Sarbanes-Oxley: It's Delicious and (Mostly) Good for You

by: Zubin Jelveh

On the day Treasury Secretary Paulson calls for tougher banking regulation, it's worth remembering that less than two years ago, the Paulson-backed Committee on Capital Markets Regulation was campaigning for the opposite.

The committee released a report in November 2006 arguing, in part, that financial market oversight needed to be relaxed, otherwise the U.S. -- New York City in particular -- would lose its place as the world's money center. The primary evidence for this argument was that the U.S. share of the IPO market was falling, and the blame for this was placed on Sarbanes-Oxley, everyone's favorite piece of post-Enron legislation.

And the SOX-ripping still continues. Tuesday, the National Venture Capital Association said that 57 percent of its members blamed Sarbanes-Oxley for the lack of venture-backed I.P.O.s in the just-ended 2nd quarter. It was the first time in 30 years that a quarter didn't feature any venture-backed I.P.O.s.

It's hard to argue that Sarbanes-Oxley hasn't increased the direct costs of going public, a number of studies have shown this to be true. Firms have to spend more money on monitoring, reporting and auditing in order to comply with regulation.

But there is a greater benefit to compliance: Investors are now more informed about public companies. If we remember, during the Tech Bubble, I.P.O.s surged on their first day of trading. This reflected, some argue, the fact that companies artificially kept their offering price low in order to attract attention on the first day of trading when the stock shot through the roof.

Now, because of increased reporting by companies, Sarbanes-Oxley has helped reduce this information mismatch, argue economists Christoph Kaserer, Alfred Mettler, and Stefan Obernberger in a new paper. As a result, I.P.O. underpricing was reduced and actually offset some of the increased costs of SOX.

Looking at I.P.O. data between 1993 and 2007, the researchers found that while flotation costs increased by 0.8 percent, almost entirely because of higher accounting and legal fees, the indirect benefits of less underpricing was between 3 percent and 4 percent. On average, it looks like SOX was actually beneficial for the I.P.O. market.

But there's also something to what the National Venture Capital Association argues. The positive effect of less underpricing holds primarily for offerings that are larger than $50 million, meaning that the incentive for small firms to go public has been reduced. And this is borne out in the numbers: Before Sarbanes-Oxley, smaller offerings made up about 31 percent of the I.P.O. market, afterwards that number declined to 23 percent.

The S.E.C. is currently investigating the effects of SOX on smaller companies, and announced in June that it was granting a one-year extension for small companies not to have to comply with SOX. Small companies are defined as those with offerings of less than $75 million. (Go here for some unintended consequences of the small company-exemption.)

But the takeaway from this episode seems fairly clear. When Congress and the next President get around to handing the Federal Reserve new powers, it's worth keeping in mind that regulation has the ability to lower costs for the entire financial system.