Regulation Week: Is Regulation a Good Thing for Investors?

So this week we see the new financial regulation dropping, so I’ll be dedicating the next couple of blog posts to that very subject. We are going to do some heavy lifting together, so let’s start out with a warm-up exercise. Some regulatory stretching for our minds.

Let’s say you are the primary shareholder of Rortybomb Blog, Inc., a company dedicated to selling the latest in Avril Lavigne ringtone technology in the sidebars of this blog. I’m Mike, your CEO. You’ve read recently on the conservative blogs that pseudonymous bloggers are “cowards” and “irresponsible”, and since you get most of your opinions from conservative blogs you suddenly find me very untrustworthy. In fact, your big concern is whether I want to hold onto your cash from Rortybomb earnings in order to buy myself expensive champagne and fast cars.

Along comes a regulatory bill that will soon be put up for a vote, oh let’s call it Sarbanes-Oxley, and I immediately get on a jet, go to Washington DC, and very publicly say, as a CEO, that it’ll ruin my business. The next day, it appears that the bill will be passing. What is your reaction as an investor?

(a) Your valuation goes down. Washington is going to charge the company you own a regulatory fee in a publicity stunt that will add no value.
(b) Your valuation goes down. The guy who runs the company you own, CEO Mike, has signaled to everyone that he has his hand in the cookie jar because he wants to fight off additional regulation, regulation that will be ineffectual against him.
(c) Your valuation goes up, because you realize CEO Mike is sneaking value from you, and that this regulation will expose that. However it’ll go down later, because you were too optimistic and when you saw its implementation you were disappointed.
(d) Your valuation goes up, because you realize CEO Mike is sneaking value from you, and that this regulation will expose that. It will continue to stay up years later.

Well we did run this experiment on the financial markets when the Sarbanes-Oxley passed, and the answer the market gave was (d). It is important to remember, in all this talk about “free” markets, that markets crave good information, and efforts that can get us to better information are worth the price.

I want to now kick it over to my favorite recent empirical accountancy paper (yes, I have one – suck it!) Ok this abstract is a bit difficult to follow, but let me walk you through it. From A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002 (pdf) (Hochberg, Sapienza, Vissing-Jørgensen, 2008):

We evaluate the impact of the Sarbanes-Oxley Act (SOX) on shareholders by studying the lobbying behavior of investors and corporate insiders in order to affect the final implemented rules under the Act. Investors lobbied overwhelmingly in favor of strict implementation of SOX, while corporate insiders and business groups lobbied against strict implementation. We identify firms most affected by the law as those whose insiders lobbied against strict implementation. Such firms appear to be characterized by agency problems, rather than motivated by concerns over compliance costs. Cumulative stock returns during the five and a half months leading up to SOX passage were approximately 7 percent higher for corporations whose insiders lobbied against SOX disclosure-related provisions than for similar non-lobbying firms, consistent with an expectation that SOX would reduce agency problems. Analysis of returns in the post-passage implementation period suggests that investors’ positive expectations with regards to the effects of these provisions were warranted.

While the Sarbanes-Oxley Act (SOX), a regulation effort taken after the fraud at Enron et al was exposed, was being debated by Congress, there was a very formal process for the financial community to lobby for-or-against certain parts of the act. The law was passed.

So what happened? According to the numbers, the market bid up the firms that hired the most lobbyists against the disclosure rules of SOX. Now what if they were optimistic about the process, and the process turned out to be wrong? Regulation seemed necessary, but what if this regulation turns out to be terrible? Then those numbers should have downward trend later compared to the non-lobbyist firms. Turns out that those firms retained their value in the years afterwards. It’s a fascinating way to approach some of the optimal regulation problems. And this is the place that we always need to make sure is accurate – if the books aren’t correct, everything else falls apart. Here is more from the paper:

There are two main competing views about the likely impact of the Sarbanes-Oxley Act (SOX) on shareholders. Proponents of the Act argue that it will lead to improved disclosure, transparency and corporate governance, thereby reducing misconduct, perquisite consumption and mismanagement by insiders (whether legal or illegal), and that these benefits will outweigh the costs of compliance. Opponents argue that SOX will be ineffective in preventing corporate wrong-doing and/or that any benefits of SOX will not be large enough to outweigh the associated compliance costs….

We find that the firms most likely to lobby were firms in mature industries, with relatively low forecasted earnings growth, high profitability and poor governance…

Our portfolio analysis of returns reveals that during the period leading up to passage of SOX (February to July of 2002), cumulative returns were approximately 7 percentage points higher for corporations whose insiders lobbied against one or more of the SOX ‘Enhanced Disclosure’ provisions than for non-lobbying firms of similar size, book-to-market and industry characteristics…

Our analysis of returns in the post-passage period indicates that the returns for firms who lobbied against an ‘Enhanced Disclosure’ rule were similar to the returns of the non-lobbying comparison group, and, thus, that the increase in relative stock price experienced by lobbying firms did not reverse during the post-passage period.

Weird, right? But it makes sense. People think that the market should be free, but being free doesn’t mean “I have the freedom to not have my results accurately and transparently observed by my bosses.” Freedom for markets is not quite the same negative liberty we experience as citizens; it’s more of a positive obligation to accurately and efficiently contribute information so that marginal decision making can be made off of that. And getting that information accurate is the key to keeping a healthy financial sector working properly. Markets need information; if that information turns out to be noise, and especially if one can’t tell the difference between those acting truthfully and those acting with a conflict, it can be worse than useless.

Comments

[Steve in Gr...:]

Thanks, Rortybomb, for the interesting note.

I wonder how the authors decided that lobbying efforts against SOX was an indicator for underlying fraud. Lobbying against SOX was a rationale response to further non-value-added U.S. government intrusion.

The Ethics Resource Center has published surveys showing ethical misconduct went down very slightly post-SOX but by 2007 it was back up to pre-SOX levels.

All SOX has done has been to help the U.K. and European exchanges take IPO business away from Wall Street and cause European companies to delist-deregister from U.S. exchanges. (That and it made the public accounting firms much richer than the were.) It has had zero impact on ethical behavior or transparency.

Jun 16 09:34 AM

[Larry House:]

Thanks for your analysis. I certainly agree as an investor/trader I want accurate and timely information from companies and about the markets. I just can't help but think the markets are in control of big money/insider money, and the only way I make money is if I happen to get in line (by accident) with what the big money is doing. We have had too many instances of news hitting the air waves and then discover that umteen thousands of options traded just before the news came out. Too late for me to make money, but someone knew what was coming and did. I don't trust the market as fair to all players. I don't want regulations that strangle business, but I want regulations that give timely information to all.

Jun 16 10:02 AM

[Hot Richard:]

I trust government regulators as much as I do a hungry, drunk Somali pirate with my cheeseburger and gin bottle.

Those that aren't crooked are incompetent.

Jun 16 10:41 AM

[Mad Hedge F...:]

Talk about a day late and a dollar short! Ho hum. Another day of financial reform debate. Another day of closing the barn door after the horses have bolted. Please stop scratching your fingernails on the chalkboard, will you? What has the market come to? The volatility index (VIX) spikes 7% in one day, and we only get a 187 point drop in the Dow. It’s getting so you can’t even get a decent crash going. Thank goodness I’m not a Master of the Universe anymore. Life in that industry is about to become incredibly boring.

Jun 16 02:14 PM

[carey_jim:]

In baseball a pitcher can gain an enormous advantage if he throws the ball at batters' heads now and then. Umpires are sensitive to this strategy which, in itself, is no worse than throwing a curve ball that looks like it might hit the batter but then curves across the plate. Curve balls are allowed but fastballs directed at the head are not.

In the past, basketball teams of shorter but more agile and skilled basketball players managed to beat teams of bigger players by using a strategy of passing and ball control. But the fans wanted higher scoring games so basketball 'regulators' made up the 24 second rule where each team was forced to shoot the 24 seconds after they crossed the half court line.

Basketball and baseball could have evolved in many different directions and could change into many different games in the future. For instance, if the regulators wanted to maximize basketball skill and ball handling and minimize the advantage of size, the basket could be raised by two feet.

In a similar manner, regulators decide what aspects of human nature to allow free play in the game of finance.

The biggest danger of living in a democracy is that the majority might decide on to pass regulations which make are good for the majority of little players but make the big, powerful players unhappy.

But who decides whether Big Time Wrestling is an better or worse than Cage fighting?

Jun 17 02:36 PM