Corporate scandals, the Sarbanes-Oxley Act of 2002 and equity prices.

Thapa, Samantha ; Brown, Christopher L.

ABSTRACT

Recently, a series of corporate scandals has hit the U.S. financial markets. The improper accounting practices of such large and well known companies as Enron, WorldCom, Xerox, Merck, and Bristol Myers has shaken investors' confidence in the financial markets thereby shaking the very foundation of a free enterprise system. In response, the U.S. Congress passed the Sarbanes-Oxley Act and President Bush signed the Act into law on July 30, 2002. This study investigates the stock market reaction to the signing of this Act into law. We detect a significant positive stock price reaction to this event, indicating that investors believe the Sarbanes-Oxley law will provide for better corporate governance in the future.

INTRODUCTION

Recently, several corporate scandals have rocked the U.S. financial markets. Starting with the debacle of Enron, many more scandals have come to light. For example, WorldCom overstated cash flows by recording $3.8 billion in operating expenses as capital expenditure and later on admitted another $3.3 billion in revenue was improperly booked. Similarly, Adelphia Communications overstated revenues by inflating capital expenses and hiding debt. They backed a $3.1 billion loan to the Rigas family, founders of Adelphia Communications. Bristol Myers inflated its 2001 revenue by $1.5 billion, Qwest communications admitted that it incorrectly accounted for $1.3 billion in sales and will restate results for 2000-2002, and Xerox misstated financial results for 5 years boosting income by $1.5 billion and is restating financials dating back to 1997 (see Patsuris, 2002 for the scandal sheet). A sample of the well publicized, high profile cases are shown in Table 1. These are all well known large public companies. Their improper accounting practices and, in some cases fraudulent reporting, has shaken investors' confidence in the stock market.

In order to improve corporate governance and restore investors' confidence in the stock markets, President Bush signed into law the Sarbanes Oxley Act on July 30, 2002. This Act contains the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt (Miller and Pashkoff, 2002). The purpose of this study is to investigate the stock market reaction to the passage of this Act into law.

Although, there have been numerous articles written on the Sarbanes-Oxley Act, no rigorous econometrics investigation of the stock market reaction to the passage of Sarbanes-Oxley Act has appeared in the literature to date. Since the passage of the Act into law introduces sweeping reforms in corporate governance, this type of econometrics study enhances the Finance literature.

SARBANES-OXLEY ACT OF 2002

This Act significantly changes federal regulation of public company corporate governance and reporting obligations, and tightens accountability standards for directors, officers, auditors, securities analysts and legal counsel. The Act has eleven provisions (titles) and impacts many of the parties involved in capital formation process--management, auditors, accountants, security analysts, attorneys and regulators. Its key provisions are:

* establishes Public Company Accounting Oversight Board (PCAOB). The PCAOB is an independent, nongovernmental and non-profit organization and its purpose is to oversee the audits of public companies,

* imposes specific requirements for audit committee. The audit committee must consist solely of independent directors,

* CEO/CFOs must certify financial statements stating that the reports fairly present the company's financial and operating results. Penalties can be up to $5 million and/or up to 20 yrs in prison for false certification,

* prohibits loans to executive officers,

* requires real-time disclosure of information useful to investors and requires more detailed financial information and other disclosures in SEC filings,

* changes the deadline for insiders to report trading in company's securities to within two business days of the transaction,

* requires issuers to review their relationship with their auditors to ensure continued independence,

* imposes more stringent rules for U.S. attorneys,

* protects whistleblowers, and

* imposes sanctions and penalties on violators of the provisions of this Act.

IMPLICATIONS FOR THE STOCK MARKET

For a free market economy to work properly, investors, who are the suppliers of capital, must have trust and confidence that capital markets are functioning in an efficient and ethical manner. But the spate of recent corporate scandals has eroded public confidence in the system. As one scandal after another unfolded, it was revealed that many of the key players in the market--corporate executives, auditors, lawyers, security analysts and regulators were either engaged in unethical behavior and/or outright fraud or were lax in carrying out their responsibilities.

As can be seen from the provisions, Sarbanes-Oxley Act attempts to influence corporate executives' behavior by imposing new regulations and punitive measures in cases of noncompliance in order to improve corporate governance and restore investors' confidence in the stock market. Specifically, it requires companies to divulge detailed information about company activities in real-time, certify the veracity of financial reports, set up independent audit committees, and also provides for severe penalties for any fraudulent activities (Leeds, 2003 and Guerra, 2004). Hence, the passage of this act into law should have a positive impact on stock prices.

Critics, on the other hand argue that the recent examples of corporate fraud do not justify a new set of regulations. They maintain that federal regulation is not the answer, that the financial markets have mechanisms to correct such practices. Additional regulations simply add layers of bureaucracy and the cost for complying is significant. Further, they argue that this Act may change the risk taking behavior of honest managers, which is so important for the growth and success of a company (Rebistian, 2002 and Morgan, 2003). Although, this viewpoint has some merit, we argue that the intended impact of Sarbanes-Oxley on corporate governance, auditing, and management accountability far outweighs the burden it imposes on companies. Hence, the passage of this Act into law should have a net positive impact on the stock market.

LITERATURE REVIEW

The literature review consists of two parts: the first part consists of studies that measure stock price reactions to various events, and the second part consists of articles on the Sarbanes-Oxley act. The finance literature is replete with event studies, such as changes in dividend policies, stock splits, changes in accounting rules, mergers & acquisitions, changes in tax laws and regulatory practices. Since event studies have become so standard in finance literature, we will review only a few of them here.

Khurana (1991) investigates the stock price reaction of firms to the adoption of SFAS No. 94, which requires firms to consolidate all majority-owned subsidiaries, including foreign subsidiaries and subsidiaries with heterogeneous operations. They report a negative stock price reaction to the adoption of this rule. Similarly, Espahbodi, Strock, and Tehranian (1991) study the impact of SFAS No. 106 on equity prices and report a negative stock price reaction. SFAS 106 requires companies to use the accrual method of accounting for nonpension postretirement benefits. Beatty, Chamberlain and Magliolo (1996) study the impact of the adoption of SFAS 115 on equity prices of bank holding companies and insurance companies. This rule requires the use of fair value accounting for some categories of investment securities and requires that unrecognized gains and losses on these securities be accounted for on the balance sheet. (see also, Boyd, Hayt, Reynolds and Smithson, 1993 and Mittelstaedt and Warshawsky, 1993).

Numerous articles have appeared on the Sarbanes-Oxley act in the literature. The majority of these articles view this act as a positive development., but there are some critical of this Act.

Miller and Pashkoff (2002) argue that Sarbanes-Oxley is one of the largest reform packages in corporate governance since Franklin D. Roosevelt's New Deal. They focus on provisions most important to accounting companies engaged in the auditing function. Highlighting the role of Public Company Accounting Oversight Board (PCAOB), they point out that this board (PCAOB) should develop guidelines detailing which public accounting companies should register with the board. Burns and Musmon, 2003 state that instead of looking at Sarbanes-Oxley as a burden, corporations should take it as an opportunity to communicate the corporate mission, values and ethics to all potential investors.

Leeds (2003) argues that the loss of investor confidence in the capital markets is because of a breach of trust by corporate managers by their unethical behavior and non- disclosure of information to investors. One of the essential requirements for functioning of a market economy is public disclosure. But the spate of corporate scandals revealed that information about the misconduct of the executives was withheld from shareholders, regulators, rating agencies and others. This revelation eroded the public confidence in the functioning of financial markets. The passage of the Sarbanes-Oxley act should help the markets function properly.

Guerra (2004) states that the cause of the investor confidence crisis is lax corporate governance processes. Sarbanes-Oxley is an attempt to correct this problem. He urges regulators to strictly enforce the new rules set by the Sarbanes-Oxley act. Similarly, Guerra ( 2004) argues that the Sarbanes-Oxley act is the response to minimize the conflict of interests in the process of issuing and marketing securities. They argue that this reform package is based on fostering integrity, independence, transparency, and accountability.

But there are some articles critical of the Sarbanes-Oxley act. For example, Ribostein ( 2002) argues that new corporate regulations are not the answer to the recent occurrences of corporate frauds. New regulations will simply add significant direct and indirect costs by fostering distrust and bureaucracy in firms. Although, imperfect, market based approaches are more efficient and effective in enhancing corporate governance. Similarly, Morgan (2003) critique the provisions of Sarbanes-Oxley directed at lawyers. They argue that provisions contained in the Sarbanes-Oxley act pertaining to lawyers are more likely to complicate than improve lawyers' conduct.

Despite numerous articles on Sarbanes-Oxley act, we did not find any empirical studies investigating the impact of this act on securities' prices. That is the focus of this paper.

DATA

The event examined in this investigation is the signing of the Sarbanes-Oxley act into law on July 30, 2002. The sample consists of companies in the Standard and Poors 500. In order to be included in the sample, companies had to have returns in the CRSP database for the 255 day control period prior to the event period and for the 30 day event period. Firms with significant events during the event period that were not related to the Sarbanes-Oxley Act were removed from the sample. The final sample includes 442 firms. Historically, the Wall Street Journal Index has been the major source of information for event dates. We also reviewed the Wall Street Journal for any other major events around this time. The only major event during that period was the ongoing debate over the Iraq war.

RESEARCH METHODOLOGY

Event study methodology is used to model stock price reactions. We employ a single factor market model using the following equation to calculate expected stock price returns:

[r.sub.jt] = [a.sub.j] + [b.sub.j] [r.sub.mt] + [e.sub.jt], (1)

where

[r.sub.jt] = the return on security j for period t,

[a.sub.j] = the intercept term,

[b.sub.j] = the covariance of the returns on the jth security with

those of the market portfolio's returns,

[r.sub.mt] = the return on the CRSP equally-weighted market portfolio for period t, and

[e.sub.jt] = the residual error term on security j for period t.

The parameters of the market model were estimated during a 255-day control period that began 271 days before the announcement date and ended 16 days before the announcement date. The announcement date (Day 0) is July 30, 2002, the date that the Sarbanes-Oxley Act was signed into law by President Bush. The market model parameters from the estimation period are used to estimate the expected returns for each day of the event period. The event period begins 15 days (Day-15) before the announcement date and ends 15 days (Day 15) after the announcement date. The abnormal return ([ABR.sub.jt]) is the difference between the actual return and the expected return. It is calculated by subtracting the expected return (which uses the parameters of the firm from the estimation period and the actual market return for a particular date in the event period) from the actual return ([R.sub.jt]) on that date. The equation is as follows:

[ABR.sub.jt] = [R.sub.jt] - ([a.sub.j] + [b.sub.j][R.sub.mt]), (2)

where each of the parameters are as previously defined. The average abnormal return for a specific event date is the mean of all the individual firm abnormal returns for that date:

[AR.sub.t] = [N.summation over (j=1)][ABR.sub.jt]/N (3)

where N is the number of firms used in calculation. The cumulative average return (CAR) for each interval is calculated as follows:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (4)

We perform a Z-test to determine if the CARs are significantly nonzero. We use the cross-sectional test proposed by Boehmer, Musumeci and Poulson (1991). The event study returns are normalized and a cross-sectional test is performed on the standardized residuals to determine if the abnormal returns are significantly different from zero. Boehmer, Musumeci and Poulson (1991) find this cross-sectional test is less likely to have Type I errors (i.e., rejecting the null hypothesis when the null is true) than the traditional Z-test.

FINDINGS AND CONCLUSIONS

The findings are reported in Table 2. The cumulative abnormal return (CAR) for the firms in the sample for the event window (0, +1) is 0.34% (significant at the .01 level) and for the event window (-1, +1) the CAR is 1.35% (significant at the .001 level). There appears to be some reaction to the passage of the bill in the days leading up to President Bush's signing of the Act. Given the media attention around passage of the Act, and given that President Bush indicated his intention to sign the bill into law, this is expected. In fact, the CAR for the event window (-5, 0) is 5.39% (significant at the .01 level). This translates into an annualized return of approximately 280%. The positive stock price reaction to the passage of the Sarbanes-Oxley Act is an indication that investors believe the Act will provide for better oversight of management by the board of directors and that accounting records will be more closely scrutinized by the board of directors, independent auditors, and regulators.

Based on the positive stock price reaction to the passage of Sarbanes-Oxley, investors don't seem to be concerned about the financial costs borne by corporations to comply with the Act or by the restraints that may be placed on managers by boards or the reduced risk-taking by managers to avoid personal liability for their decisions. The stock price reaction indicates that investors believe the positive impact of Sarbanes-Oxley on financial reporting and board oversight outweigh the potential negative impact of increased costs to comply with the Act, reduced risk-taking by managers, and restraints that may be placed on managers by boards of directors.

REFERENCES

Beatty, A., S. Chamberlain and J. Magliolo (1996). An empirical analysis of the economic implications of fair value accounting for investment securities. Journal of Accounting and Economics, 22, 43-77.

Boehmer, E., J. Musumeci, and A. Poulsen (1991). Event-study methodology under conditions of event-induced variance. Journal of Financial Economics. (Dec), 253-272.

Boyd, J. F., G. Hayt, R. Reynolds, and C. Smithson (1996). A review of industry reaction to proposed changes in derivatives accounting. Journal of International Financial Management & Accounting, (Autumn), 243-258.

Burns, J and E. Musmon (2003). Sarbanes-oxley: burden or opportunity. Financial Executive, 19, 46-48.

Espahbodi, H., E. Strock, and H. Tehranian (1991). Impact on equity prices of pronouncements related to nonpension postretirement benefits (FAS 106). Journal of Accounting & Economics, (Dec.), 323-346.

Guerra, J.E. (2004). The sarbanes-oxley act and evolution of corporate governance. The CPA Journal, 74(3), 14-16.

Guerra, J.E. (2004). The sarbanes-oxley act and evolution of corporate governance. The CPA Journal, 74(5), 14-16.

Khurana, I. (1991). Security market effects associated with SFAS No. 94 concerning consolidation policy. The Accounting Review, 611-621.

Leeds, R. (2003). Breach of trust: leadership in market economy. Harvard International Review, (25), 76-83.

Miller, R.I. and P.H. Pashkoff (2002). Regulations under the sarbanes-oxley act. Journal of Accountancy, (194), 33-37.

Mittelstaedt, H.F. and M.J. Warshawsky (1993). The impact of liabilities for retiree health benefits on share prices. Journal of Risk & Insurance, (March), 5-27.

Morgan, D.T. (2003). Sarbanes-oxley: a complication, not a contribution in the effort to improve corporate lawyers' professional conduct. The Georgetown Journal of Legal Ethics, (Fall), 1-34.

Patsuris, P. (August 26, 2002). The corporate scandal sheet. Retrieved October 3, 2004 from www.forbes.com

PricewaterhouseCoopers (March, 2003). Navigating the sarbanes-oxley act of 2002, overview and observations. Retrieved October 7, 2004 from www.pwcglobal.com/images/bz/so_overview.pdf.

Ribostein, L.E. (2002). Market vs. regulatory responses to corporate fraud: a critique of the sarbanes-oxley act of 2002. Journal of Corporation Law, (28), 1-67.

Samanta Thapa, Western Kentucky University

Christopher L. Brown, Western Kentucky University

Table 1: Recent Corporate Scandals

Company When Scandal Allegations
 Went Public

Adelphia Apr-02 Founding Rigas family collected $3.1
Communications billion in off-balance-sheet loans
 backed by Adelphia; overstated
 results by inflating capital expenses
 and hiding debt.

AOL Time Warner Jul-02 As the ad market faltered and AOL's
 purchase of Time Warner loomed, AOL
 inflated sales by booking barter
 deals and ads it sold on behalf of
 others as revenue to keep its growth
 rate up and seal the deal. AOL also
 boosted sales via "round-trip" deals
 with advertisers and suppliers.

Bristol-Myers Jul-02 Inflated its 2001 revenue by $1.5
Squibb billion by "channel stuffing," or
 forcing wholesalers to accept more
 inventory than they can sell to get
 it off the manufacturer's books

Duke Energy Jul-02 Engaged in 23 "round-trip" trades to
 boost trading volumes and revenue.

Enron Oct-01 Boosted profits and hid debts
 totaling over $1 billion by
 improperly using off-the-books
 partnerships; manipulated the Texas
 power market; bribed foreign
 governments to win contracts abroad;
 manipulated California energy market

Global Crossing Feb-02 Engaged in network capacity "swaps"
 with other carriers to inflate
 revenue; shredded documents related
 to accounting practices

Halliburton May-02 Improperly booked $100 million in
 annual construction cost overruns
 before customers agreed to pay for
 them.

Kmart Jan-02 Anonymous letters from people
 claiming to be Kmart employees allege
 that the company's accounting
 practices intended to mislead
 investors about its financial health.

Merck Jul-02 Recorded $12.4 billion in
 consumer-to-pharmacy co-payments that
 Merck never collected.

Qwest Feb-02 Inflated revenue using network
Communications capacity "swaps" and improper
International accounting for long-term deals.

Tyco May-02 Ex-CEO L. Dennis Kozlowski indicted
 for tax evasion. SEC investigating
 whether the company was aware of his
 actions, possible improper use of
 company funds and related-party
 transactions, as well as improper
 merger accounting practices.

WorldCom Mar-02 Overstated cash flow by booking $3.8
 billion in operating expenses as
 capital expenses; gave founder
 Bernard Ebbers $400 million in
 off-the-books loans.

Xerox Jun-00 Falsifying financial results for five
 years, boosting income by $1.5
 billion

Source: Patsuris, P. (2002) The Corporate Scandal Sheet,
www.Forbes.com, August 26, 2002

Table 2: Cumulative Abnormal Returns (CARs)

Event Window CAR Z-stat P-value

Day 0 to +1 0.34% * 3.22 < .01
Day -1 to +1 1.35% ** 8.65 < .001
Day -5 to 0 5.37% ** 27.61 < .001
Day -5 to +5 4.29% ** 17.57 < .001

*significant at .01 level

**significant at .001 level