Center For The Study of Financial Regulation

Winter 2011 - Issue NO.4

THE BONDING HYPOTHESIS AND SOX

by Lance Young, an Assistant Professor of Finance at the Foster School of Business of the University of Washington.

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The Sarbanes-Oxley Act (SOX) has attracted a great deal of attention in both the popular press and the academic finance literature. Opponents have argued that SOX imposed costs that harmed shareholders. Proponents argue that the benefits to shareholders outweigh the costs. While the debate about the benefits and costs of SOX continues, evidence is mounting that by helping to restrain managers from extracting private benefits, SOX provides a net benefit to many firms' shareholders.

The 11 titles in the act contain a range of provisions that restrict public companies' board composition, prohibit top managers from borrowing from their companies, require extensive reviews of companies internal control structure, and require that senior executives certify their firms' financial statements. The act also provides for civil and criminal penalties for both firms and senior executives personally.

Critics point to a number of costs imposed by SOX. The act's internal control reviews are often cited as onerous in terms of management time and effort. Moreover, if shareholders want managers to take risks and adopt innovative strategies, government threats of increased personal liability on executives may end up thwarting the shareholders ability to incentivize managers to act in their interests

The economic nature of SOX's benefits are not as clear as the costs. Press accounts and SEC releases note that the regulation will "increase public confidence and integrity in capital markets." While this is a laudable goal, what is its value to shareholders, in economic terms? With managers and shareholders free to contract, why should government restrictions on the activities of corporate managers increase integrity and improve disclosure where private parties could not? While some might argue that SOX reduces fraud, SOX restricts activities that fall well short of outright fraud. Furthermore, fraud already is actionable and even before SOX perpetrators faced severe reputation costs in the event they were caught.

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Where, then, would the economic benefits of SOX come from? One place to look for the economic benefits of SOX comes from the so-called "bonding hypothesis." Under this hypothesis, it is costly for shareholders to coordinate with one another, and costly for them to oversee the activities of the people they must hire to run the firm for them. These information asymmetry and agency problems make it hard for shareholders to write contracts that rule out opportunistic activity on the part of managers. These activities need not be fraud, per se. They can range from simple shirking to consumption of perks and other private benefits of office. Furthermore, managerial benefit extraction is not a simple zero-sum transfer from shareholders to managers. Consumption of private benefits by managers is associated with a deadweight loss. That is, managers do not get to keep every dollar that they expropriate. For instance, a shirking manager might reduce firm value by failing to implement good internal controls. However, even though she enjoys the extra leisure, her enjoyment may not be worth the entire decline in the value of the firm. Put differently, if the shareholders had the ability to write (and enforce) contracts that forced managers to bear the entire cost of their actions, they would not optimally choose to shirk. However, because of the difficulties in coordinating among diffuse shareholders and the cost of overseeing managers, small, individual shareholders do not necessarily have the incentive or the ability to write such a contract. In the absence of such contracts, the resulting deadweight loss can be potentially very costly to shareholders.

In these circumstances, managers of firms with growth options that need funding may choose to allow themselves to be regulated by an agency that has greater ability to enforce limitations on managers than individual shareholders. That is, in exchange for their share of sufficiently large growth opportunities, managers are willing to submit to oversight and follow a set of rules that requires them to give up at least some of their private benefits. Upon joining the regulatory regime, insiders commit credibly to stop or at least reduce their extraction private benefits. Thus, shareholders not only gain from the additional growth opportunities that the firm can now finance, but they also benefit from the reduction in the deadweight loss associated with managerial rent extraction. In essence, if the reduction in the deadweight loss is in excess of the costs of implementing the new regulatory requirements, the firm's assets are worth more, even apart from the increased growth options.

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The bonding hypothesis provides a more concrete and economically rigorous statement of the potential benefits of regulation than claims about the "integrity of the markets." The question remains whether SOX provided a sufficient reduction in the deadweight losses associated with managerial rent extraction to offset the costs of implementing the regulation. To address this question, some regulators and researchers have looked at the effect of SOX on the probability of a foreign firm listing in the U.S. Some have argued that the net costs imposed by the regulation are so great that foreign firms are avoiding listing their shares in the U.S. in favor of greener pastures, particularly the U.K. The evidence on this point is mixed. While some studies, such as Zingales (2006), find that foreign firms are less likely to list in the U.S. after SOX, Doidge, Karolyi, Stulz (2009) find no evidence that foreign firms are less likely to list in the U.S. after SOX.

Duarte, Kong, Siegel and Young (2010) find that the picture is more complicated than foreign firms simply avoiding the U.S. after SOX. They find foreign firms from weak regulatory regimes are less likely to list in the U.S. while firms from strong regulatory regimes are more likely to list in the U.S. after SOX. Furthermore, they find that on average shareholders in foreign firms benefited more from U.S. listings after SOX. Moreover, shareholders in foreign firms from countries with weak regulatory regimes react even more positively to U.S. listings after SOX than the average firm. These facts are consistent with bonding hypothesis and suggest that by helping to restrain managers from extracting private benefits, SOX may provide a net benefit to many firms' shareholders.

Reference

Doidge, C., Karolyi, A., Stulz, R., 2009, Has New York become less competitive in global markets? Evaluating foreign listing choices over time, Journal of Financial Economics 91, 253-277.

Duarte, J., Kong, K., Siegel, S. and Young, L., The impact of the Sarbanes-Oxley Act on shareholders and managers of foreign firms, Working paper, University of Washington, Seattle, WA.

Zingales, L., 2006, Is the U.S. capital market losing its competitive edge? Working paper, University of Chicago, Chicago, IL.

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