Eric Talley, Co-Faculty Director of BCLBE and Visiting Professor of Law at Boalt Hall, recently co-authored an article entitled "Going Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross Country Analysis", with Ehud Kamar and Pinar Karaca-Mandic. We recently interviewed him about his findings.
Q: In this article you examine the phenomena of public companies going private within the first two years after the enactment of Sarbanes-Oxley. What did you find?
Talley: We found evidence consistent with the claim that Sarbanes-Oxley has disproportionately affected smaller companies, using a methodology that may be a little bit more reliable than methodologies others have used to answer this question. For example, some researchers have tried to gauge how onerous SOX has been on small companies by conducting surveys. The problem with this approach is that you can’t know whether you’re getting the truth or an exaggerated response, and what’s more, you never look at any of SOX’s benefits. For example, if it were the case that small businesses tend to be responsible for most fraud then the survey approach wouldn’t be a way to measure any benefits of compliance. Other researchers have tried to come up with accounting measures of compliance cost. Those are a little better, but accounting measures are not completely accurate reflections of what’s going on within a company and also don’t measure any of the benefits of SOX compliance.
So our thought was to examine costs and benefits by measuring actions rather than statements. We thought one of the best places to measure this is at the very junction where a company decides whether to go private or to stay public, or conversely whether to go public or stay private. So we looked at one of those thresholds: the decision to stay within the public capital markets or to exit them; with the idea that companies at that point are truly weighing the cost and the benefits. How costly will it be for us to comply, versus what’s the benefit of being out in the capital markets?
Q:How do you know that the costs of SOX compliance drove the going private decision, rather than some other issue?
Talley: That’s a really hard question. The approach we arrived at – and it’s not perfect, but pretty good – is to say, look, a perfect test in a laboratory would be to set up two identical Petri dishes next to one another. Both would have an identical securities market in them and we would introduce Sarbanes-Oxley to one and not to the other. We don’t have that, but we do have a global securities market and a bunch of foreign exchanges on which stocks are actively traded, companies go public, companies go private on a daily basis, just like in the US, and Sarbanes-Oxley was not imposed, at least initially, in these foreign jurisdictions. So we focused on comparing the rates and the proclivities of going private among foreign traded companies versus those in the United States, both before and after SOX’s introduction. We focused on whether there were any differences between US and European firms with respect to going private decisions and whether that difference shrinks or grows after Sarbanes-Oxley. That approach is much more likely to pinpoint a specific Sarbanes-Oxley effect. It’s not perfect, but it does a little bit better than, I think, the existing literature does.
Q: What did you find?
Talley:We found two pieces of evidence that are pretty consistent with the idea that Sarbanes-Oxley has imposed a cost mainly on smaller issuers. First, the aggregate amount or the rate at which companies go private relative to their foreign counterparts initially increased in the US. It turns out that that increase is really taking place largely among issuers who have under $50 million market cap. This is a little bit smaller than the $75 million dollar group of companies that are now going to be exempt until 2007 from compliance with the internal control mandates.
Second, US companies going private are much more likely than their foreign counterparts to be bought by a private US company than a public company, and that's particularly true among smaller issuers. Why is that important? Well, if you're a public company and you're bought by another public company, all of your operations still are subject to internal control attestations. All of your operations are still subject to SOX compliance. So to the extent that there are variable costs of compliance, you're not escaping those costs by being bought by a public company. You have to be bought by a private company. That ratio shifted after SOX but particularly so with the smaller cap firms.
Q: By a private company, do you mean a private equity firm, or do you mean a larger private company?
Talley: It could be either. We didn't try at first to distinguish between private equity firms that are built for the purpose of buying out the stock of public companies or large privately held operating firms, like Cargill, that may make acquisitions everyday. Later on in the project we try to determine whether this, in fact, is being driven more by private equity investment firms or existing operational firms. We found that the proclivity to be bought by a financial buyer increased the most. Private buyers, however, generally got good deals in going private transactions, whether buying for operational or for financial reasons. Again, remember that these smaller firms may not have wanted to remain public regardless of who their buyer was.
Q: So many commentators have said that Sarbanes-Oxley is actually a boon for private investors and private equity firms. Is that consistent with your findings?
Talley:Well, it’s hard to say with absolute certainty that private equity has been able to eat at the SOX trough. I think smaller issuers may have been pushed a little bit by SOX to decide to go private. Now, that may be the exact same force causing the emergence of more private equity interests. Knowing that there are going to be more firms going private, maybe it makes a lot more sense on the buy side to invest in the private equity market. Does that necessarily mean that it has been a boon for private equity? Not necessarily, because those various private equity investment funds are competing with one another to invest in firms going private. When that happens, the people who make out are not the private investors, per se, but the selling shareholders. So, it may have actually created a partial benefit to private equity, but that benefit may also have been passed to the public shareholders.
The real question is, fundamentally, from a policy perspective, not who gets that benefit but whether that benefit is something that's been created only because of a large regulatory cost from SOX. Is there a benefit that is being destroyed by going private, regardless of who receives the payments of going private, is now not going to be realized because this company might be a better fit being traded in the public markets but it's not because of compliance costs.
Q: Have you examined that issue?
Talley: That's a really hard issue to get at. It may well be the case that these firms should be going private, should've been going private before, and SOX is just channeling them into going private now. We can't get at that ultimate issue. All we can do is rule out a few things. We are able to get to at least one thing this paper: are the costs uniform across companies? The answer to that clearly seems to be "no," at least given the angle that we are taking. It's the smaller firms that seem to be the ones, at least initially, who are exiting. Even there, that initial uptake tended to flatten out and die after the first year and half of SOX. Maybe that's because some maladapted firms got out and the ones that remain are better adapted to deal with the new regulatory environment. That one's a little bit harder to know.
Q: Some commentators have noted that the major costs are in the first year or so and after that the costs are sunk so there should be less of a drag.
Talley: That's another possibility and, in fact, might be consistent with the idea of companies getting out to avoid those fixed costs. But if that were the case, there's no reason for companies going private to sell to private investors as opposed to public companies. If it's just a big fixed cost, and if you're a big public company, you're going to sink that cost anyway -- why not sink it with a number of other acquisitions? Even if it is a fixed cost, it's a fixed cost that goes up with the scale of the operation. That seems to have been at least partially what we're inferring was driving a lot this skew toward private as opposed to public acquirers.
Q: Just recently the SEC has said that it would delay compliance with Rule 404 until 2007, for companies under $75 million market cap.
Talley: Part of the interesting thing here is, "What does this mean from a policy perspective?" We've already talked about the possibility that, in fact, SOX channeled companies that should've been going private before and weren't for some other reason and now are. The exemption from SOX internal controls mandates might slow that process. So part of this really turns on whether you think SOX is driving these companies into the private realm in a way that is good for society or in a way that is just a cost. If it's just a cost then one would conclude that there are companies that are now going to be facing a more delayed or attenuated cost. There's some talk that the SEC is actually going to impose a different internal controls requirement for these smaller issues. Sort of a "404 Lite." If you think that SOX has been a cost, this might be a slight dampening of that cost that would, under that view, be good for public policy reasons.
Another more interesting question, though, is: "What are our goals for some of these smaller issuers?" Or, "What should our goals be?" Suppose we wanted a regulatory environment in which smaller issuers actually had an incentive to enter the public market and then grow. Would a small business exemption under "404 Lite" be consistent with the goal of entrepreneurship and growth? Or might it actually create an incentive not to grow, not to get to the point where you cross over the "404 Lite" threshold into a full compliance requirement? Or maybe it would encourage companies to finance predominately through debt rather than equity so that it looks like you're a small cap firm even though you're a large cap firm? So, interestingly enough, even if our findings are consistent with SOX being a net cost for small firms, it's not so obvious that the way to respond to that is to create a size exemption for those companies. It might give rise to other sorts of behavioral distortions that could be even worse than the disease.
Q: How about SOX's effect on entrepreneurship and innovation?
Talley: Entrepreneurial and innovative activities often take place when a firm is small. We've mentioned that if SOX represents predominantly a cost on smaller issuers, many smaller entrepreneurial firms will decide not to go public as quickly as they would have before. Whether that's good or not good is hard to tell. There might be some of them who might be better off going public early and are now deciding not to or possibly even going public in a foreign exchange and aren't traded on US markets. That may be bad for US markets; it may not necessarily be bad for investment in US companies if some of their operations are in US, but it's something we probably have to remain attentive to. At this point the study is not really able to answer some of those broader normative questions.
Q: Are you conducting any follow-up work?
Talley: We are trying to pick apart the trends of private equity. In some ways the delay in enforcement of Rule 404 has created yet another natural experiment for us to look at. For those companies that decide not to go private, what will their growth trajectories look like in the US as compared to growth trajectories abroad? This gets back to whether we could measure if a threshold is pro- entrepreneurship or creates constraints on entrepreneurship. We are going to try to keep our eyes peeled for whether 404 costs recur every year. We are interested in looking at and measuring the European jurisdictions that are now starting to implement 'Sarbanes-Oxley like' restrictions of their own, using the US companies as the control group.
article you examine the phenomena of public companies going private within the first two years after the enactment of Sarbanes-Oxley. What did you find?