An interesting new study by Professors Craig Doidge, Andrew Karolyi, and René Stultz, “Has New York Become Less Competitive in Global Markets?” has been said to support the controversial Sarbanes-Oxley Act. Virtually everyone, including the responsible regulatory agencies, the SEC and the PCAOB, agrees that the costs of Sarbanes-Oxley have been and continue to be excessive. The vast expense, paperwork, and bureaucracy are a fact. If they exceed the benefits, the result is by definition bad for investors.

But there is a debate over the law’s benefits. This study updated analysis of the premium relative to book value of shares of foreign companies that are “cross listed”—that is, listed on a U.S. exchange subject to U.S. rules as well as on a foreign exchange. It found that the premium has remained approximately the same: about 15 percent before and 14 percent after Sarbanes-Oxley. Thus, “the premium has not fallen significantly in recent years,” the authors conclude.

They believe the premium comes from the higher confidence that investors have in highly-regulated U.S. markets. We should ask why, if Sarbanes-Oxley improved investor protection so much, that premium did not increase. The foreign companies had to bear a lot more cost and bureaucracy than before, which means a lower book value from the increased costs, but still got a slightly lower, rather than an improved, market to book ratio. What did they get for the increased cost? Nothing, apparently.  

The foreign companies had to bear a lot more cost and bureaucracy than before, which means a lower book value from the increased costs, but still got a slightly lower, rather than an improved, market to book ratio.

The Doige, Karolyi and Stultz paper suggests an instructive thought experiment: if Sarbanes-Oxley 404 were voluntary, would investors differentiate among American companies and pay a premium for the securities of those companies which implemented it, compared to those which chose not to? The National Venture Capital Association has commented that its members see no evidence of such a tendency, but it is a logical possibility.

In this context, we can say there are two competing theories:

A. Sarbanes-Oxley is bad for investors because the costs are excessive relative to the benefits, and

B. Sarbanes-Oxley is good for investors because it protects them and makes them willing to pay more for securities.

Theory B is usually used as an argument for keeping Sarbanes-Oxley Section 404 mandatory, but it is actually a great argument for making it voluntary.  

Under a voluntary regime, if Theory B is right and investors love how they are protected by Sarbanes-Oxley 404, they will bid up the prices of the securities issued by companies who implement it. We will then observe within the U.S. market a premium analogous to the “cross listing” premium, and everyone will end up following suit.

But if, as many of us believe more likely, investors think their money is better spent on research and development or marketing than on excessive accounting routines, paperwork, and bureaucracy, the companies will respond accordingly.

The logic of the voluntary proposal seems impeccable. It is reflected in Sarbanes-Oxley reform bills introduced in the House by Congressmen Meeks and Feeney, and in the Senate by Senator DeMint, which would make Section 404 voluntary for smaller public companies. Applying the principle more widely, Congressman Flake has announced he will reintroduce a bill making Section 404 voluntary for all.

Investor choice would demonstrate whether Theory A or Theory B is correct. Alternately stated, let’s send Sarbanes-Oxley to the court of Investors.

Alex J. Pollock is a Resident Fellow at the American Enterprise Institute.