The Case for Clarity

You know about the cost of Sarbox. What about the benefits?

Adds Christy Wood, senior investment officer at Calpers, the $200 billion California pension fund: “I would ask anyone who told me 404 was too expensive, How much is too much? How much is too much to ensure the authenticity and integrity of financial-statement reporting?”

With 16 percent of reporting companies disclosing weaknesses in internal controls during the second year of Sarbox and 7 percent falling into that category so far this year, it is hard to argue that every company aside from Enron and WorldCom was trouble-free. A poll by accounting firm KPMG revealed that 74 percent of audit-committee and other board members were not surprised by the number of internal-control weaknesses identified to date. “How can a company say that 404 was a waste of money if three-quarters of board members had an inkling that something wasn’t quite right?” asks Haskins.

From Weakness, Strength

Indeed, finance executives who say Sarbox has done nothing to lower their cost of capital may simply be venturing a guess, as it is extraordinarily difficult to quantify investor confidence.

One recent academic study attempted to do so by examining how investors have reacted to companies’ announcements of internal-control deficiencies. The study, co-authored by Ryan LaFond, an assistant professor at MIT’s Sloan School of Management, found that firms that announce control problems see a median increase of one percent in their cost of capital compared with firms that make no such announcements.

For companies that subsequently address their control problems and receive an unqualified opinion, the cost of capital goes down by a median of 1.3 percent. “The markets seem to be valuing and honoring the discovery and addressing of material weaknesses,” says Haskins. “There may be a positive response to the fact that the company found the weakness.”

But for those that never receive an adverse opinion, the cost of capital goes down by only 0.58 percent. “If you’re a good firm and everybody knows you’re a good firm, you don’t appear to see as much benefit to 404,” says LaFond.

One reason why companies that receive repeated clean opinions may not see much cost-of-capital benefit is that their investors assume they have good controls. That assumption of financial integrity is already priced into the stock. “Compliance is like having insurance. You don’t get points for having proper insurance, but if you don’t have it you get hammered,” says Haskins.

In fact, such “insurance” may be part of the valuation premium that companies listing on U.S. stock exchanges enjoy. Observes Nasdaq CFO David Warren: “I don’t think we’ve spent enough time getting people to understand that against the costs [of Sarbox] there are benefits to raising your capital in the U.S.”

Foreign issuers that list in the United States see as much as a 30 percent higher valuation than companies that list only in their home markets, says Ohio State University professor Andrew Karolyi, who has co-authored a study on the topic. “We found that the valuation premium was larger for firms that come from countries that have less-developed financial markets and legal systems with fewer protections for minority shareholders,” he says.


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