Submitted for presentation at the Spring 2003 Accounting Research Consortium
Comments welcome. Please do not quote or circulate without permission.
Current version: March 2003
CAPITAL MARKET REACTIONS TO the
Sarbanes-oxley act of 2002
The Sarbanes-Oxley Act of 2002 (the Act) was enacted in response to numerous corporate and accounting scandals and aimed at reforming business practices of the financial community and the accounting profession. This study examines the market reaction to the Act and finds a positive abnormal return at the time of several events leading to the passage of the Act. Furthermore, firms with higher market capitalization, earnings to price ratio, and stock price volatility are affected more by the Act compared to other firms. Results suggest that the Act created news which was viewed as good news by investors in increasing the market’s confidence in firms’ corporate governance and accounting systems.
Keywords: Financial scandals; the Sarbanes-Oxley Act of 2002; market reactions;
Data Availability: Data are commercially available from the sources identified in the study.
JEL Classification: G14; G28; M41
CAPITAL MARKET REACTIONS TO the
Sarbanes-oxley act of 2002
i - Introduction
Two thousand two was a challenging and rather difficult year for corporate America as evidenced by the stock market’s swift decline, a significant number of earnings restatements, substantial corporate and accounting scandals and resulting loss of confidence in corporate governance, financial reports, and related audit functions. To restore public confidence, lawmakers enacted bipartisan legislation by passing the Sarbanes-Oxley Act of 2002 (hereafter the Act) in July 2002. A major reason for enactment of the Act and establishment of the Securities and Exchange Commission (SEC) related implementation rules was the belief that new regulations were necessary to make corporations more accountable to shareholders and to restore the confidence of investors in the capital market. However, the Act has received a mixed response from the financial community and the accounting profession. The Act was viewed by many as the most sweeping measures taken by legislators addressing corporate governance, financial reports, and audit functions.1 Results of a real-time poll of 450 CFOs and senior financial executives during a live webcast with former SEC chairman Arthur Levitt revealed that 90 percent of participants believe new regulations intended to make corporations more accountable to shareholders are necessary (Levitt 2002). Others consider the Act as patchworks and codification responses by Congress to widely publicized business and accounting scandals, with no direct impacts on improving corporate governance and financial disclosures, at least beyond those of market-based mechanisms.2 Sorin, et al. (2002) argue that although the Act may improve future investor confidence, it does not provide restitution to investors who lost their investments because of financial scandals, and to securities professionals the Act gives the illusion of increased accountability.
There exists an extensive literature, propagated mostly by economists, accountants and lawyers, on the Act and its possible impacts on public companies’ corporate governance, financial reporting process, and audit functions. These writings (Rezaee 2002; Osterland 2002; IIA 2002; Ribstein 2002; Sorin et al. 2002; Cunningham 2003) concentrate on analyzing specific provisions of the Act and their impacts on financial, business, and accounting communities. The conclusions reached on the various effects of the Act, therefore, are based generally on this descriptive evidence which range from “sweeping measures” that will eventually reform corporate governance and the financial reporting of public companies to “patchworks, codifications and further studies” of the existing corporate governance and financial disclosures regulations and requirements. The major theme of these studies is that despite characterization of the Act as either “sweeping reform” or “patchworks and codifications,” it is intended to and will restore investor confidence in the capital markets. The purpose of this study is to empirically test capital market reactions to several events (Congressional bills) leading to the passage of the Act.
Empirical market-based accounting research3 typically examines the market reactions to the announcement of particular events (e.g., accounting standards, regulations) via analysis of the relation between these events and various market variables. Consistent with empirical market-based accounting research, this study examines whether the announcement of nine events (see Table 1) leading to the passage of the Act provided any new information to investors that may have affected their perceptions of the likelihood of the passage of the Act and its impacts on public companies’ corporate governance, financial reports, and audit functions. Specifically, we (1) examine capital market reactions to nine events leading to the passage of the Act to determine whether the Act conveys value-relevant information to investors in restoring the market’s confidence in corporate America, and (2) investigate whether the detected market reactions are associated with company characteristics and attributes (e.g., corporate governance, financial reports, and audit functions). We detected positive abnormal returns around dates corresponding to the passage of the Act suggesting the capital market reacted positively to the Act. We also investigated the determinants of the detected price reaction by using firm specific variables. We found that firms with higher market capitalization, earnings to price ratio, and stock price volatility were affected more by the Act compared to other firms. Results also indicate that financial scandals were not limited to a handful of companies because investors perceived them to be an industry-wide problem.
The results of this study have implications for public companies and their executives, investors, and policy makers. The results suggest that investors value regulations such as the Act that create positive changes in corporate governance, the financial reporting process, and audit functions. Public companies and their senior executives should realize that they will be under scrutiny to conduct their business ethically and thus should have a long-term focus on improving corporate governance and financial reports, as the capital markets and rating agencies will likely factor these improvements and firm characteristics, including corporate governance, more explicitly into their valuation and rating processes. Policy makers (Congress) and regulators (SEC) should be encouraged regarding the important oversight role of restoring public confidence in corporate America. Our results suggest that the Act has created a climate of confidence in financial information and therefore more investors’ confidence in the capital markets and the economy. This study contributes to the extant literature on law and finance, examining the relationship between the legal protection of investors and the development of financial markets. Results support the findings of Laporta et al. (1998), documenting that legal systems including legislations and regulations are important integral components of corporate governance and corporate finance.
The remainder of the paper proceeds as follows: The next section discusses the effects of major provisions of the Act. Section III briefly reviews the related literature. Theoretical framework, events leading to the passage of the Act, and testable hypotheses are presented in Section IV. Section V discusses data and methodology. Results are presented in Section VI and a final section concludes the paper.