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Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation

By Harvard Law School Program on Corporate Governance

(Editor’s note: This post comes to use from Feng Gao, Joanna Shuang Wu, and Jerold Zimmerman at the Simon School of Business Administration at the University of Rochester. This paper was presented by Professor Wu at the National Bureau of Economic Research Conference on Corporate Law and Investor Protection on July 28th, 2008.)

In our paper Unintended Consequences of Granting Small Firms Exemptions from Securities Regulation: Evidence from the Sarbanes-Oxley Act, we investigate whether the enactment of SOX created incentives for certain firms to stay small ? in particular to keep their public float below $75 million, the threshold in the SEC?s definition of ?non-accelerated? filers. Since 2003, the SEC has on several occasions deferred the implementation deadline for non-accelerated filers regarding Section 404 of SOX, considered by many commentators as one of the most onerous parts of SOX, particularly for smaller firms.

At least two non-mutually exclusive reasons can motivate managers to retain their firm?s non-accelerated filer status: (i) they believe that complying with Section 404 reduces shareholder value, and/or (ii) they believe that Section 404 reduces their private control benefits. Our paper does not differentiate between these two motives. Rather, it documents that regulatory size thresholds in fact induce some firms to remain below the threshold and identifies the various methods used to accomplish this objective. Our sample consists of non-accelerated filers and a control sample of accelerated filers with market capitalizations below $150 million. Our event period spans June 1, 2003 (following the first SEC deferment of Section 404 compliance deadline for non-accelerated filers) to December 31, 2005 (soon after the SEC issued the new exit rule for accelerated filers).

We document several actions that non-accelerated filers appear to employ to keep their public float below the $75 million threshold post-SOX. We find that they take actions to reduce net investment in property, plant, and equipment, intangibles, and acquisitions, that they pay out more cash to shareholders via ordinary and special dividends and share repurchases, and that they take actions to decrease the number of shares held by non-affiliates. Because the testing date of a firm?s filing status occurs only once each fiscal year (the last trading day of its second fiscal quarter), we find that non-accelerated filers disclose more bad news and report lower accounting earnings in the second fiscal quarter in an effort to exert temporary downward pressure on share prices before testing their filing status. Furthermore, we find evidence that the non-accelerated filers? incentives to undertake the above actions are weaker when they are further away from the $75 million threshold. Finally, we document that the various actions undertaken by the non-accelerated filers post-SOX appear to be effective in that these firms are more likely to remain below the $75 million threshold in the following year.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on August 04, 2008 (boomark / email).