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UI Researchers Find Positive Market Reaction to Sarbanes-Oxley Act

While corporate executives say their businesses are groaning under the weight of complying with Sarbanes-Oxley regulations, two University of Iowa business professors have found that most investors cheered the law during its early days.

Research by Sonja Rego and Haidan Li in the Tippie College of Business shows that stock market values increased significantly as a result of the reforms imposed by the Sarbanes-Oxley Act in July 2002. The two authors said that while the law may impose burdens on businesses, it has restored investor confidence in a market that was battered by a six-month long string of corporate scandals from Enron to WorldCom.

Their research also found that market values increased even more significantly for those corporations that were thought to have been the most aggressive in managing -- and occasionally manipulating -- their earnings in order to artificially inflate their stock price.

"Investors had some idea that companies were manipulating their earnings, and which companies were doing it more aggressively," said Li, an assistant professor of accounting. "When Sarbanes-Oxley became law, investors expected firms to reduce such manipulation so that the financial information they received from the firms would be more reliable."

The Sarbanes-Oxley Act (now known by the shorthand SOX) became law in July 2002 in an attempt to restore investor confidence in U.S. markets by improving the accuracy and reliability of financial statements issued by corporations. Many corporate executives today are critical of SOX, saying the amount of money and time their companies spend in order to comply with its regulations does not justify the benefits they provide of more accurate financial statements.

However, Rego and Li's research found that whatever controversy there might have been about the potential costs SOX would impose was outweighed by its expected benefits as investors were looking to have their faith restored in the market. In their research, Rego and Li followed the price of 850 stocks starting on June 25, 2002, the date of the announcement of a $3.8 billion accounting fraud at WorldCom, the largest corporate fraud in American history at that time. Stocks sunk to new lows on news of the fraud, as investors increasingly lost faith in companies' earnings statements. The WorldCom scandal turned out to be the event that spurred Congress to reform corporate governance and accounting regulations.

The government's response began almost immediately, with the SEC filing suit against WorldCom executives on June 26 and requiring chief executive and chief financial officers at all publicly traded U.S. companies to certify their companies' financial statements. Within a month, Congress had passed what would become the Sarbanes-Oxley Act, which was signed into law by President Bush on July 30.

Stock prices began to rebound almost as soon as the SEC announced its actions on June 26, as stock returns increased by 3.6 percent by the end of the trading day June 27 from their lows of the day before. The market dropped again in the coming weeks amid more accounting fraud revelations and a general consumer gloom about the economy, but increased once more on July 24th, when a Congressional conference committee issued the Sarbanes-Oxley Act and sent it to the House and Senate for approval. On that news, the market jumped 5.4 percent.

It jumped another 5 percent on July 29, when the SEC said it would publicly identify those CEOs and CFOs who did not certify their firms' financial statements.

Overall, the market jumped 11 percent by the end of the study period on Aug. 15 from its post-WorldCom low on June 26. Li and Rego said the increase is largely the result of investor confidence that SOX would make companies' financial statements more accurate and reliable.

"The market had high hopes for Sarbanes-Oxley and investors thought it would be successful in cleaning up financial reporting," said Rego, an assistant professor of accounting. "The specifics of how much it would cost firms to comply with the law were not known, but at that time, the market's greater priority was in cleaning up the reporting."

As a result, the companies that benefited the most were those perceived by investors to have previously engaged in the most aggressive earnings manipulation. Rego's and Li's research studied a sub-set of 425 companies that were seen as using aggressive accounting tactics prior to SOX and their value increased by an additional 5 percent during the study period, likely because their stock price had been driven low during the post-Enron period by investors who placed little reliability in their financial statements.

"Investors believed those companies' numbers would now become more reliable after Sarbanes-Oxley became law and their stock prices increased since they were no longer discounted by the market," Li said.

Li's and Rego's paper, "Market Reaction to Events Surrounding the Sarbanes-Oxley Act of 2002 and Earnings Management," will be published in the Journal of Law and Economics in 2008. Their co-author in the study is Morton Pincus, a professor of accounting at the University of California, Irvine.


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