paper contributes to the debate over the effects of SOX on firms’ investment decisions

and challenges the extant evidence that SOX had an adverse effect on investment. Bargeron et al.

(2010) and Kang et al. (2010) use UK firms as a benchmark and find that U.S. firms decreased their

investment more than UK firms. Litvak (2008) compares foreign cross-listed firms in the U.S. (thus

bound by U.S. law) to similar non-cross-listed firms and finds that the risk of those firms subject to

SOX declined after SOX. In these papers, however, a causal link is subject to differences in legal

rules, economic conditions, and contemporaneous events across countries.

Our paper also adds to the literature that focuses on the impact of SOX on small firms

although we do not find any differential investment behavior across small and large firms. Our

sample of small firms is particularly relevant as Gao et al. (2009) show that small firms have an

incentive to manipulate their public float to avoid complying with SOX404 and several studies show

that the compliance costs of SOX404 are a significant burden to small firms (e.g., Engel, Hayes, and

Wang, 2007; Chhaochharia and Grinstein, 2007; Kamar et al., 2007; Kang et al., 2010; and

Alexander et al., 2010).

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The remainder of the paper proceeds as follows. In Section 2, we review the institutional

background and timeline of Section 404 of SOX. Section 3 describes the sample selection and data.

Section 4 presents the empirical tests and results. Section 5 offers additional robustness tests and

Section 6 concludes.

2. Institutional Background and Sequence of Events

In this section, we provide a brief description of the institutional background and sequence of

key events regarding SOX and, in particular, Section 404 (see Figure 1). We then explain why the

implementation of Section 404 provides an empirical setting that allows us to isolate its effects from

those of other confounding events.

Shortly after SOX was signed into law on July 30, 2002, the SEC required publicly listed

companies to declare accelerated filer status in their 2002 annual reports, based on the size of their

public float in the second (fiscal) quarter of 2002. Public float is the fraction of the common stock

not held by insiders—such as managers, employees, and board members—and is reported on the first

page of the company’s 10-K. Firms with a float over the $75 million threshold became “accelerated

filers” and had to keep that status going forward (see Exchange Act Rule 12b-2).9 Accelerated filers

had to complete their 10-K filing within 75 days of their fiscal year-end; the prior deadline had been

90 days. In May of 2003, under the SOX404 guidelines, the SEC announced that all accelerated filers

must file a new management report beginning in 2004. However, firms with a public float less than

the $75 million threshold in 2002, 2003, and 2004 did not need to comply with SOX404 and file the

management report until a later date. These firms were also exempted from an auditor’s attestation of

the management report until June 2010.

9 A company with accelerated filer status can become a non-accelerated filer only if its revenues and public float are smaller than $25 million for two consecutive years (SEC release 33-8182). Firms who do not have public equity but have public debt are, by definition, non-accelerated filers as they do not meet the criteria of an accelerated filer.

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We develop our empirical tests based on this sequence of events. First, we use companies’

public floats, as reported in their 2002 10-Ks, to define the treatment and control groups. The key for

our empirical strategy is that firms declared their accelerated filer status at the end of fiscal year

2002. Moreover, firms did not know that the declaration of accelerated filer status would

subsequently require them to file a management report, so our classification into treatment and

control groups based on the 2002 public float avoids concerns regarding manipulation or endogeneity

of public float. Specifically, firms with a public float over the $75 million threshold are mandatory

filers, since they must comply with SOX404 starting in 2004 (regardless of the size of float in 2003

or 2004) and hence are directly affected by it (treatment group). Firms with a public float below the

threshold in 2002 are the control group; their changes from the pre- to post-SOX periods are used as a

benchmark to measure changes in the treatment group.

We define the pre-SOX and post-SOX periods to include the fiscal years of 1994 to 2002 and

2003 to 2006, respectively; these periods are also used in Bargeron et al. (2010). Since firms were

required to file their first management report in 2004 (for the fiscal year ending on or after June 15,

2004 and later postponed for fiscal years ending on or after November 15, 2004), we conduct a

robustness test that excludes the transition year of 2003 and defines the post-SOX period to include

only the fiscal years of 2004 to 2006. We obtain qualitatively similar results.

3. Sample Selection and Descriptive Statistics

3.1. Sample Selection

Our sample consists of approximately 440 unique firms that appear on Compustat with a

public float between $50 million and $150 million in 2002, excluding financial firms (with SIC codes

between 6000 and 6900) and regulated firms (with SIC codes between 4900 and 4939). The public

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float equals the value of the common stock owned by outside investors, which we hand-collect from

the cover page of each firm’s 10-K report. Accounting and financial information is obtained from

Compustat. Several studies show that SOX404 compliance costs lead many small firms to deregister

their common stock (“go dark”) or to go private so as to avoid complying with SOX (see Leuz,

Triantis, and Wang, 2008; Engel et al., 2007). These decisions can induce a survivorship bias that

could lead us to find no effect across the filers and the control group if the filers most affected by

Section 404 delisted. To alleviate such concerns, we use a constant sample of filer and control firms

with available data for the full sample period of 1994 to 2006. Our final sample has approximately

3,700 firm-year observations covering that period.

3.2. Descriptive Statistics

Table 1 reports descriptive statistics for the sample firms, which include filers and the control

group. Panel A presents summary statistics for firm characteristics across both groups for the fiscal

year of 2002, just before SOX took effect, as well as the p-values for the difference in means and

medians across the two groups. All variables are defined in Appendix A. We winsorize all the

variables used in the tests at the 1st and 99th percentiles to minimize the effect of outliers. As shown

in Panel A, the average 2002 public floats for the filers and the control group are $105 million and

$62 million, respectively. Sixty-three percent (277 / [277+166]) of the firms are mandatory filers; the

remaining thirty seven percent are the control group.10 Panel A also shows that the total pre-SOX

investment scaled by total assets (INVEST) is statistically significantly higher for the control group

than for filers; the mean investment values are 0.164 and 0.129, respectively. The mean control firm

is relatively smaller than the mean filer firm, when measured by market capitalization, and less

profitable; mean earnings before interest and taxes scaled by assets (EBIT) are -0.108 and -0.047 for

10 In the robustness section, we replicate the tests using a sample with the same number of filers and non-filers and obtain qualitatively similar results.

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control firms and filers, respectively. When comparing the median filer to the median control firm,

we do not find that they differ in their investment levels or profitability measures. Filers and control

firms do not seem to exhibit different levels of growth opportunities before SOX; for example,

neither the stock returns (STKRET) nor the market-to-book ratios (MTB) of the two groups are

statistically different from each other. Because prior studies argue that SOX404 leads firms to engage

in less risk-taking behavior and thus to invest less, we also analyze firms’ level of riskless assets—

that is, cash—and stock-return volatility. Bargeron et al. (2010) argue that if a firm engages in less

risk-taking behavior due to SOX then the amount of cash it holds would increase and the volatility of

its stock returns decrease. Table 1 shows that short-term investments scaled by total assets (CASH)

and the standard deviation of returns (STD) are also not statistically different across the two groups.

In summary, filers exhibit relatively lower levels of investment and higher accounting performance

and are larger than control firms prior to the 2002 enactment of SOX. However, the growth prospects

do not seem to be different across the two groups.

Panel B provides descriptive statistics for the variables of interest across the pre-SOX (1994-

2002) and post-SOX (2003-2006) periods for control firms and filers. Filers exhibit a decrease in

investment (CAPEX, INVEST) and volatility (STD) and an increase in cash holdings from the pre-

SOX to the post-SOX period. During the post-SOX period, the mean level of growth options (MTB)

declined, but the median (unreported) level of growth options actually increased. Control firms also

show a decrease in capital expenditures (CAPEX) and volatility (STD) and an increase in cash

holdings in the post-SOX period. Post-SOX INVEST also decreases for the control group, but the

difference is not statistically significant at conventional levels. In the last column of Panel B, we test

whether the differences between the filers and control firms in the changes observed from the pre-

SOX to the post-SOX periods are statistically significant. None of the univariate changes is

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statistically different between filers and control firms. For example, although, in the post-SOX

period, both filers and control firms decreased their investment in capital expenditures—in the

amount of -0.021 and -0.015, respectively—the decrease in CAPEX for filers is not statistically

different from that for the control group (p-value of 0.211).

Figures 2 through 6 show how each of the variables capturing investment and risk-taking

activities—CAPEX, R&D, INVEST, CASH, and STD—change through the sample period for filers,

control firms, and large firms, with the latter defined as all Compustat firms with market

capitalization above $150 million. The figures show how these variables change through time

unconditionally. Figure 2 shows that CAPEX moves in tandem for all three sets of firms, decreasing

between 1996 and 2003, with a more accentuated decline immediately after 2000, and then increasing

between 2003 and 2006. Figure 3 shows R&D for the three groups. It increases from 1995 to 1998

and declines in 1999 and 2000 for both the filers and control firms, followed by a slight increase from

2000 to 2006 for the filers and an increase from 2000 to 2002 and then a slight decline for the control

group. These results suggest that during the post-SOX period, it is the control firms—not the filers—

that exhibit a slight decline in R&D expenditures. The mean R&D for the large firms does not change

significantly throughout the sample period. Figure 4 shows the results for total investment. Consistent

with Figure 2, the decline in investment for all three groups starts in 1999, rather than in 2003 when

SOX became effective. During the post-SOX period, investment increased rather than decreased,

which raises questions about prior findings that U.S. corporations became more risk-averse after

SOX. Figure 5 reports the trend in CASH holdings. For all three groups, the level of cash holding

increases throughout the entire period, while the rate of increase seems to decline slightly in the post-

SOX period. The argument that firms have become more risk-averse suggests that they prefer to hold

more of the risk-free asset—cash. However, the evidence suggests that the rate of increase in cash

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holdings actually declined after SOX, particularly for filers. Finally, Figure 6 shows how the average

firm’s stock volatility evolved throughout the sample period. Volatility increased up to 2000, when

the tech bubble burst, then steadily declined. To the extent that the decrease in volatility is found

across all the groups, including the control group, it calls into question whether it was caused by any

risk-aversion attributable to SOX404.

4. Empirical Tests and Results

4.1 The Impact of Section 404 on Filers versus Control Firms Using a Difference-in-Differences Approach

To test whether compliance to SOX’s Section 404 impacted firm’s willingness to take risks,

we estimate the following regression models:

!i,t! = !!!+ !!0 ∗ !"#$!!"#t!+ ! !m!!!! ∗ !"#$%"&i,t!1!+ !t + !!i+ !i,t!, (1)

!i,t! = !!!+ !0 ∗ !"#$!!"#t!+ !!1 ∗ !"#$!!"#t!*"!"#$%i+ !m!!!! ∗ !"#$%"&i,t!1!!

!!!!!!!!!!!!!!!!!!+ !m!!!! ∗ !"#$%"&i,t!1 ∗ !"#$%i!+ !t + !!i+ !!i,t . (2)

We follow Bargeron et al. (2010) and measure Yi,t, a proxy for a firm’s willingness to take

risks, using the following five variables: CAPEX, R&D, INVEST, CASH, and STD. The control

variables used are EBIT, MTB, and DEBT, as in Bargeron et al. (2010). EBIT and MTB are included

to account for any variation in investment or cash holdings that is related to a firm’s profitability or

growth opportunities. The STD regressions include EBIT, MTB, and DEBT as controls to account for

the effect of a firm’s profitability, growth prospects, and debt on the volatility of its stock. All the

control variables are lagged one year. The variable Post-SOX is an indicator variable that takes the

value of one for the years 2003 through 2006. The variable Filer is an indicator variable that takes the

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value of one if a firm’s public float is above the $75 million threshold in 2002. The regression models

are estimated using year and firm fixed effects. The year-fixed effects, !t, control for any

unobservable time-aggregate effect or time trend in the dependent variables.11 The firm fixed effects,

!i, control for any omitted firm characteristics that are time-invariant.

We use two empirical models to test the hypothesis that SOX404 caused firms to become

more risk-averse. The empirical model specified in Equation 1 tests whether there is a change in the

variable of interest, Yit, for filers in the post-SOX period. However, showing such a change is not

sufficient to show causality, because the same change in Yit could have been caused by other

concurrent events. In order to uniquely identify the impact of SOX on the variables of interest, we use

a sample of non-filer U.S. firms as a control group and estimate Equation 2. This regression model

also adds interaction terms between the control variables and a dummy variable for the filers in order

to capture any differential marginal impact of the control variables on the variable of interest for

these firms. The empirical model specified in Equation 2 allows for a difference-in-differences test,

where the coefficient β1 captures the change in the outcome variable between the pre-SOX and post-

SOX periods for the filers when benchmarked against the change for the non-filers during the same

period. If SOX404 caused firms to engage in less risk-taking behavior, as suggested by prior studies,

we expect β1<0. If, instead, the level of risk-taking behavior is due to the general economic

conditions or if filers are able to enjoy greater transparency and lower cost of capital thanks to

SOX404, then β1≥0.

Table 2 presents the results of estimating Equations 1 and 2 for each of the five dependent

variables. Columns 1, 3, 5, 7, and 9 report the results of estimating Equation 1 using the sample of

11 Bargeron et al. (2010) also include GDP growth and an index return to control for the impact of the UK and U.S. economies’ growth on the variables of interest. We do not include these variables because our sample consists only of U.S. firms; GDP growth and the index return are subsumed by the inclusion of the year fixed effects. Inclusion of the S&P500 index and GDP growth yields qualitatively similar results.

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filers only. Columns 2, 4, 6, 8, and 10 report the results of estimating Equation 2 using the sample of

filers and the control group. The results in Columns 1, 3, 5, and 9 show that CAPEX, INVEST, and

STD are significantly lower for the filers during the post-SOX period when compared to the reference

period of 1994 through 2002 (coefficients of -0.035, -0.048, and -0.003 respectively). These results

are consistent with those obtained in Bargeron et al. (2010, Table 2) and Kang et al. (2010, Table 2)

for U.S. firms.12 However, Columns 2, 4, and 6 show that the coefficients on Post-SOX*Filer are not

statistically different from zero, suggesting that the change in investment during the post-SOX period

for filers is not statistically different from that for the control group, which casts doubt on the effect

of Section 404 on a firm’s level of investment. Moreover, the coefficients on the Post-SOX indicator

remain negative and significant suggesting that both filers and control group decrease investment in

the post-SOX period for reasons other than the regulation.

The results for CASH are reported in Columns 7 and 8. Contrary to the findings in Bargeron et

al. (2010), we do not find that CASH increased significantly post-SOX for the filers, nor when

compared to the control group. Our finding that small firms do not tend to hold more of this risk-free

asset in the post-SOX period differs from the finding in Bargeron et al. (2010). The difference is due

to the fact that we include year dummies to account for the time-trend identified in Figure 5. If we

exclude the year dummies, the coefficient on Post-SOX becomes positive and statistically significant,

while the remaining coefficients remain qualitatively the same.

When analyzing the impact of SOX404 on stock volatility for both filers and control firms in

Column 10, we find that the coefficient on Post-SOX is still negative (-0.012) and is statistically

significant, providing evidence that both filers’ and control firms’ stock volatility declined following

SOX. However, the results in Column 10 show that the post-SOX decline in volatility is marginally

12 In contrast with these papers, we do not find that R&D decreased during the post-SOX period for our sample of constant firms. If, however, we do not restrict the sample to reflect the same firms before and after SOX, we do find that R&D decreased after SOX.

16

smaller for filers than for control firms; the coefficient on Post-SOX*Filer is 0.002 (t-statistic=1.72).

This casts doubt on the view that SOX404 discouraged risk-taking behavior on the part of firms that

were subject to compliance (the filers), causing a more significant decline in stock volatility for these

firms.

We further investigate whether the lack of a statistically significant difference in risk-taking

and investment behavior between filers and control firms is due to a lack of statistical power to detect

such a difference. First, we check whether the lack of statistical significance in Table 2 for the

coefficient Post-SOX*Filer is due to a high correlation between this variable and Post-SOX.

Although the correlation between these two variables is 0.73, excluding Post-SOX from the

regressions in Columns 2, 4, 6, 9, and 10 yields very similar results.13 Second, the economic

significance of the coefficient associated with Post-SOX*Filer is about one-fifth of the economic

significance of the Post-SOX coefficient. During the post-SOX period, CAPEX decreased by 2.4

percent for both filers and control firms. However, the incremental economic impact on CAPEX for

the filers relative to the control firms is a decrease of only 0.5 percent. Because the size of the

coefficient estimate is not affected by the power of the test, we conclude that it is the lack of

economic significance and not of statistical power that primarily explains our results.

4.2 The Impact of Section 404 on Filers versus Control Firms Using Instrumental Variables

To avoid endogeneity concerns, we define firms as the treatment group (filers) and the control

group (non-filers) based on their float in 2002. However, it is possible that some of the firms in the

control group end up having to comply with SOX404 in 2004 if their float crosses the threshold of

$75 million in 2003 or 2004. Moreover, we want to examine whether filers and the control group

behaved differently in terms of corporate investment in the first year after SOX404 became effective,

13 The inclusion of Post-SOX leads to the statistical insignificance of the year dummies for the post-SOX period (2003 to 2006).

17

when the effect of SOX is arguably the strongest. We thus follow Iliev (2010) and, in order to

account for potential misclassification of filers as non-filers, use a two-stage least square instrumental

variables (IV) approach by first estimating whether a firm will become a filer (Wooldrige, 2009;

Angrist and Pischkle, 2009). In the second stage, we use the estimated filer status obtained from the

first stage to examine the difference in corporate investment between filers and non-filers.

Specifically, we estimate the following IV model:

!"#$%!,!""# != !!!+ !!0 ∗ !"#$%!,!""!!+ !!! ∗ !"#$%"i,2002 + !!! ∗ !"#i,2002!+ !

!i,2004! = !!!+ !!0 ∗ !"#$%&'#$!!"#$%i,2004&+ ! !m!!!! ∗ !"#$%"&i,2003!+ !i+ !. (3)

First, we need to find instruments to estimate whether the firm will become a filer; these

instruments must be highly correlated with the probability of becoming a filer but not with the

variables of interest in the second stage. Therefore, we use the exogenous variable Float—the firm’s

public float in 2002. Following the suggestion of Hayes (2009, page 513), we also use the expected

returns (STKRET) and the stock return volatility (STD), measured in 2002, as instruments to estimate

whether a firm will become a filer in 2004. Firms with a larger public float, higher expected returns,

or greater return volatilities are assumed to have a higher ex-ante probability of crossing the $75-

million threshold and having to comply with SOX404 by 2004. Second, we use the estimated filer

value from the first-stage regression as an explanatory variable—along with EBIT, MTB, DEBT,

measured at the beginning of fiscal year, and industry dummies—to predict CAPEX, R&D, INVEST,

CASH, and STD in 2004.

Table 3 presents the results using the IV approach. As can be seen from Column 1, becoming a

filer in 2004 is highly correlated with the size of the firm’s public float in 2002, its stock return

18

volatility, and its expected returns (the latter proxied by the actual returns) in 2002. The second-stage

regression results show that the estimated filers invest more in 2004, the first year of SOX

implementation, than the control group, which contrasts with the findings of prior studies. Column 5

shows that the estimated filers tend to hold more of the riskless asset (cash). Finally, Column 6

shows that estimated filers have lower volatility of returns. These results are inconsistent with firms

avoiding risky investment due to SOX, but reinforce our results using the difference-in-difference

approach. We also replicate the second-stage results using the CAPEX, R&D, INVEST, CASH, and

STD in 2005 and 2006 and obtain similar (untabulated) results for the investment variables. However,

we no longer find that the estimated filers’ cash and stock return volatility are statistically different

from that of the control group.

4.3 The Impact of SOX’s Section 404 on Small versus Large Filers

To investigate whether the above findings are driven by the fact that small firms’ investment

levels and risk-taking behaviors are inherently different from those of larger firms, we replicate Table

2 using a sample that includes both small accelerated filers and large accelerated filers. Table 4 shows

that investment and volatility decreased, while the level of cash increased, during the post-SOX

period. However, the interaction between Post-SOX and the indicator variable Large is not

statistically significant in any of the regressions, except for the STD equation. These results are

inconsistent with the notion that small firms differ from large firms in post-SOX investment level and

risk-taking behavior. Column 10 shows that larger firms exhibit a smaller decrease in volatility in the

post-SOX period than smaller firms do (coefficient of 0.002, t-statistic of 2.73). To the extent that

changes in STD reflect changes in a firm’s level of risk-taking behavior, this result is consistent with

smaller firms decreasing their level of risk taking more than larger firms do in the post-SOX period.14

14 Several studies find that SOX compliance imposed higher relative costs on smaller firms (Chhaochharia and Grinstein, 2007 and Kang et al., 2010).

19

4.4 Other Cross-sectional Evidence

In this subsection, we examine whether the impact of SOX’s Section 404 on filers varies for

those with a higher proportion of insider holdings and for those with internal control problems (or

material weaknesses).

4.4.1 Filers with a Large Proportion of Insider Holdings

We investigate whether filers with a higher proportion of insider holdings—and presumably a

greater concern about potential liability costs associated with Section 404 compliance—invest less

than filers with a lower proportion of insider holdings. Specifically, if SOX404 reduces incentives to

engage in risk-taking activities, this negative effect would be more pronounced in firms with higher

insider ownership since the risk-adverse executives would have more personal wealth at stake. We

test this hypothesis by adding the interaction terms Post-SOX*InsiderHold and Post-

SOX*InsiderHold*Filer in Equation 2, where InsiderHold is an indicator variable equal to one if the

level of insider holdings of the firm’s equity in 2001 (before SOX) is above the sample median. The

insider ownership data is hand-collected from the firms’ proxy statements (Form DEF 14A) and it

includes shares owned by all the insiders (such as executives and board members). Note that we do

not include InsiderHold as a control because Equation 2 is estimated with firm fixed effects and thus

any time-invariant firm characteristic drops out, as is the case for the 2001 level of insider ownership.

Table 5 shows the results of this test. We find some evidence that filers with a high level of

insider holdings invest more, not less, during the post-SOX period than do filers with a lower level of

insider holdings (coefficients of 0.016 (t-value of 1.73) for CAPEX and 0.036 (t-value of 1.81) for

INVEST). To the extent that a high level of insider holdings reflects the higher potential costs to

20

which insiders are exposed, these results cast doubt that SOX404 has discouraged risk-taking among

executives and directors.

4.4.2 Filers with Material Weaknesses

Eldridge and Kealey (2005) find that firms that reported ineffective internal controls after

SOX404 experienced higher SOX audit costs than firms that reported effective internal controls. Ge

and McVay (2005) analyze firms with material weaknesses and show that poor internal controls are

usually associated with insufficient resources committed for accounting controls. We thus predict that

filers that report having material weaknesses in their internal control systems need to allocate more

resources to their accounting controls in order to comply with Section 404 and are thus more likely to

cut investment. We test this hypothesis by adding the interaction term Post-SOX*Filer*Weakness in

Equation 2, where Weakness is an indicator variable equal to one if the filer discloses at least one

internal control (material) weakness in its SEC filings during the post-SOX period. The information

regarding material weaknesses related to SOX404 is obtained from Audit Analytics. The coefficient

on this interaction term captures the extent to which, during the post-SOX period, filers with material

weaknesses exhibit lower CAPEX, R&D, and INVEST than do filers without material weaknesses.

Table 6 presents the results. We do not include firm fixed effects in Table 6 because about 60

percent of the firms reporting a material weakness in their internal controls do so for two or more

years during the post-SOX period. The inclusion of firm fixed effects would prevent us from

detecting any statistically significant difference because disclosure of a material weakness is a firm

characteristic that is weakly time-invariant. Consistent with our prediction, we find that filers with

material weaknesses do decrease their investment subsequent to Section 404 compliance, but that

filers without material weaknesses do not invest less than the control firms. Economically, the total

21

investment scaled by assets of a filer with a material weakness decreases by 3.8 percent more than

those of a filer without a material weakness. This result needs to be interpreted cautiously because the

classification of filers with material weaknesses suffers from potential endogeneity biases, as these

firms are classified after SOX404 is implemented. It is possible that firms that decrease their

investment because of lack of growth opportunities or profitability are also more likely to report a

material weakness, in which case it maybe the lack of future growth prospects rather than reporting a

material weakness that leads these firms to cut investment.

5. Robustness Tests

Section 404 is more likely to cause internal control problems for filers that grow through

acquisition, since acquired firms may have poor accounting systems. To investigate whether filers

reduced their level of acquisition more than the control firms did, we replicate the results in Table 2

using acquisitions as our measure of investment level. The (untabulated) results are consistent with

those in Table 2; we do not find that filers exhibit significantly lower levels of acquisition than

control firms do.

Recent studies show that U.S. firms are pursuing growth strategies by outsourcing and by

taking large equity holdings in other companies as a form of investment, approaches which are not

necessarily reflected in larger capital expenditures or R&D investments (e.g., Bhagwati, Panagariya,

and Srinivasan, 2004; McCarthy, 2002). This change in investment strategy raises the question of

whether this paper’s findings, using capital expenditures and R&D expenditures as measures of

investment, accurately portray the current risk-taking characteristics of U.S. firms. To investigate the

possibility that they do not, we replicate Table 2 and Equation 2, using three variables to measure

investment that are independent of investment strategy: employment growth, asset growth, and sales

22

growth. The (untabulated) results show that the employment and sales growth for both filers and non-

filers decline during the post-SOX period (while asset growth remain stable for both groups), but the

decline is not statistically different across filer and control firms. The results are thus consistent with

those presented above.

Even though the focus of our study is on the impact of Section 404 on corporate investment

and risk taking activities, it is possible that other corporate governance provisions that were adopted

around the time SOX was enacted could have had an impact on firms’ behavior. In particular,

Bargeron et al. (2010) show that the decline in investment levels after SOX for U.S. firms is related

to the board structure prior to SOX. While SOX require independence of the auditing committee of

the board, the New York Stock Exchange (NYSE) and Nasdaq revised their exchange listing rules

around the time SOX was enacted to increase the required percentage of independent directors on

corporate boards and board committees, namely auditing, nominating and compensation. These

NYSE and NASDAQ board independence requirements were enforced for all firms (filer and control

group firms). Moreover, Cohen, Dey and Lys (2007) examine the effects of SOX on compensation

contracts and argue that CEO pay-for-performance sensitivity decreased after SOX leading firms to

reduce their investment levels. To account for the effects of changes in board structure and CEO’s

compensation contracts on firm’s corporate investment, we rerun the tests in Table 2 adding the

following controls: the percentage of insiders in the board of directors and the percentage of equity in

CEO’s total pay. We further include board size as an additional control variable to capture the level

of monitoring of the CEO’s actions by the board as some studies argue that larger boards can provide

more effective monitoring when the CEO’s opportunity to consume private benefits is high (e.g.,

Harris and Raviv, 2008; Boone et al., 2007). We hand collect these data for the years of 2001 and

2006 and use the values of 2001 (2006) for all the pre-SOX (post-SOX) values. We estimate an

23

expanded version of equation (2) that includes the three control variables mentioned above by

themselves, and interacted with the filer indicator variable to capture whether the impact of these firm

characteristics on corporate investment and risk taking behavior is different for filer firms. The results

in Panel A of Table 7 show that an increase in the percentage of board insiders is associated to an

increase in the level of R&D and INVEST for the control group (coefficients of 0.179 and 0.227,

statistically significant at 5% level, respectively). Although, we do not find that the percentage of

board insiders is also positively associated with an increase in investment for filer firms (the

coefficients of 0.033 (=0.179-0.146) and 0.017 (=0.227-0.210) on R&D and INVEST, respectively,

are not statistically significantly different from zero at common significance level), we do not find

evidence that it decreases as suggested by prior studies. The extent to which an increase in board

independence improves board oversight and decision-making, it seems that both filer firms and the

control group do not decrease investment when board oversight is stronger. The results in Panel A

also show that an increase in board size is positively associated with R&D and INVEST for filer

firms. The results in Panel B show that the level of equity pay percentage is not statistically

associated with a firm’s level of investment in our sample. Overall, the main results are robust to

controlling for these other concurrent corporate governance mechanisms that could influence firm’s

investment decisions and we do not find that the change in corporate governance decisions lead to a

decrease in investment level for filer firms.

The sample in this study covers firms with a float between $50 million and $150 million in

order to have a large enough sample of similar firms. However, one can question whether our results

are due to a lack of power to detect statistically significant differences between the filers and the

control group due to the lower proportion of control firms in the main sample. To address this

concern, we redefine the sample to be composed of firms with a public float between $50 million and

24

$100 million and between $25 million and $150 million and find that the (untabulated) results remain

qualitatively the same.

6. Conclusion

The impact of the Sarbanes-Oxley act on corporate investment has attracted significant

attention from both practitioners and academics since its enactment in 2002. Prior studies attribute the

decrease in corporate investment in the U.S. to SOX and argue that it results from managers’

unwillingness to take risks due to the increase in litigation and compliance costs associated with

SOX. However, a stream of literature suggests that SOX could actually have a positive impact on

corporate investment as investors benefit from greater transparency conferred by improved

disclosure, which can lead to lower cost of capital. Moreover, because the post-SOX period is also a

period of major changes in corporate governance and of other significant events, it is a challenge to

uniquely identify the impact of SOX on corporate investment.

We use a natural experiment to identify a control group to isolate the effects of Section 404,

arguably SOX’s most demanding requirement, on corporate investment. We compare the impact of

SOX404 on a sample of small firms with public float just above the $75 million threshold to the

impact on firms with a public float just below that threshold. Filers are required to comply with

Section 404, while non-filers are not, leading to natural treatment (filers) and control (non-filer)

groupings. Even though both groups significantly decrease their investment in the post-SOX period

(2003-2006) relative to that of the pre-SOX period (1994-2002), we do not find that firms complying

with SOX404 decreased their level of investment to a greater or lesser degree than firms in the

control group did. We also find that our results are not a characteristic of small firms only, as we do

not find that the impact of SOX404 on large firms’ investment is statistically different from the

25

impact on small firms. We further show that for small filers, for the control group, and for large

filers, the decrease in investment starts in 1999, not in 2003 when SOX became effective. In fact,

when we use an instrumental variables approach to estimate which firms will comply with SOX404

in 2004, we find that the filers actually invest more than the control group do after SOX404 is

implemented, suggesting that filers may actually have benefited from the newly mandated

disclosures.

Our cross-sectional and robustness tests further corroborate the above results. We examine

large-scale acquisition and do not find that filers make fewer acquisitions after SOX than the control

group does. We also find that filers with a higher percentage of insider ownership and thus greater

concern about litigation costs invest more, not less, in the post-SOX period than filers with lower

levels of insider holdings do. Only for filers with material internal-control weaknesses do we find

some evidence of a decrease in investment, probably because these firms had to reallocate investment

capital to fix their internal control systems. Taken together, our results challenge the conventional

wisdom that SOX “had a chilling effect on risk-taking” by publicly traded firms (Bargeron et al.,

2010).

26

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29

APPENDIX A

Definitions of Variables

Float Public float reported on the company’s annual report. CAPEX Capital expenditures divided by the average assets for the last two years. R&D Research and development expenditures for the year divided by the average assets for the

last two years. INVEST The sum of CAPEX and R&D. CASH The year-end level of cash and short-term investments divided by average assets for the last

two years. STD The standard deviation of the returns for the year. EBIT The earnings before interest and taxes divided by average assets. MTB The year-end market value of the assets divided by the year-end book value of assets. DEBT The average total debt divided by the average market value of total assets. ASSETS The year-end book value of the assets. MKT CAP Fiscal year-end stock price multiplied by the number of shares outstanding.

REVENUES Total sales for the year. STKRET Buy-and-hold stock return for the year. Pre-SOX An indicator variable equal to one for the years 1994 through 2002, zero otherwise. Post-SOX An indicator variable equal to one for the years 2003 through 2006, zero otherwise. Large An indicator variable equal to one if a firm has market cap greater than $150 million at the

end of 2002, zero otherwise. InsiderHold An indicator variable equal to one if the percentage of insider ownership in 2001 is above the

sample median and equal to zero otherwise. Weakness An indicator variable equal to one if the firm reports a material weakness in its internal

control systems in at least one of the quarters during the fiscal year and equal to zero otherwise.

Board Insider The firm’s percentage of total insider members in the board of directors. This information is hand-collected from the firm’s proxy statements for the fiscal years of 2001 and 2006 We use the 2001 (2006) values for all the observations in the pre-SOX (post-SOX).

Board Size The firm’s total number of board members. This information is hand collected from the firm’s proxy statements for the fiscal years of 2001 and 2006. We use the 2001 (2006) values for all the observations in the pre-SOX (post-SOX).

Equity Pay Share Total value of restricted stock holdings and the Black-Value of stock options granted to the CEO as a percentage of total compensation received. This information is hand collected from the firm’s proxy statements for the fiscal years of 2001 and 2006. We use the 2001 (2006) values for all the observations in the pre-SOX (post-SOX). For the calculation of total CEO pay we consider three components: cash and bonuses, restricted stock grants and stock options. The value of restricted stock is calculated as the number of shares granted during the fiscal year multiplied by the average stock price in the granting year. Following prior work (e.g., Core and Guay 2001), we use the Black-Scholes formula to convert the number of options granted into a dollar value. To calculate the value of the options, we use the average stock-return volatility prior to the granting year, the dividend yield during the granting year,

30

a time-to-maturity of seven years, and the mid-year yield on 1-year Treasuries as the risk-free rate

ASSETS Growth The percentage annual growth in book value of the assets. MKT CAP Growth The percentage annual growth in market capitalization. Employment Growth

The percentage annual growth in the number of employees.

SALES Growth The percentage annual growth in total sales.

31

Table 1: Sample Description and Summary Statistics The sample includes firms with public floats between $50 and $150 million in 2002 and with data available from Compustat during the 1994 through 2006 period. The public float equals the value of the company owned by outside investors as reported in the 10-K. Filers are firms with public float above $75 million and control firms are those with public float below $75 million in 2002. Panel A reports summary statistics for filers and control firms in 2002 (the year SOX was signed into law). Panel B reports summary statistics for filers and control firms in the pre-SOX period (1994-2002) and post-SOX period (2003-2006), as well as summary statistics for the differences between the pre- and post-SOX periods for the two groups of firms. CAPEX is capital expenditures divided by the average assets for the year. R&D is research and development expenditures divided by the average assets for the year. INVEST is the sum of CAPEX and R&D. CASH is the year-end level of cash and short-term investments divided by average assets. STD is the standard deviation of the returns for the year. EBIT is the earnings before interest and taxes divided by average assets. MTB is the year-end market value of the assets divided by the year-end book value of assets. DEBT is the average total debt divided by the average market value of total assets. These variables are winsorized at the 1% and 99% levels. N represents number of firms. The remaining variables are defined in Appendix A. P-values are based on results from difference in means tests and from Wilcoxon rank-sum tests for differences in medians.

Panel A: Summary Statistics for Filers and Control Firms in 2002

Means Medians Filer

N=277 Control N=166

P-Value Filer N=277

Control N=166

P-Value

Float 105.32 61.90 0.000 101.80 62.34 0.000 CAPEX 0.044 0.047 0.602 0.026 0.028 0.810 R&D 0.085 0.117 0.056 0.024 0.020 0.740 INVEST 0.129 0.164 0.048 0.087 0.088 0.460 CASH 0.263 0.263 0.988 0.179 0.207 0.842 STD 0.047 0.045 0.606 0.044 0.043 0.460 EBIT -0.047 -0.108 0.035 0.023 0.013 0.165 DEBT 0.179 0.163 0.475 0.062 0.055 0.588 MTB 1.485 1.782 0.185 1.006 0.969 0.759 ASSETS 328.8 187.4 0.232 146.2 96.6 0.000 MKT CAP 136.6 90.3 0.000 128.5 80.9 0.000 REVENUES 310.6 185.5 0.108 112.5 84.4 0.003 STKRET -0.184 -0.166 0.754 -0.280 -0.254 0.719 ASSETS Growth -0.054 -0.070 0.616 -0.029 -0.034 0.714 MKT CAP Growth -0.337 -0.314 0.718 -0.211 -0.198 0.412

32

Panel B: Summary Statistics for Filers and Control Firms across the Pre-SOX and Post-SOX Periods

Filers Control Firms Filer vs. Control Pre-SOX

N=277 Mean

Post-SOX N=277 Mean

Diff.

P-Value Pre-SOX N=166 Mean

Post-SOX N=166 Mean

Diff.

P-Value

Diff. of Diff. P-Value

CAPEX 0.066 0.045 -0.021 0.000 0.065 0.050 -0.015 0.000 0.211 R&D 0.081 0.083 +0.002 0.664 0.101 0.102 +0.001 0.944 0.412 INVEST 0.149 0.129 -0.020 0.000 0.170 0.154 -0.014 0.142 0.820 CASH 0.237 0.291 +0.054 0.000 0.263 0.312 +0.049 0.000 0.603 STD 0.045 0.032 -0.013 0.000 0.048 0.033 -0.015 0.000 0.289 EBIT -0.001 -0.012 -0.011 0.266 -0.092 -0.095 -0.003 0.865 0.636 DEBT 0.191 0.145 -0.045 0.000 0.158 0.112 -0.045 0.000 0.310 MTB 2.487 2.077 -0.410 0.006 2.682 2.466 -0.216 0.285 0.283

33

Table 2: The Impact of SOX on Filer’s Corporate Investment and Risk Taking Activities The sample includes firms with public floats between $50 and $150 million in 2002 and with data available from Compustat during the 1994 through 2006 period. The public float equals the value of the company owned by outside investors as reported in the 10-K. Filers are firms with public float above $75 million in 2002 and control firms are those with public float below $75 million in 2002. Each column in this table reports regressions of investment and risk-taking variables on a set of firm fixed effects, a set of year indicators (not reported), and either an indicator variable equal to one for the years 2003 through 2006 (Post-SOX) or interactions between an indicator for filers and Post-SOX (Filer * Post-SOX). All variables are defined in Appendix A. The control variables are winsorized at the 1% and 99% levels and are lagged one year in the regressions. T-stats are reported below coefficients based on standard errors clustered by firm. The symbols ***, **, and * denote two-sided statistical significance at the 1%, 5%, and 10% level, respectively.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) CAPEX CAPEX R&D R&D INVEST INVEST CASH CASH STD STD Post-SOX -0.035*** -0.024*** -0.014 -0.016* -0.048*** -0.036*** 0.024 -0.008 -0.003** -0.012*** (-6.14) (-4.36) (-1.52) (-1.94) (-4.33) (-3.45) (1.23) (-0.42) (-2.38) (-9.10) Post-SOX *Filer -0.005 0.001 -0.008 0.002 0.002* (-1.08) (0.07) (-0.85) (0.17) (1.72) EBIT 0.045*** 0.015 -0.126*** -0.130*** -0.088** -0.112*** -0.015 -0.040 -0.018*** -0.013*** (4.05) (1.37) (-3.59) (-5.27) (-2.43) (-3.26) (-0.40) (-0.79) (-5.28) (-4.48) EBIT *Filer 0.031** 0.025 0.021 -0.005 (1.97) (0.51) (0.34) (-1.05) MTB 0.005*** 0.004*** 0.003** 0.004 0.009*** 0.006** 0.018*** 0.016*** 0.000 -0.001*** (4.69) (3.26) (2.14) (1.39) (4.60) (2.17) (6.09) (3.49) (0.96) (-3.75) MTB*Filer 0.002 -0.001 0.003 0.002 0.001*** (0.98) (-0.20) (0.84) (0.30) (3.60) DEBT 0.006 -0.000 (1.50) (-0.05) DEBT*Filer 0.007 (1.26) Constant 0.068*** 0.065*** 0.081*** 0.083*** 0.147*** 0.148*** 0.230*** 0.237*** 0.039*** 0.043*** (12.47) (16.79) (11.48) (13.84) (16.00) (19.82) (14.37) (17.13) (25.24) (35.00) Firm fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Year fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Observations 2,293 3,691 2,306 3,728 2,293 3,691 2,306 3,728 2,295 3,712 Number of firms 277 443 277 443 277 443 277 443 277 443 Adjusted R2 0.15 0.11 0.09 0.10 0.12 0.10 0.07 0.07 0.36 0.35

34

Table 3: The Impact of SOX on Filer’s Corporate Investment and Risk Taking Activities for Fiscal Year 2004 This table presents the results of estimating CAPEX, R&D, INVEST, CASH, and STD in 2004, using two-stage least squares. The sample includes all Compustat firms with public floats between $50 and $150 million in 2002 and with data available for the 1994 through 2006 period. The public float equals the value of the company owned by outside investors as reported in the 10-K. Column 1 presents the results for the first-stage regression, which estimates whether a firm will become a filer in 2004, using as instruments the firm’s public float, stock return, and standard deviation of returns, all measured in 2002. Columns 2 through 6 present the results for the second-stage OLS regression which uses the estimated Filer_04 from the first stage as one of the independent variables. Each column in this table reports regression results of investment and risk-taking variables on a set of industry fixed effects based on two-digit SIC codes. All variables are defined in Appendix A. The control variables are winsorized at the 1% and 99% levels. T-stats are reported below coefficients based on standard errors clustered by firm. The symbols ***, **, and * denote two-sided statistical significance at the 1%, 5% and 10% level respectively.

(1) (2) (3) (4) (5) (6) VARIABLES Filer_04 CAPEX_04 R&D_04 INVEST_04 CASH_04 STD_04 Float_ 02 0.003*** (6.99) STKRET_02 0.041* (1.80) STD_02 2.295*** (3.21) Predicted FILER_04 0.040** 0.123*** 0.161*** 0.299** 0.010* (2.69) (2.26) (2.74) (2.39) (1.66) EBIT_03 0.021** -0.280*** -0.260*** -0.284*** -0.018*** (2.18) (-12.66) (-10.93) (-5.58) (-7.81) MTB_03 0.005*** 0.005** 0.010*** 0.020*** -0.000 (5.47) (2.08) (4.12) (3.97) (-0.21) DEBT_03 0.002 (0.66) Constant 0.542*** 0.015 -0.092 -0.074 -0.276 0.005 (10.31) (0.32) (-0.84) (-0.63) (-1.10) (0.42) Industry fixed effects Yes Yes Yes Yes Yes Yes Observations 410 390 390 390 390 389 Adjusted R2 0.12 0.51 0.56 0.51 0.41 0.31

35

Table 4: The Impact of SOX on Large versus Small Firms The sample includes (i) small firms with public floats between $75 and $150 million in 2002 and with data available from Compustat during the 1994 through 2006 period and (ii) large firms with market capitalization above $150 million and with data available from Compustat during the 1994 through 2006 period. The public float equals the value of the company owned by outside investors as reported in the 10-K. Each column in this table reports regressions of investment and risk-taking variables on a set of firm fixed effects, a set of year indicators (not reported), and either an indicator variable equal to one for the years 2003 through 2006 (Post-SOX) or interactions between an indicator for large firms and Post-SOX (Large * Post-SOX). All variables are defined in Appendix A. The control variables are winsorized at the 1% and 99% levels and are lagged one year in the regressions. T-stats are reported below coefficients based on standard errors clustered by firm. The symbols ***, **, and * denote two-sided statistical significance at the 1%, 5%, and 10% level, respectively.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) CAPEX CAPEX R&D R&D INVEST INVEST CASH CASH STD STD Post-SOX -0.022*** -0.026*** -0.004*** -0.007* -0.028*** -0.034*** 0.020*** 0.030*** -0.002*** -0.004*** (-17.86) (-9.88) (-3.59) (-1.68) (-14.38) (-6.44) (6.13) (3.55) (-6.85) (-5.35) Post-SOX *Large 0.003 0.003 0.006 -0.010 0.002*** (1.13) (0.80) (1.21) (-1.26) (2.73) EBIT 0.050*** 0.063*** -0.050*** -0.079*** -0.000 -0.028 0.029** -0.052 -0.044*** -0.043*** (9.94) (3.93) (-8.04) (-2.97) (-0.01) (-0.79) (2.01) (-1.04) (-23.44) (-9.02) EBIT * Large -0.013 0.029 0.027 0.081 -0.002 (-0.78) (1.08) (0.76) (1.56) (-0.32) MTB 0.005*** 0.006*** 0.003*** 0.004** 0.008*** 0.010*** 0.020*** 0.021*** 0.000*** 0.001** (13.96) (4.97) (6.84) (2.40) (13.37) (4.99) (15.93) (6.98) (3.18) (2.35) MTB* Large -0.001 -0.001 -0.002 -0.001 -0.000 (-0.92) (-0.52) (-0.93) (-0.41) (-0.87) DEBT 0.009** (9.31) (2.14) DEBT* Large 0.000 (0.02) Constant 0.055*** 0.055*** 0.034*** 0.037*** 0.093*** 0.096*** 0.124*** 0.130*** 0.031*** 0.032*** (46.47) (48.32) (32.09) (34.50) (47.47) (50.61) (37.35) (39.83) (77.59) (81.87) Firm fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Year fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Observations 32,312 34,578 35,624 37,903 32,312 34,578 35,618 37,897 35,195 37,467 Adjusted R2 0.10 0.10 0.02 0.02 0.07 0.07 0.05 0.05 0.30 0.30

36

Table 5: The Impact of SOX on Filers with Large Percentage of Insider Holdings The sample includes firms with public floats between $50 and $150 million in 2002 and with data available from Compustat during the 1994 through 2006 period. The public float equals the value of the company owned by outside investors as reported in the 10-K. Filers are firms with public float above $75 million in 2002 and control firms are those with public float below $75 million in 2002. Each column in this table reports regressions of investment and risk-taking variables on an indicator variable equal to one for the years 2003 through 2006 (Post-SOX); an interaction between an indicator for filers and Post-SOX (Filer * Post-SOX); an interaction between Post-SOX and an indicator for whether the firm’s level of insider holdings in 2001 is above the sample median (Post-SOX*InsiderHold); an interaction between Post-SOX, an indicator for whether the firm’s level of insider holdings in 2001 is above the sample median, and Filer (Post-SOX*InsiderHold*Filer); control variables; and a set of year indicators (not reported). All variables are defined in Appendix A. The control variables are winsorized at the 1% and 99% levels and are lagged one year in the regressions. T-stats are reported below coefficients based on standard errors clustered by firm. The symbols ***, **, and * denote two-sided statistical significance at the 1%, 5%, and 10% level, respectively.

(1) (2) (3) (4) (5) CAPEX R&D INVEST CASH STD Post-SOX -0.023*** -0.023* -0.036** -0.005 -0.013*** (-3.00) (-1.66) (-2.15) (-0.21) (-7.49) Post-SOX*Filer -0.012 -0.004 -0.025 0.016 0.003 (-1.61) (-0.30) (-1.44) (0.67) (1.56) Post-SOX*InsiderHold -0.006 0.009 -0.006 -0.002 0.002 (-0.80) (0.70) (-0.39) (-0.06) (0.96) Post-SOX*InsiderHold*Filer 0.016* 0.011 0.036* -0.023 -0.002 (1.73) (0.67) (1.81) (-0.75) (-0.60) EBIT 0.018 -0.147*** -0.118*** -0.062 -0.014*** (1.54) (-4.28) (-3.20) (-1.24) (-4.50) EBIT*Filer 0.027 0.023 0.032 0.053 -0.004 (1.64) (0.48) (0.63) (0.86) (-0.89) MTB 0.004*** 0.004 0.007** 0.017*** -0.001*** (3.44) (1.46) (2.28) (3.48) (-3.74) MTB*Filer 0.001 -0.001 0.002 0.001 0.001*** (0.74) (-0.28) (0.64) (0.15) (3.81) DEBT 0.001 (0.26) DEBT*Filer 0.004 (0.60) Constant 0.065*** 0.087*** 0.152*** 0.240*** 0.043*** (15.77) (13.92) (19.56) (16.51) (34.54) Firm fixed effects Yes Yes Yes Yes Yes Year fixed effects Yes Yes Yes Yes Yes Observations 3,389 3,420 3,389 3,420 3,405 Adjusted R2 0.12 0.10 0.11 0.07 0.35

37

Table 6: The Impact of SOX on Filers with Material Weaknesses The sample includes firms with public floats between $50 and $150 million in 2002 and with data available from Compustat during the 1994 through 2006 period. The public float equals the value of the company owned by outside investors as reported in the 10-K. Filers are firms with public float above $75 million in 2002 and control firms are those with public float below $75 million in 2002. Each column in this table reports regressions of investment and risk-taking variables on an indicator variable equal to one for the years 2003 through 2006 (Post-SOX); an interaction between an indicator for filers and Post-SOX (Filer * Post-SOX); an interaction between Post-SOX, Filer, and an indicator for whether the firm discloses having a material weakness under Section 404 (Post-SOX*Filer*Weakness); control variables; and a set of year indicators (not reported). All variables are defined in Appendix A. The control variables are winsorized at the 1% and 99% levels and are lagged one year in the regressions. T-stats are reported below coefficients based on standard errors clustered by firm. The symbols ***, **, and * denote two-sided statistical significance at the 1%, 5%, and 10% level, respectively.

(1) (2) (3) (4) (5) CAPEX R&D INVEST CASH STD Post-SOX -0.027*** -0.010 -0.042*** 0.073*** -0.005*** (-4.69) (-1.00) (-3.63) (3.15) (-3.51) Post-SOX*Filer -0.003 -0.001 -0.009 -0.001 0.001 (-0.60) (-0.08) (-0.92) (-0.03) (1.11) Post-SOX*Filer*Weakness -0.017*** -0.021* -0.038*** -0.026 0.002 (-4.01) (-1.78) (-3.39) (-0.91) (1.13) EBIT 0.025** -0.432*** -0.406*** -0.391*** -0.032*** (2.18) (-13.10) (-12.14) (-6.79) (-12.42) EBIT*Filer 0.023 0.079* 0.098** -0.039 0.003 (1.49) (1.72) (2.16) (-0.49) (0.68) MTB 0.003*** 0.006* 0.007** 0.024*** -0.000 (2.76) (1.82) (2.37) (4.49) (-0.28) MTB*Filer 0.000 0.007** 0.009** 0.006 0.000* (0.14) (2.14) (2.58) (0.95) (1.71) DEBT -0.004 (-1.20) DEBT*Filer -0.003 (-0.63) Constant 0.067*** 0.061*** 0.137*** 0.169*** 0.041*** (13.14) (7.13) (13.60) (9.47) (30.07) Firm fixed effects No No No No No Year fixed effects Yes Yes Yes Yes Yes Observations 3,691 3,728 3,691 3,728 3,712 Adjusted R2 0.05 0.55 0.47 0.32 0.37

38

Table 7: Controlling for Changes in Corporate Governance and Equity Pay around SOX Enactment The sample includes firms with public floats between $50 and $150 million in 2002 and with data available from Compustat during the 1994 through 2006 period. The public float equals the value of the company owned by outside investors as reported in the 10-K. Filers are firms with public float above $75 million in 2002 and control firms are those with public float below $75 million in 2002. Each column in this table reports regressions of investment and risk-taking variables on an indicator variable equal to one for the years 2003 through 2006 (Post-SOX); an interaction between an indicator for filers and Post-SOX (Filer * Post-SOX); corporate governance variables (Board Insider and Board Size) and CEO equity pay percentage (Equity Pay Share); control variables (same as in Table 2 and not reported); and firm and year fixed effects (not reported). All variables are defined in Appendix A. The control variables are winsorized at the 1% and 99% levels and are lagged one year in the regressions. T-stats are reported below coefficients based on standard errors clustered by firm. The symbols ***, **, and * denote two-sided statistical significance at the 1%, 5%, and 10% level, respectively.

(1) (2) (3) (4) (5) CAPEX R&D INVEST CASH STD

Panel A – Controlling for Governance Variables Post-SOX -0.023*** -0.017 -0.041*** -0.015 -0.011*** (-3.55) (-1.31) (-2.71) (-0.69) (-7.13) Post-SOX*Filer -0.006 -0.004 -0.009 0.009 0.002 (-1.06) (-0.29) (-0.67) (0.50) (1.33) Board Insider 0.053 0.179** 0.227** -0.103 0.010 (1.11) (2.31) (2.28) (-0.71) (0.76) Board Insider *Filer -0.070 -0.146* -0.210* 0.110 -0.006 (-1.41) (-1.71) (-1.97) (0.67) (-0.38) Board Size 0.002 -0.014** -0.012 -0.005 -0.002** (0.78) (-2.06) (-1.54) (-0.55) (-1.99) Board Size * Filer -0.000 0.015** 0.014* 0.010 0.001 (-0.05) (2.10) (1.79) (0.88) (0.90) Other Controls, Firm and Year FE Yes Yes Yes Yes Yes Observations 3,691 3,728 3,691 3,728 3,712 Adjusted R-squared 0.05 0.55 0.47 0.32 0.37

Panel B – Controlling for Equity Pay Percentage Post-SOX -0.025*** -0.028* -0.053*** 0.030 -0.009*** (-3.86) (-1.84) (-3.18) (1.57) (-5.07) Post-SOX*Filer -0.004 0.007 0.003 0.005 0.001 (-0.64) (0.60) (0.27) (0.30) (0.61) Equity Pay Share 0.005 -0.011 -0.007 -0.003 -0.003 (0.43) (-0.48) (-0.28) (-0.06) (-1.31) Equity Pay Share *Filer 0.003 0.017 0.021 0.010 0.002 (0.22) (0.65) (0.70) (0.22) (0.50) Other Controls, Firm and Year FE Yes Yes Yes Yes Yes Observations 3,101 3,126 3,101 3,126 3,111 Adjusted R2 0.10 0.07 0.09 0.09 0.31

39

Figure 1: Key Events and Timeline

2001 2002 2003 2004 2005 2006 2007 2008

• Event&1:!The!Sarbanes+Oxley!Act!was!signed!into!law.

• Event&2:!SEC!Press!Release!No.!2002+128:!Accelerated!filer!status!definition!and!acceleration!schedule.

• Event&3:!The!SEC!voted!to!adopt!rules!concerning!management’s!report!on!internal!control!(Section!404).!Accelerated!filers!are!expected!to!comply!for!fiscal!years!ending!on!or!after!June!15,!2004.!All!other!issuers!would!be!required!to!comply!for!their!fiscal!years!

ending!on!or!after!April!15,!2005.!

• Event&4:!The!SEC!approved!an!extension!of!the!original!compliance!dates.!For!accelerated!filers,!the!compliance!dates!are!extended!to!fiscal!years!ending!on!or!after!November!15,!2004!and,!for!non+accelerated!filers,!to!fiscal!years!ending!on!or!after!July!15,!2005.!

• Event&5:!The!SEC!extended!Section!404!compliance!dates!for!non+accelerated!filers!and!foreign!private!issuers!to!the!firm’s!first!fiscal!year!ending!on!or!after!July!15,!2006.!

• Event&6:!The!SEC!proposed!providing!further!relief!for!non+accelerated!filers!regarding!Section!404!compliance!dates.!The!compliance!date!is!moved!to!the!firm’s!first!fiscal!year!ending!on!or!after!December!15,!2007.!The!compliance!date!to!provide!an!auditor’s!

attestation!report!on!interval!control!is!moved!to!the!fiscal!year!ending!on!or!after!December!15,!2008.!

• Event&7:!The!SEC!approved!an!additional!one+year!extension!of!the!compliance!date!for!smaller!public!companies!to!meet!Section!404’s!auditor!attestation!requirement.!Smaller!companies!will!now!be!required!to!provide!the!auditor’s!attestation!report!for!fiscal!years!

ending!on!or!after!December!15,!2009.!

Event 5: Mar 2, 2005

Event 3: May 27, 2003

Event 1: July 30, 2002

Event 6: Dec 15, 2006

Event 4: Feb 24, 2004

Event 7: June 20, 2008

Event 2: Aug 27, 2002

40

!

Figure!2.!Capital!expenditures!scaled!by!total!assets!

Figure!3.!R&D!expenditures!scaled!by!total!assets!

Figure!4.!Total!investment!scaled!by!total!assets!

0.03!

0.04!

0.05!

0.06!

0.07!

0.08!

0.09!

1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006!

Filer!capx_at!Large!capx_at!Nonfiler!capx_at!

0.02!0.03!0.04!0.05!0.06!0.07!0.08!0.09!0.1!0.11!0.12!

1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006!

Filer!xrd_at!Large!xrd_at!Nonfiler!xrd_at!

0.06!

0.08!

0.1!

0.12!

0.14!

0.16!

0.18!

0.2!

1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006!

Filer!inve~_at!

Large!inve~_at!

Nonfiler!inve~_at!

Control

Filer-Small Filer-Large

Control

Filer-Small Filer-Large

Filer-Small

Control

Filer-Large

Pre-SOX Post-SOX

Pre-SOX Post-SOX

Pre-SOX Post-SOX

41

Figure!5.!Cash!holdings!scaled!by!total!assets!

!

Figure!6.!Standard!deviation!of!returns

0.1!

0.15!

0.2!

0.25!

0.3!

0.35!

1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006!

Filer!che_at!Large!che_at!Nonfiler!che_at!

0.015!

0.025!

0.035!

0.045!

0.055!

0.065!

1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006!

Filer!sdret!Large!sdret!Nonfiler!sdret!

Control

Filer-Small Filer-Large

Control

Filer-Small Filer-Large

Pre-SOX Post-SOX

Pre-SOX Post-SOX