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SARBANES-OXLEY: THE EVIDENCE REGARDING

THE IMPACT OF SOX 404

Robert Prentice*

INTRODUCTION

The central debate regarding the way forward for U.S. capitalmarkets centers upon the Sarbanes-Oxley Act of 2002 (SOX) generallyand, more specifically, upon its provision requiring audits of internalfinancial controls, Section 404 (SOX 404). When decidedly banal

securities laws gain the attention of presidential candidates and otherhigh-profile politicians,1 as has happened with SOX, it is clear thatsomething significant is happening.

The premise of this Article is that while empirical academicliterature cannot conclusively settle the ongoing controversy over SOX404, especially at this relatively early stage, it can contributeimportantly to the conversation as well as serve as a crucial check uponthe self-interested and often short-sighted views of many of the moreactive participants in the debate.

There are two primary sets of complaints regarding SOX 404.First, corporate managers legitimately complain about SOX 404s costsfor implementation and ongoing maintenance. The empirical evidencewill indicate, however, that critics tend to exaggerate SOX 404sadmittedly substantial costs and ignore its countervailing benefits.2

Second, Wall Street and its supporters claim that SOX, particularlythrough SOX 404, is damaging New Yorks status as center of thefinancial world. Mayor Bloomberg and Senator Schumercommissioned McKinsey & Co. to study the matter.3 Secretary of the

* Ed & Molly Smith Centennial Professor of Business Law, McCombs School of Business,

University of Texas at Austin.1 See Steve Forbes, Right Man for Our Times, FORBES, Apr. 23, 2007, at 19 (supporting

Giulianis presidential aspirations in part because of his opposition to various SOX provisions).2 See Donald C. Langevoort, The Social Construction of Sarbanes-Oxley, 106 Mich. L. Rev.

(forthcoming 2008) (working paper at 22), available at http://ssrn.com/abstract=930642[hereinafter Langevoort, Social Construction] (observing that managers believe they deserve

autonomy and control over the institution so long as they respect very basic legal and businessnorms and keep their constituents satisfied and assuming that on average, managers consider

SOX an intrusion and resent nearly all of it).3 See MCKINSEY & CO., SUSTAINING NEW YORKS AND THE US GLOBAL FINANCIAL


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Treasury Hank Paulson assembled a group of academics and others, theCommittee on Capital Markets Regulation (CCMR), which decried therole of SOX in the decline of U.S. dominance in investment banking

and related businesses.4 In March 2007 the U.S. Chamber ofCommerces Commission on the Regulation of U.S. Capital Markets inthe 21st Century issued a similarly critical report.5 The evidenceadduced in this Article will indicate that although SOX 404 is havingsome adverse impact upon New Yorks securities business, so manyother factors are at play that even outright repeal of SOX 404 wouldlikely have little beneficial effect.

Importantly, SOX critics assume that when those who control U.S.companies take them private or those who control foreign firms droptheir U.S. listing in apparent efforts to evade SOXs requirements, theyare acting in the best interests of the firm. The academic literatureindicates that this is not a safe assumption.

The controversy could not be more important, because substantialpolitical pressure is being applied by opponents of SOX 404,6which hasbecome nearly synonymous with Sarbanes-Oxley itself.7 Whether SOXis ultimately considered a success or a failure will likely depend uponSOX 404s legacy. At the moment, the smart money seems to be on theproposition that SOX is a disaster,8 with SOX 404 being the lawsmost complained-of provision.9 Although the critics may ultimately beproved correct, there are substantial grounds, based in empiricalacademic literature,10 to be deeply skeptical of most of their primary

SERVICES LEADERSHIP (2007)[hereinafterMCKINSEY REPORT].4

COMMITTEE ON CAPITAL MARKETS REGULATION, INTERIM REPORT (2006) [hereinafterCCMRREPORT].5 COMMISSION ON THE REGULATION OF U.S. CAPITAL MARKETS IN THE 21ST CENTURY,

REPORT AND RECOMMENDATIONS (2007) [hereinafter CHAMBER REPORT].6 See Brett H. McDonnell, Recent Skirmishes in the Battle Over Corporate Voting and

Governance 10 (Minn. Law School Legal Studies Research Paper No. 07-04) (Jan. 2007),available at http://ssrn.com/abstract=960278 (Much political pressure has built to roll back the

most controversial elements of SOX, especially section 404.).7 See Donald C. Langevoort,Internal Controls After Sarbanes-Oxley: Revisiting Corporate

LawsDuty of Care as Responsibility for Systems 2 (Sept. 2005) (unpublished manuscript, on

file with Georgetown University Law Center), available at http://ssrn.com/abstract=808084

[hereinafter Langevoort,Internal Controls] (noting that objections to other portions of SOX havelargely quieted so that today the sustained [criticism] is largely reserved for just one piece of the

legislation: the internal controls requirements found [in] section 404 . . .).8 See Gregory Carl Leon, Stigmata: The Stain of Sarbanes-Oxley on U.S. Capital Markets 7

(George Washington Univ. Law School Public Law Research Paper No. 224) (Nov. 8, 2006),

available at http://ssrn.com/abstract=921394 (The voices of those that persist in the opinion that

SOX is beneficial to the U.S. market are few and far between.).9 A Price Worth Paying?Auditing Sarbanes-Oxley, ECONOMIST,May 21, 2005.

10 Due to page constraints, this article does not address the substantial number of studies

focusing on how the stock market reacted to various announcements that SOX had passed certainlegislative and administrative hurdles in its passage and implementation. Those studies are wildly

conflicting and of uncertain value. For an earlier discussion of some of those studies, see Robert


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2007] SARBANES-OXLEY: THE EVIDENCE 705

claims.A statute can shape the beliefs and norms that are prerequisite for

effective legal compliance, but only if it is viewed as legitimate. SOX

has the potential to have substantial beneficial influence in creating aculture of compliance so that corporate employees are not simply tryingto game the financial reporting system, but are instead trulycommitted to producing accurate financial information for investors.11However, if critics succeed in discrediting SOX, it may be no moreeffective than was Prohibition in shaping beliefs and actions. On theother hand, if SOX comes to be viewed more accurately as a well-intended but imperfect means to protect U.S. capital markets from theirown excesses, then perhaps its credibility can be salvaged so that it canbe studied and, if necessary, amended, without being discredited. In thefinal analysis, whether SOXs benefits exceed its costs may turn uponwhether its legitimacy is maintained. This Article adduces substantialevidence supporting the essential soundness of SOX and its Section404.

I. SOX404S BACKGROUND

A. SOX Internal Control Provisions

Sarbanes-Oxley was enacted against a backdrop of infamouscorporate scandal. Enron, WorldCom, and many other companiesengaged in massive securities frauds that undermined the very heart ofthe federal securities lawstheir antifraud and mandatory disclosure

provisions. Many CEOs had been paying little attention to thesereports, and many CFOs had been viewing their jobs primarily asbullying their firms outside auditors into certifying as aggressive a setof financial statements as possible on the theory that all theircompetitors were doing the same. Centrally, for purposes of thisArticle, Congress enacted a triumvirate of provisions aimed directly atreestablishing investor confidence in financial statements.

Section 302 requires that CEOs and CFOs of public companiescertify that the companys periodic reports do not contain materialmisstatements or omissions and fairly present the firms financial

A. Prentice & David B. Spence, Sarbanes-Oxley as Quack Corporate Governance: How Wise is

the Received Wisdom?,95GEO.L.J.1843,1856-57(2007).11 Langevoort has correctly noted that the social construction of SOX may ultimately decide

whether it actually influences actors within the financial reporting system to take theirresponsibilities seriously or simply causes them to insincerely check the box. Langevoort,

Social Construction,supra note 2, at 30.


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condition and results of operations.12 In addition, the officers mustaffirm that they are responsible for the internal controls, have designedthem to ensure that material information is brought to their attention,

have evaluated their effectiveness, have presented in the report theirconclusions about their effectiveness, and have discussed in the reportany changes in the internal controls, including corrective actionstaken.13 Section 906(a) creates a new criminal penalty for officers whoknowingly certify an inaccurate financial statement.14 Finally, and mostsignificantly, SOX 404 requires the filing of a management reportattested to by the external auditor assessing the reliability of the issuersinternal financial controls.15

Although most legal scholars have been highly critical of SOX404,16taken together, the three provisions seem a logical response to theproblems Congress was trying to solve. Given substantial evidence ofwidespread and serious corporate reporting fraud, it was sensible forCongress to conclude that a signal should be sent to CEOs and CFOs ofpublic companies that they should take seriously their responsibilities inthe public company reporting system. Although these officers werealready signing financial statements filed with the SEC, Congressplausibly concluded that a new message needed to be sent via sections302 and 906.17 Congress then enacted SOX 404 after reasonablyconcluding that executive certification would be more meaningful and

12 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 302, 116 Stat. 745, 777-78 (2002)(codified at 15 U.S.C. 7241 (2000)).

13 See Langevoort, Internal Controls, supra note 2, at 8-9 (summarizing provisions of

Sections 302 and 404).14 Pub. L. No. 107-204 906(a), 116 Stat. at 806 (codified at 15 U.S.C. 1350).15 Id. 404, 116 Stat. at 789 (codified at 15 U.S.C. 7262). See generally Thomas C.

Pearson & Gideon Mark, Furthering SOXs Goals with Statutory and Regulatory Enhancements

and More Effective Investigations to Assure Reliable Financial Information,86 NEB.L.REV.43

(2007)(explaining SOX 404 in detail).16 See, e.g., Robert Charles Clark, Corporate Governance Changes in the Wake of the

Sarbanes-Oxley Act: A Morality Tale for Policymakers Too 2 (Sept. 2005) (Harvard Law and

Econ. Discussion Paper No. 525), available at http://ssrn.com/abstract=808244; Larry E.Ribstein, Sarbox: The Road to Nirvana, 2004 MICH.ST.L.REV.279,293(arguing that SOX is an

example of Sudden Acute Regulatory Syndrome).17 See A Price Worth Paying?, supra note 9 (It has certainly been a salutary reminder to

corporate leaders that they are paid a lot of money because they are responsible for a lot of

thingsin particular, for ensuring that their companies accounts provide investors with as honest

a view as possible of the state of their organisation.).Firms were also supposed to be filing timely 8-Ks before SOX, but their performance in that

regard improved substantially after SOX reminded them of their responsibilities. SeeRobert E.

Pinsker,Has Firms Form 8-K Filing Behavior Changed Since Section 409 of the Sarbanes-Oxley

Act Became Effective? 4-5 (Sept. 13, 2006) (unpublished manuscript, on file with Old Dominion

University), available at http://ssrn.com/abstract=930063 (finding that firms filing behavior has

significantly improved with SOX, valid[ating] the [SECs] effort (and that of SOX) to shortenthe Form 8-K filing time and provide corporate information to investors in a more timely

fashion).


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persuasive to investors if those executives had reasonable grounds tobelieve that the internal financial controls on the process producingthose numbers were solid.

B. SOX 404s Rationale and Lineage

Events at Enron and WorldCom, the two most damagingscandals,18 certainly justify Congresss emphasis on internal financialcontrols. For example, Enrons stated strategy was to aggressively takerisks because tight internal controls would ensure that things did not getout of hand.19 However, Enrons vaunted Risk Assessment and ControlDepartment was an utter sham, resulting in a situationwhere [e]veryone at Enron was concerned with hitting the numbers; noone was concerned with the integrity of the numbers.20

[What Enron-era frauds rendered apparent was not] that somemanagers were unscrupulous (which had always been the case) butthat the controls on their financial disclosures were weaker than mostpeople thought and, perhaps even more important, that theweaknesses were heightened rather than reduced by powerful trendsshaping the current business environment, such as the acceleration ofcorporate restructuring, disruptive technology changes, and constantfinancial innovation.21

Congresss conclusion regarding the importance of internalfinancial controls was consistent with the academic literature. Expertsin accounting theory have long emphasized the importance of internalcontrols to all parties interested in production of accurate corporatefinancial statements.22 If reliable internal financial controls are relevantto the accuracy of the financial statements produced, then theoretically

18 Weak internal controls are also assigned major blame in one of the scandals that has cometo light post-Enronthe stock option backdating scandal. See Victor Fleischer, Options

Backdating, Tax Shelters, and Corporate Culture2 (Univ. of Colo. Law Legal Studies Research

Paper No. 06-28) (Oct. 2006), available at http://ssrn.com/abstract=939914 (noting thatbackdating was collateral damage from weak internal controls and, in some cases, the rent-

seeking of executives).

Many other scandals have been tied directly to internal control problems, including some ofEuropes largest recent ones. See Bruno Cova, The Parmalat Fraud Has Generated Too Little

Reform,FIN.TIMES,Nov. 7, 2005, at 17 (Parmalat); Bernard Taylor, Shell-Shock: Why Do Good

Companies Do Bad Things? 14 CORP.GOV.181, 181 (2006) (Shell Oil).19 BETHANY MCLEAN & PETER ELKIND, THE SMARTEST GUYS IN THE ROOM 121 (2003)

(noting that Jeff Skilling claimed Enron could be managed loosely because of its tight internal-

control mechanism).20 Fleischer,supra note 18, at 22 n.73.21 NICOLAS VERON ET AL., SMOKE & MIRRORS, INC.: ACCOUNTING FOR CAPITALISM 1

(2006).22 William R. Kinney, Jr. et al.,Assertions-Based Standards for Integrated Internal Control,

4 ACCT.HORIZONS 1(Dec. 1990).


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firms with poor internal controls should have to pay more for capitalbecause of the increased risk they present to investors.23 Empiricalstudies confirm the theory by indicating that firms with poor internal

controls tend to (a) restate earnings more often,24(b) be the subject ofmore SEC accounting and auditing enforcement releases (AAERs),25(c)face more frequent SEC enforcement actions,26 and (d) be worseperformers and systematically riskier than comparable firms.27

Langevoort supplemented the theoretical and empirical cases forinternal controls by consulting the management and psychologyliterature to build a persuasive case for the common sense conclusionthat auditing internal financial controls as demanded by SOX 404 isgenerally a good idea. A critical agency issue is at stake becausemanagers are conflicted by the self-serving bias. They naturally do notwish to be monitored if they can avoid it, and are often motivated tofudge the numbers not only to help their firm (at least in the short run),

23See, e.g.,David Easley & Maureen OHara,Information and the Cost of Capital,54 J.FIN.1553, 1575 (2004) (Reducing the risk of informed trading, and correspondingly increasing the

amount of public information, reduces the risk premium uninformed traders demand to hold the

stock.); Christian Leuz & Robert E. Verrecchia, Firms Capital Allocation Choices, InformationQuality, and the Cost of Capital 22 (Jan. 2005) (unpublished manuscript, on file with University

of Chicago Graduate School of Business), available at http://ssrn.com/abstract=495363(establishing a theoretical link between a firms information quality and its cost of capital).

24 Hollis Ashbaugh-Skaife et al., The Discovery and Reporting of Internal Control

Deficiencies Prior to SOX-Mandated Audits 26 (McCombs Working Paper No. ACC-02-05)(Feb. 28, 2006), available at http://ssrn.com/abstract=694681 (finding that firms that discloseinternal control problems tend to have had a higher incidence of restatements); William R.

Kinney, Jr. & Linda S. McDaniel, Characteristics of Firms Correcting Previously Reported

Quarterly Earnings, 11 J. ACCT. & ECON. 71 (1989) (finding that a restatement indicatesproblems with the internal control system).

Firms that must restate are typically punished by the market. Hemang Desai et al., TheReputational Penalty for Aggressive Accounting: Earnings Restatements and Management

Turnover, 81 ACCT. REV. 83 (2006) (finding that the market imposes a substantial penalty on

those firms that engage in earnings management and have to restate financials); Kinney &McDaniel, supra note 24, at 71 (finding that firm profitability is negatively associated with

restatements).25 See,e.g., Ashbaugh-Skaife et al.,supra note 24, at 26-27.26 See, e.g., Jeffrey T. Doyle et al., Accruals Quality and Internal Control over Financial

Reporting (Jan. 24, 2005) (AAA Financial Accounting and Reporting Section [FARS] Meeting

Paper), available at http://ssrn.com/abstract=789985 [hereinafter Doyle et al., Accruals Quality](finding that firms that disclosed at least one material weakness in internal controls 2002-2005

tended to have lower quality earnings); William Kinney, Research Opportunities in Internal

Control Quality and Quality Assurance, 19 AUDITING: J. OF PRAC. & THEORY 83, 84 (Supp.2000) (noting that internal controls are linked with the quality of earnings).

27 Stephen Bryan & Steven Lilien, Characteristics of Firms with Material Weaknesses in

Internal Control: An Assessment of Section 404 of Sarbanes Oxley24 (April 14, 2005), available

athttp://ssrn.com/abstract=682363;see alsoJeffrey Doyle et al., Determinants of Weaknesses inInternal Control Over Financial Reporting (Sept. 14, 2005), available at

http://srn.com/abstract=770465 (reporting study finding that firms disclosing materialweaknesses after SOX tended to be financially weaker, as well as smaller, younger, more

complex, growing rapidly, or undergoing restructuring).


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but also themselves.28Congresss focus on internal controls was not only consistent with

existing theoretical and empirical academic literature, it also followed in

a tradition of pragmatic legislation. Thirty years ago in the shadow ofthe Watergate affair, Congress was forced to respond to a large scandalinvolving American corporations paying bribes to obtain contracts fromforeign governments. In the Foreign Corrupt Practices Act of 1977(FCPA),29Congress not only enacted anti-bribery provisions,30but alsorequired public companies to install internal accounting controlssufficient to ensure that assets did not walk out the door withoutcompany authorization and to prevent top corporate officers fromenjoying plausible deniability.31 Like SOX 404, the major goals ofthe internal accounting control provisions were to improve the accuracyof financial reporting already required by the SEC and to provideinvestors greater assurances regarding the integrity of firmmanagement.32

In 1978, the Cohen Commission, a blue ribbon group convened bythe American Institute of Certified Public Accountants (AICPA) notedthat [u]sers of financial information have a legitimate interest in thecondition of the controls over the accounting system and managementsresponse to the suggestion of the auditor for correction ofweaknesses.33 Soon thereafter, the Treadway Commission, a privategroup sponsored by five accounting organizations, also recognized theimportance of internal controls and made several recommendations forimproving them. The Treadway Commission originally focused onfraud prevention, but later addressed internal controls as a broader

concept.34

Its Committee on Sponsoring Organizations (COSO)

28 Langevoort, Internal Controls,supra note 7, at 15 (arguing that we should all agree ontwo points: internal accounting and disclosure controls cannot be left to managements business

judgment, and they are costly).29 Pub. L. No. 95-213, 91 Stat. 1494 (1977) (codified as amended at 15 U.S.C. 78dd-1

(2000)).30 Exchange Act 30A, 15 U.S.C. 78dd-2.31 Exchange Act 13(b)(2); 15 U.S.C. 78b(b)(2). For a more detailed history of those

provisions, see Peter Ferola, Internal Controls in the Aftermath of Sarbanes-Oxley: One Size

Doesnt Fit All,48 S.TEX.L.REV.87,89-92(2006).32 See JAMES D.COX ET AL.,SECURITIES REGULATION:CASES AND MATERIALS 57(5th ed.

2006); Renee Jones,Does Federalism Matter? Its Perplexing Role in the Corporate Governance

Debate,41 WAKE FOREST L.REV.879(2006).The FCPA provisions were not revolutionary in that they simply codified (nearly word-for-

word) the then-existing Institute of Internal Auditors Statement on Auditing Procedure No. 54,

which defined accounting control. Melvin A. Eisenberg, Corporate Governance: The Board of

Directors and Internal Control, 19 CARDOZO L. REV. 237, 240-44 (1997) (giving a history of

internal controls development).33 AM. INST. OF CERTIFIED PUB. ACCOUNTANTS, THE COMMISSION ON AUDITORS

RESPONSIBILITIES:REPORT,CONCLUSIONS AND RECOMMENDATIONS xxiii (1978).34 Eisenberg,supra note 32, at 243-44.


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developed a framework to flesh out the concept of good internalcontrols.35

SOX 404 was taken nearly verbatim from another legislative

antecedent, the Federal Deposit Insurance Corporation ImprovementAct of 1991,36which required managers of all covered banks annuallyto evaluate risks and corresponding mitigating controls.37 Altamuro andBeattys recent empirical study found evidence that the provisionaccomplished its purpose by improving the quality of earnings reportingby regulated banks, which the authors concluded was good news forthose who hope SOX 404 internal controls will have a similar effect.38

Delawares Chancellor Allen has also noted the importance ofinternal controls,39ruling in the famous Caremarkcase that a directorsobligation includes a duty to attempt in good faith to assure that acorporate information and reporting system, which the board concludesis adequate, exists . . . .40

The persuasive logic and evidence supporting the importance ofinternal controls is widely recognized abroad.41 The NetherlandsCorporate Governance Code requires in-control statement[s] in whichcompanies have to declare that the internal risk control and auditingsystems are adequate and effective.42 In 1998, Germany putmandatory requirements in place that defined internal controls beyondthe reliability of financial reporting and provided a clear framework for

35 COMMITTEE OF SPONSORING ORGS. OF THE TREADWAY COMMITTEE, AM. INST. OF

CERTIFIED PUB. ACCOUNTANTS, INTERNAL CONTROLS: AN INTEGRATED FRAMEWORK (1992),

available at http://www.coso.org. This report has been a key influence in SOX 404simplementation. Troy A. Paredes, Corporation Decisionmaking: Too Much Pay, Too Much

Deference: Behavioral Corporate Finance, CEOs, and Corporate Governance,32 FLA.ST.U.L.REV.673,753(2005)(noting that COSO reports were the primary sources for early attempts tocomply with SOX 404).

36 12 U.S.C. 1831m(b)-(c) (2000).37 Susan S. Bies,Keynote Address,8 FORDHAM J.CORP.&FIN.L.81,85 (2003). Managers

implementing this provision also looked to COSO for guidance. Id.38 Jennifer Altamuro & Anne Beatty, Do Internal Control Reforms Improve Earnings

Quality? (Sept. 15, 2006), available athttp://ssrn.com/abstract=930690.39 So have prominent legal scholars. See, e.g.,Eisenberg,supra note 32, at 237.40In reCaremark Intl Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996). The decision has

been termed a creative marriage of the business judgment rule, the American Law Institutes

Principles of Corporate Governance, and the Sentencing Guidelines for Organizations,

[extending] the fiduciary duties of corporate directors . . .to matters of organizationalcompliance. WILLIAM S.LAUFER,CORPORATE BODIES AND GUILTY MINDS 36(2006).

41 Indeed, many SOX provisions have been widely adopted around the globe. See generally

Ethiopis Tafara, Statement by SEC Staff: A Race to the Top, International Regulatory Reform

Post Sarbanes-Oxley, http://www.sec.gov/news/speech/2006/spch091106et.htm (Sept. 2006)

(detailing these imitations).42Geert T.M.J. Raaijmakers, The Effectiveness of Rules in Company and Securities Law, 23

n.115 (Maastract Faculty of Law Working Paper, 2006), available at

http://ssrn.com/abstract=932022 (citing II.1.4. of the Netherlands Corporate Governance Code).


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the monitoring and audit of internal control systems.43 Brown et al.recently found empirical evidence that the German provisions achievedthe intended goal of increasing earnings quality.44 In 1999, India

adopted a series of major corporate governance reforms that includedCEO/CFO certification of internal controls. A recent empirical studyfound that those reforms were greeted positively by investors.45 Severalother countries have (a) adopted comply-or-explain approaches tomanagement assessment of internal controls,46 (b) adopted rulesrequiring a management assessment of internal controls,47or (c) enactedcorporate codes that recommend management assessment of internalcontrols.48

Ceteris paribusit is undeniable that a firm is better off with goodinternal financial controls than without them.49 Perhaps the Enron-erascandals would have been minimized had the SEC enforced the FCPAsinternal accounting control provisions more vigorously,50 or hadDelaware courts taken Caremarkmore seriously.51

II. SOXS APPARENT SUCCESSES

That there were reasonable grounds for Congress to believe thatSOX 404 was a sensible approach to bolstering the reliability of thefederal securities disclosure regime does not mean that it is bound tosucceed, but there have been some positive signs. Although advocating

43

Nerissa C. Brown et al., The Effect of Internal Control Regulation on Earnings Quality:Evidence from Germany and Implications for SOX 302 and 404 (Sept. 2007), available at

http://ssrn.com/abstract=945590.44 Id.45 Bernard S. Black & Vikramadita S. Khanna, Can Corporate Governance Reforms Increase

Firms Market Values: Event Study Evidence from India 4 J. EMPIRICAL LEGAL STUD.(forthcoming 2007) (working paper at 18), available at http://ssrn.com/abstract=914440

(conducting events study finding that when India announced a major securities law reform that,

among other things, required CEO/CFO certification of internal controls, the stock price of thelarge firms to which the rules would apply rose by 4.5% relative to small firms to which the

reforms did not apply over a two-day window and 7% over a four-day window).46 SEC Chair Christopher Cox,Hearing of the House Financial Services Committee Subject:

Sarbanes-Oxley at Four: Protecting Investors and Strengthening the Markets, FED.NEWS SERV.,Sept. 19, 2006 (citing the UK, Australia, and Hong Kong); Tafara,supra note 41 (noting a variety

of approaches to requiring establishment and maintenance of internal control systems).47 Tafara,supra note 41 (citing Japan, France, and Canada).48 Id.(citing Mexico).49 Eisenberg,supra note 32, at 244(The need for internal control is currently not a matter of

dispute.). The cost, of course, is the factor that renders all other things not equal.50 See Langevoort, Social Construction, supra note 2, at 30 ([T]he SEC was simply not

diligent about its enforcement.).51 By July 2002, no director had been held liable in Delaware for breaching Caremarkduties.

SeeLAUFER,supra note 40, at 114-15 (noting Caremarks negligible impact).


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for many changes in securities regulation, the recent Interim Report ofthe Committee on Capital Markets Regulation (CCMR) reached theconclusion that [i]nvestors have benefited from the stronger internal

controls, greater transparency, and elevated accountability that haveresulted from this new law.52 In many ways, SOX 404 has producedsignificant benefits.

A. Reviving the Capital Markets

When SOX was passed, the stock markets were nearly in a freefall. From 2000 market peaks, the Dow Jones Industrial Average haddropped 25%, the S&P 500 had declined more than 40%, and NASDAQhad plummeted more than 70%.53 Investor confidence in the capitalmarkets was at record lows, causing average trading volume to drop54%.54 The lack of confidence stemmed not from worries that Congresswould legislate, as conservative pundits have asserted, but from the factthat 84% of the investing public believed that corporate wrongdoingwas widespread rather than isolated.55 Professor Paredes noted at thetime that restoring [investor] confidence might be the most importantthing that the SEC and Congress can do, just as it was the top priorityduring the crisis of confidence following the 1929 stock marketcrash.56

As even critics concede,57 SOX helped restored investor

52 CCMR REPORT,supra note 4, at xiii. After digesting the CCMR Report, the McKinsey

Report and the Chamber of Commerce Report, Secretary of the Treasury Hank Paulsonannounced initiatives that scarcely touched SOX and noted, consistent with SOXs philosophy,

that [a]ccurate and transparent financial reporting is vital to the integrity of our capital marketsand the strength of the US economy. Henry Paulson, The Key Test of Accurate Financial

Reporting is Trust, FIN.TIMES,May 17, 2007, at 11.53 Leon,supra note 8, at 4.54 Hsihui Chang et al., CEOs/CFOs Swearing by the Numbers: Does It Impact Share Price

of the Firm?,81 ACCT.REV.1,2 n.1 (2006) (citing sources).55 Amy K. Choy & Ronald R. King, An Experimental Investigation of Trust and Justice:

Implications for Corporate Governance 3 (Feb. 2006) (unpublished manuscript), available at

http://ssrn.com/abstract=892332 (citing Conference Board report); see also Roberta S. Karmel,

Reconciling Federal and State Interests in Securities Regulation in the United States and Europe,28 BROOK.J.INTL L.495,545(2003) (noting soon after July 2002 that [a] similar [to the early

1930s] crisis of investor confidence exists today due to the bursting of the technology stock

market bubble and the corporate financial scandals of Enron Corp., WorldCom, and othercompanies).

56 Troy A. Paredes, Blinded by the Light: Information Overload and Its Consequences for

Securities Regulation, 81 WASH.U.L.Q.417, 469 (2003).57 K. Alvarado, CFOs Report Lower Compliance Costs,INTERNAL AUDITOR,June 1, 2006, at

15 (reporting results of Financial Executives Internationals survey of CFOs that found 83% of

respondents agreed that Section 404 compliance had increased investor confidence in theircompanies);Internal Control: Companies Start to Feel Less of a Pinch,ACCOUNTANT,Apr. 30,

2006, at 5 (noting that research commissioned by the Big Four showed that most companies


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confidence in the stock market,58 facilitating a rapid and dramaticrecovery.59 This should be no surprise, for studies show that investorsvalue increased transparency about a companys corporate governance,

including the internal audit functions, when making investmentdecisions.60 Indeed, Lord and Benoits post-SOX study showed thatover a two-year period, there was a 27.67% increase in the averageshare prices for companies that had effective internal controls in bothyears, a 25.74% increase in average stock price for companies that hadineffective SOX 404 controls in year one but effective controls in yeartwo, but a 5.75% decrease in average stock prices of companies thatreported ineffective SOX 404 controls in both years.61

believe investor confidence has risen as a result of Section 404); Greg Jonas, Moodys InvestorsServs., The Second Year of Section 404 Reporting on Internal Control1 (May 2006) (unpublished

comment), available at http://ssrn.abstract=959025 (noting that Moodys continue[s] to believe

that reporting on internal control has helped restore investor confidence in financial reporting).58Given record budget deficits, record trade deficits, record gasoline prices, unprecedented

job outsourcing, the impact of Hurricane Katrina, and the burdens of fighting both terrorism and

the Iraq war, American capital markets have performed remarkably well since July 2002. See,e.g., Edward Cone, Compliance: Is Sarbanes-Oxley Working?, CIO INSIGHT, June 12, 2006

(noting that the Dow Jones Industrial Average is up more than 50% above its 2002 lows); Jed

Graham, SEC Mulls Fresh Sarbanes-Oxley Fixes to Ease Small Firms Compliance Costs,INVESTORS BUSINESS DAILY, May 11, 2006, at A01 ([W]ith stock indexes near multiyear or

all-time highs, investors seem to have regained confidence in corporate books.); Andy Serwer,Stop Whining About SarbOx!; Critics Want to Repeal the Law, but Its Been a Boon to the

Market,FORTUNE,Aug. 7, 2006, at 39 (noting that the market value of the Wilshire 5000 index,

a proxy for all public companies in the U.S., increased 54% in the four years after SOX wassigned).

59 Bengt Holmstrom & Steven N. Kaplan, The State of U.S. Corporate Governance: Whats

Right and Whats Wrong? 22 (European Corporate Governance InstituteFinance Working

Paper No. 23/2003) (Sept. 2003), available at http://ssrn.com/abstract=441100 (At this point,SOX has probably helped to restore confidence in the U.S. corporate governance system.); Floyd

Norris,Board Proposes Lighter Auditing of Internal Controls,N.Y. TIMES, Dec. 20, 2006, at C1(noting that the stock market bottomed out at about the time efforts to pass SOX got underwayand has been on a sustained rise ever since); Dan Roberts, Corporate US Begins to Reflect

Sarbanes-Oxley: The Reform Process Has Entered Its Final Stages,FIN.TIMES,Nov. 29, 2004, at7 (If investorspresumably still scarred by past scandalsare indeed a reliable guide to new-

found corporate responsibility, then the [post-Sarbanes-Oxley] improvement is easy to measure:

the S&P 500 is up 50 per cent since its 2002 low.). It is impossible to know the role ofSarbanes-Oxley, but it is clear that the dot-com crash never reached the depths hit in other

collapses, such as in the 1930s or the 1970s. E.S. Browning, Ah, the 1990sFour Years Ago,

the Pundits Peaked Along With Stocks; Where Are They Now?,WALL ST.J.,Feb. 23, 2004, at C1.60 See J. Bonasia,Firms Struggle with Sarbanes-Oxley Rules,INVESTORS BUS.DAILY,Apr.

13, 2005 (referencing a survey finding 60% of financial analysts are willing to pay a 10%

premium for shares of f irms that can demonstrate solid compliance with SOX); Travis P. Holt &Todd DeZoort, The Effects of Internal Audit Report Disclosure on Investor Confidence and

Investment Decisions 19 (Jan. 13, 2007) (unpublished manuscript), available at

http://ssrn.com/abstract=957055 (finding from experiment that investors value information aboutinternal audit reliability); David Nicklaus, Ease Stock Regulation, Just Not Too Much, ST.LOUISPOST-DISPATCH, Dec. 10, 2006, at E1 ([A]cademic studies have shown that even the

controversial Section 404 has its good side: Companies with strong internal controls get a higherstock-market value than those whose controls are deficient.).

61 ROBERT BENOIT,THE LORD AND BENOIT REPORT:DO THE BENEFITS OF 404EXCEED THE


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Corporations now complaining about SOX are also racking uprecord profits that were 88% higher in 2006 than in 2002.62 AlthoughWall Street has been howling about SOX 404, in 2006 and early 2007

the Dow Jones Industrial Average reached heights that were not touchedeven during the unsustainable frenzy of the dot-com boom.63 All majorWall Street investment banks reported record profits in 2006.64 Thus, itis extremely difficult to find any macro evidence to support assertionsthat SOX 404 has been throwing buckets of sand into the gears of themarket economy.65 Rather, consider that in October 2002, the darkdays when the market was most nervous about the quality of financialreporting,66 credit spreads for investment grade companies were 2.5percentage points over Treasury rate, whereas by 2006 that spread hadshrunk to 0.85%. The managing director of Moodys Investors Serviceshas stated that not all of that shrinkage can be attribute[d] to 404, but ifonly 10 percent of that reduction is due to 404, put those numbers inyour calculator and you get a benefit that is absolutely enormous.67

B. Improving Corporate Governance

Studies often correlate improved corporate governance with betterperformance by firms.68 A study of 2,500 international companiesperformed by GovernanceMetrics International concluded that SOX

COST?3 (2006).62 Matthew Goldstein, The Perils of Paulson, THE STREET.COM, Dec. 1, 2006,

http://www.thestreet.com/newsanalysis/businessinsurance/10325296.html?puc=_tscs([C]orporations are spending a record sum on stock buybacks, an indication that business still

has plenty of cash to throw around despite higher regulatory costs. Over the first nine months of[2006], corporations spent $325 billion on share buybacks, up 32% from [2005].); GregMacSweeney, The Audacity,WALL STREET &TECH.,Dec. 1, 2006, at 8 (noting that corporations

are screaming about SOX even though in 2006 corporate profits were setting records).63 Gerard Baker, Markets Applaud as US Economy Walks Tightrope, TIMES (London), Oct.

31, 2006, at 52 (noting that the Dow Jones Industrial Average had recently set a new all-time

high).64 See, e.g., David Wighton, Merrill Has Its Most Successful Year, FIN. TIMES, Jan. 19,

2007, at 18 (noting that Merrill Lynch joined Wall Street rivals by reporting record earnings for

2006).65 Steven Marlin, Gaining Strength from SarboxSarbanes-Oxley Compliance May Be a

Burden, But Its Helping Some Companies Improve Operations at Various Levels, INFORMATION

WEEK,Mar. 21, 2005, at 36 (quoting Sun Microsystems CEO Scott McNealy).66 Helen Shaw, Can SOX 404 Be Measured?, CFO.COM, May 16, 2006,

http://cfo.com/article.cfm/6940147?f=search (quoting Gregory Jonas).67 Id.68 See, e.g.,Prentice & Spence,supra note 10, at 1858-66 (citing numerous studies showing

that companies located in countries with higher corporate governance standards tend to perform

better than companies in countries with worse corporate governance and that, within nations,firms with better corporate governance outperform their peer domestic firms with weaker

corporate governance).


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reforms led to a 10% improvement in the corporate governanceperformance of U.S. companies versus their foreign counterparts.69 Tothis improvement Healy and Roberts attribute much of the U.S. stock

markets rebound from the 20% tumble it took in 2002 precedingSOXs enactment.70 SOX 404s contribution to this improvementcannot be precisely parsed out, but improved formal governancestructures mean little if they do not create more reliable informationupon which managers and investors can act.

C. Improving Liquidity

Jain and colleagues found empirical evidence that SOX improvedthe liquidity of American capital markets both in the short-term and thelong-term, suggesting that these regulatory actions appear to besuccessful in restoring market participants confidence in corporategovernance, financial reports, and audit functions.71 In the fall of2006, one observer noted that the U.S. markets were enjoying recordliquidity and record foreign investment72in part due to a flight to qualitygiven the unprecedented transparency of U.S. public companiesaccounting.73 SOX 404 plays an important role in that increasedtransparency, as the next section indicates.

D. Improving Financial Reporting

Many believe that the SOX 404 is working,74that its accounting

69 Thomas Healey & Robert Steel, Sarbanes-Oxley Has Let Fresh Air Into Boardrooms, FIN.

TIMES (London),July 29, 2005, at 17.70 Id.71 Pankaj K. Jain, Jang-Chul Kim, & Zabihollah Rezaee, The Effect of The Sarbanes-Oxley

Act of 2002 on Market Liquidity 27 (Sept. 2006), 14th Annual Conference on Financial

Economics and Accounting, available at http://ssrn.com/abstract=488142.72 In 2005, U.S. financial stock (equities, bonds, loans and deposits) stood at $51 trillion,

more than twice that of the next largest country (Japan). MCKINSEY REPORT,supra note 3, at 31.73Eleanor MacDonald, Senior Editor, Forbes, Kudlow & Co.(CNBC television broadcoast

Nov. 16, 2006) (Theres record liquidity . . . and its a flight to quality as well into the US stock

markets with Sarbanes-Oxley. You havent seen such a transparent accounting ever in this

country.).74 See Tim Leech, Shock NewsSOX is Working,GLOBAL RISK REGULATOR,Feb. 2005

([T]he real problem for SOX detractors is that it is working. Theres growing, irrefutable

evidence for this, despite SOXs technical flaws and the need for improvement in some areas . . . .Financial disclosures from US listed companies are more reliable. Profit management

gamesmanship has been curtailed. Chief financial officers and chief executives are far more

reluctant to push the limits of generally accepted accounting principles . . . . [A]udited financialstatements for US listed companies are now, on balance, more reliable than those being produced

for companies listed in London and on European exchanges. The financial statements of US


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reforms have been a win,75and that it is a godsend76for investors.The academic research provides important support for theseconclusions.

1. Section 302

Most studies of Section 302 are strongly supportive of the impactof internal control provisions.77 For example, Chang et al. found thatbid-ask spreads decreased after 302 certifications,78 indicating that thecertifications make disclosures more credible and reduce informationasymmetry between owners and managers.79 Overall their evidenceindicated that Section 302 had a positive effect on the market value ofcertifying firms . . . consistent with the notion that certificationimproved investors confidence in corporate disclosures.80

Hammersley and colleagues examined the market price and tradingvolume reactions to Section 302 disclosures of material internal controlweaknesses, determining that on the day of the internal weaknessdisclosure, returns were significantly negative for disclosing firms.81Thus, the Section 302 certifications provided investors with muchmore timely information about the quality of a companys internal

listed companies are now also generally more trustworthy than those of US private companies

and those in the public sector, the not-for-profit sector and for public companies in other countriesthat have not yet adopted a SOX-like regime.).

75 David Henry, Not Everyone Hates SarbOx, BUS. WK., Jan. 29, 2007, available at

http://www.businessweek.com/magazine/content/07_05/b40(1)9053.htm (quoting Donald J.

Peters, a portfolio manager at T. Rowe Price Group);see also Pearson & Mark,supra note 15, at20(concluding that [i]mproved financial reporting is evident from companies adopting stronger

internal controls and producing more reliable financial statements . . . .).76 Henry,supra note 75.77 In an early study, Bhattacharya et al. found that even before SOX was enacted the market

had already separated firms with good earnings transparency from those with bad so that theSECs initial required certification by selected firms in August of 2002 was a non-event, and

[t]he SEC order did not help the markets ability to differentiate further between these two types

of firms. Utpal Bhattacharya et al.,Is CEO Certification of Earnings Numbers Value-Relevant?,J. EMPIRICAL FIN. (forthcoming Sept. 2002) (working paper at 16), available at

http://ssrn.com/abstract=332621. However, most newer studies have reached much more positive

conclusions regarding the impact of Section 302. But see John E. McEnroe, Perceptions of theEffect of Sarbanes-Oxley on Earnings Management Practices, 19 RES. ACCT. REG. (2006),available athttp://ssrn.com/abstract=947359 (abstract) (finding in a survey of CFOs of Fortune

500 firms and audit partners for the thirty three largest audit firms a perception that SOXreduced earnings management in only four of fifteen cases).

78 Hsihui Chang et al.,supranote 54, at 1.79 Id. at 7.80Id.at 3.81 Jacqueline S. Hammersley et al., Market Reactions to the Disclosure of Internal Control

Weaknesses and to the Characteristics of Those Weaknesses Under Section 302 of the Sarbanes

Oxley Act of 2002, 13 REV. ACCT. STUD. (forthcoming Mar. 2008) (working paper at 25),

available at http://ssrn.com/abstract=830848.


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control system than was previously available.82Beneish et al. looked at stock returns and cost of capital effects

following Section 302 disclosures of internal control weaknesses; they

discovered significantly negative abnormal returns as well as positiveabnormal increases in implied cost of capital, indicating that thesedisclosures inform investors about the financial reporting quality ofdisclosing firms.83

Griffin and Lont found that investors responded positively to SECcertification requirements and recognized certification as a statisticallysignificant event.84 Positive response was greater for firms with priorsecurities litigation, indicating that investor confidence increased aftercertification.85

Ashbaugh-Skaife et al. found that investors were using signals ofinternal control weaknesses from Section 302 reports to evaluate riskseven before the first official disclosures of internal controldeficiencies.86 Firms with poor internal controls had less reliablefinancial reporting, which created increased information risk forinvestors, resulting, in turn, in higher costs of capital.87 The authorsconcluded that internal control risk matters to investors and firmsreporting effective internal control or firms that remediate knowninternal control problems benefit from lower costs of equity beyond thatpredicted by other risk factors.88

These and other89 early studies of Section 302 strongly indicate

82 Id.at 26.83 Messod D. Beneish et al.,Internal Control Weaknesses and Information Uncertainty34-35

(May 2007), http://ssrn.com/abstract=896192. The authors results indicate that Section 404disclosures do not provide additional information to investors. Id. at 2-4 (providing

explanations).84 Paul A. Griffin & David H. Lont, Taking the Oath: Investor Response to SEC Certification,

1 J.CONTEMP.ACCT.&ECON. 27 (2005), available athttp://ssrn.com/abstract=477586.85 Id.86Hollis Ashbaugh-Skaife et al., The Effect of SOX Internal Control Deficiencies on Firm

Risk and Cost of Equity 2 (Feb. 28, 2007), http://ssrn.com/abstract=896760 [hereinafter

Ashbaugh-Skaife et al., Cost of Equity].87 Id. at 1.88 Id.at 38.89 Hirtle, on the other hand, looked only at bank holding companies (BHCs) and found that

BHCs subject to the SECs order experienced positive and statistically significant abnormal

returns from certification, which would indicate that the certification provided valuable

information to investors. Beverly Hirtle, Stock Market Reaction to Financial StatementCertification by Bank Holding Company CEOs,38 J. MONEY CREDIT & BANKING 1263, 1264

(2006). Hirtle also found that certification resulted in a lasting decline in uncertainty concerning

these banks future earnings streams, as the variance of analysts earnings forecasts for certifyingBHCs declined significantly in the year following certification.Id.

Vermeer studied whether a voluntary disclosure system for CEO/CFO certification

effectively signals the credibility of their financial reporting and discovered that firms includingCEO/CFO certifications were less likely to practice income-increasing earnings management. He

concluded that his results showing lower earnings management for firms that voluntarily


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that executive certifications provide valuable information to the capitalmarkets in a timely fashion, boost investor confidence in theinformation they are receiving, and thereby enable firms with strong

internal controls to reduce their capital costs significantly.2. Section 404

Executive certification of financial statements is well and good, butlikely to be more meaningful to the markets if the process that producesthe information going into them is monitored by sound internal controlsthat are themselves audited by reliable third parties.90 There issubstantial empirical evidence that many firms, especially smaller ones,did not report their internal control deficiencies until SOX 404 auditsbegan.91 Whereas the Internal Controls Subcommittee of the SECsAdvisory Committee on Smaller Public Companies proposed exemptingsmaller companies from SOX 404 on grounds that other SOXprovisions dealing with improved corporate governance might suffice toenforce proper establishment and evaluation of the firms internalcontrols,92Bedard and colleagues recent empirical study indicated thatwithout independent auditor attestation associated with full applicationof SOX 404, corporate governance quality has little impact on internalcontrol over financial reporting.93 They concluded that SOX 404sbeneficial impact on internal controls supported the SECs plan toeventually require smaller firms to comply with its provisions, [o]urfindings suggest that bothSOX 404 and better corporate governance are

associated with improved quality of financial reporting.94

As with Section 302, most empirical studies of the impact of SOX

disclosed suggested that the mandatory certification of financial reports seems to enhance the

credibility of financial statements. Thomas E. Vermeer,Do CEO/CFO Certifications Provide aSignal of Credible Financial Reporting?, 18 RES.ACCT.REG.163, 173 (2005).

90 J. Efrim Boritz, Maintaining Quality Capital Markets Through Quality Information 28

(Apr. 2006), http://www.cica.ca/download.cfm?ci_id=34209&la_id=1&re_id=0.91 Letter from Lynn E. Turner, Managing Director, Glass, Lewis & Co., LLC, to Jonathan G.

Katz, Secretary, Sec. & Exch. Commn 6 (Apr. 12, 2005), available at

http://www.sec.gov/news/press/4-497/leturner041205.pdf (noting that in the first years of SOXthe vast majority of CEOs and CFOs certified their financial controls as free of material

weaknesses, and only when outside audits commenced did the extent of internal control problems

become known); Lord & Benoit, Bridging the Sarbanes-Oxley Disclosure Control Gap 8-9(2006), available at http://www.section404.org/pdf/Lord_Benoit_Report_1_.pdf [hereinafter

Lord & Benoit, Bridging] (noting that it was only after independent audits of internal controls

became required than many companies began self-reporting deficiencies under Section 302).92 SEC. & EXCH. COMMN, PRELIMINARY REPORT OF THE INTERNAL CONTROLS

SUBCOMMITTEE TO THE ADVISORY COMMITTEE ON SMALLER PUBLIC COMPANIES(2005).93 Jean C. Bedard et al.,Regulatory Intent and Political Reality: Corporate Governance and

Internal Controls in the Post-SOX World4 (Mar. 2007), http://ssrn.com/abstract=954057.94 Id. at 33.


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404 find that the reports provide useful information that aids the capitalmarkets. For example, De Franco et al. found that the market reactednegatively to corporate reports of internal control deficiencies,

indicating that the investors did not previously have the information andthat they deemed it economically significant.95 The authors concludedthat investors used this information in directing their resources, therebyincreasing capital market efficiency, as Congress and the SECintended.96

Doyle and colleagues also studied section 302 and 404 reports,learning, consistent with Sections 302 and 404, that the internal controlenvironment is a fundamental element in the production of high qualityaccruals.97 Such findings indicate that SOXs mandated disclosures oncompany-level material weaknesses are at least in part, appropriatelyidentifying poor quality firmsspecifically, those with poor accrualsquality.98 More specifically, Doyle et al. found that poor internalcontrols in their subject population were positively correlated with threedifferent measures of earnings managementdiscretionary accruals,average accruals quality, and historical restatements.99

Ashbaugh-Skaife and colleagues studied how internal controlsaffected the cost of equity capital,100 finding that firms with internalcontrol deficiencies have higher idiosyncratic risk, higher systemic risk,and higher cost of equity capital. Importantly, when such firms thenimproved their internal controls and received an unqualified SOX 404opinion, the market valued that information and their costs of capitaldecreased by 50 to 150 basis points.101

95

Gus De Franco et al., The Wealth Change and Redistribution Effects of Sarbanes-OxleyInternal Control Disclosures6 (Apr. 2005), http://ssrn.com/abstract=706701.96 Id. The authors also found that small investors benefited more from the disclosure

requirement because prior to SOX, they had lacked access to information beyond financialstatements about the firms. Id.at 5. Additional protection of small investors was an unexpected

benefit of this SOX provision. Id.at 9.97 Jeffrey Doyle et al., Accruals Quality and Internal Control over Financial Reporting, 82

ACCT.REV.1141 (2007) (working paper at 30), available at http://ssrn.com/abstract=789985.98 Id. at 31.99 Id. at 2. This study did find that Section 302 reports were more strongly associated with

earnings management than Section 404 reports, perhaps because auditors were pickier and more

likely to highlight not only the significant internal control problems that management reportedvoluntarily, but also more picayune problems that did not have significant impact on earnings

quality. Id.at 3.100 Ashbaugh-Skaife et al., Cost of Equity,supra note 86.101 Id. at 32-33. In a second study, Ashbaugh-Skaife and colleagues found that firms

displaying internal control problems show more evidence of earnings management than firms

with better internal controls. They also discovered that accrual quality generally improves if afirm remedies its internal control deficiencies and an auditor verifies the remediation, concluding

that their findings were consistent with the notion . . . that strong internal controls provide a

significant long-term benefit in improving the accuracy of financial reporting that leads to higherquality information for firms external stakeholders. Hollis Ashbaugh-Skaife et al., The Effect

of SOX Internal Control Deficiencies and Their Remediation on Accrual Quality 3 (July 23,


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Bedard studied SOX 404 (and 302) to learn whether theirrequirements improved earnings quality, as measured by unexpectedtotal and current accruals, finding that because of SOX 404s formal

internal control assessment process, firms improved their internalcontrols and/or auditors increased their audit effort, forcingmanagement to improve earnings quality by reducing accruals. Bedardconcluded [o]verall,these results are consistent with an increase in thequality of earnings caused by the Sarbanes-Oxley internal controlregulations.102

These empirical studies and many others103 strongly indicate thattogether Sections 302 and 404 are providing investors in U.S. marketswith the most reliable financial statements in history, which benefitsissuers by reducing their capital costs and benefits investors by reducingtheir risk.104 Moreover, as Professor Nelson has reminded critics, whilethe costs of SOX 404 are high and immediate, the benefits are real andlong-term.1052007) (unpublished manuscript), available athttp://ssrn.com/abstract=906474.

102 Jean Bdard, Sarbanes Oxley Internal Control Requirements and Earnings Quality 30

(Aug. 2006) (unpublished manuscript), available at http://ssrn.com/abstract=926271.103 See, e.g., Eli Bartov & Daniel A. Cohen, Mechanisms to Meet/Beat Analyst Earnings

Expectations in the Pre- and Post-Sarbanes-Oxley Eras27 (NYU Law & Economics ResearchPaper Series, Working Paper No. 07-18) (Apr. 25, 2007), available athttp://ssrn.com/abstract=954857 (finding that SOX, although not necessarily sections 302 and

404, reduced earnings management via accounting tricks); Kam C. Chan et al., EarningsManagement and Return-Earnings Association of Firms Reporting Material Internal Control

Weaknesses Under Section 404 of the Sarbanes-Oxley Act22-23 (Sept. 2006) (working paper on

file with author) (noting that prior studies suggest that poor internal control can lead to more

opportunities for earnings management, reporting findings providing mild evidence of this factand additional evidence that earnings management decreased after SOX 404 was implemented,

and concluding that [s]ince the findings of ineffective internal controls by auditors under Section404 may cause firms to improve their internal controls, Section 404 has the potential benefits of

reducing the opportunity of intentional and unintentional accounting errors and improving the

quality of reported earnings.); Chan Li & Qian Wang, SOX 404 Assessments and FinancialReporting Errors 5 (Aug. 2006), available at http://ssrn.com/abstract=926180 (finding that

auditors SOX 404 reports were representationally faithful in that they conveyed the

information that regulators wished them to convey and were useful predictors of futuremisstatements, thereby providing useful and timely information to investors);see alsoPrentice

& Spence,supranote 10, at 1899-1907 (citing several other studies, including a few with contra

findings).104 See Boritz, supra note 90, at 66 (Together, these studies indicate that internal control

assessments are useful to capital market participants because they convey information that can

help them better assess information risk.). Still, while SOX 404 reports often inform investorsregarding significant audit adjustments and related control problems that they would not

otherwise have known about, Moodys Investors Services,supranote 57, at 5, it is disappointing

that a very high percentage of SOX 404 reports follow (rather than precede) financialrestatements or material audit adjustments. Id.

105 Mark W. Nelson, Ameliorating Conflicts of Interest in Auditing: Effects of Recent

Reforms on Auditors and Their Clients 8 (July 11, 2005) (unpublished manuscript), available athttp://ssrn.com/abstract=760884. See also Anindya Ghose, Information Disclosure and

Regulatory Compliance: Economic Issues and Research Directions 5 (July 2006) (unpublished


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E. Improving Fraud Detection and Deterrence

Enron-era shareholders of defrauded companies lost more than$300 billion,106and one investor representative noted that [i]nvestorslost more in Enron alone than [will be spent] for implementing [SOX404] at all public companies.107 In 2005 alone, Fannie Mae spent $800million in consultants, accountants, lawyers, and tech support to cleanup a mess made by poor internal controls that caused it to make $11billion in accounting errors.108 If SOX 404 prevents just a few Enrons,WorldComs, or Fannie Maes by forcing corporate executives to takefinancial reporting seriously,109 by enabling detection of a financialfraud, by incentivizing gatekeepers to tend to their knitting, or byimproving deterrence by making it more likely that fraud will be

detected,110

SOX 404s benefits might easily outweigh its substantialburdens.Securities fraud not only reduces investors confidence and

increases their monitoring costs, it also leads to misallocation ofresources.111 WorldComs financial fraud, for example, caused the

manuscript), available at http://ssrn.com/abstract=921770 (noting that costs of 404 arequantifiable and immediate, whereas benefits are intangible and more difficult to quantify).

106 SeeGLASS,LEWIS &CO., YELLOW CARD:INTERIM TREND ALERT 13 tbl.A2 appended to

Letter from Lynn E. Turner, Managing Dir., Glass, Lewis & Co., to Jonathan G. Katz, Sec., Sec.& Exch. Commn (Apr. 20, 2005), available at http://www.sec.gov/news/press/4-497/leturner041205.pdf.

107 Pamela A. MacLean, SOX Inspires Backlashand Benefits, NATL L.J., 1 (2005)

(quoting Barbara Roper of the Consumer Federation of America).108Richard Beales,Fannie To Spend $800m To Restate Earnings,FIN.TIMES,May 10, 2006,

at 29.109 Many believe that the great increase in financial restatements immediately after SOXs

passage is evidence that SOX induced corporate managers to take financial reporting seriously.

See Terence OHara,Excavations in Accounting; To Monitor Internal Controls, Firms Dig EverDeeper into Their Books,WASH. POST, Jan. 30, 2006, at D1 (quoting Kurt Schacht, managing

director of the Centre for Financial Market Integrity at the CFA Institute, as saying [t]he general

consensus is [the restatements are] an indication of how well Sarbanes-Oxley is actuallyworking).

110 After SOX, actors covered by SOX have improved their fraud detection, but nonetheless

account for only slightly more than 50% of the frauds detected. I.J. Alexander Dyck et al., WhoBlows the Whistle on Corporate Fraud? (Center for Research in Security Prices Working Paper

No. 618) (Feb. 2007), available at http://ssrn.com/abstract=891482.111 Shane A. Johnson et al., Executive Compensation and Corporate Fraud 32 (Apr. 21 2005)

(unpublished manuscript), available at http://www.wlu.ca/documents/10886/tian.pdf; see also

Jere R. Francis, What Do We Know About Audit Quality?, 36 BRIT.ACCT.REV.345,361(2004)

(noting that when a corporate failure like Enron occurs there are enormous social and economicconsequences).

Simple earnings management, which SOX 404 also helps minimize, also distorts capital

markets. See Pengjie Gao & Ronald E. Shrieves, Earnings Management and ExecutiveCompensation: A Case of Overdose of Option and Underdose of Salary? 2 (July 29, 2002)

(unpublished manuscript), available at http://ssrn.com/abstract=302843 (noting that earnings


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company to misprice its products,112make unnecessary investments inbroadband capacity, pay bonuses to executives who had not earnedthem, and pay taxes on income that it did not earn.113 Investors bought

WorldCom stock when the economy would have benefited from theirinvestment dollars going elsewhere.

Worse still, WorldComs competitors, inaccurately believing thatWorldComs strategy was succeeding, followed its lead by over-investing in broadband capacity, which ultimately led to a largeoversupply and to layoffs of thousands of workers.114 Above andbeyond the massive loss to WorldCom shareholders, the fraud caused itscompetitors investors to lose $7.8 billion115 and inflicted losses tosocial welfare of $49 billion, according to one study.116

The adverse economic impact of WorldComs fraudulent activitywas typical for such schemes. Kedia and Philippon found that [i]nequilibrium, [fraud firms] hire and invest too much, distorting theallocation of real resources. In short, it is not sufficient to merelymisreport performance. Poor quality firms also have to mimic higherquality firms in their investment and hiring decisions.117 The authorsconcluded that the publicly traded firms that restated their earnings in2000 and 2001 lost between 250,000 and 600,000 jobs . . . .118 Again,if SOX 404 produces a meaningful improvement in corporate reporting,the benefits in improved allocation of resources could easily outweigh

management distorts information flow and that its impact on stock returns is economically

significant).112

Gil Sadka, The Economic Consequences of Accounting Fraud in Product Markets: Theoryand a Case from the U.S. Telecommunications Industry (WorldCom) 26-27 (June 1, 2006)

(unpublished manuscript), available at http://ssrn.com/abstract=906153 (theorizing and findingthat managers committing financial fraud will make nonoptimal pricing decisions as well).

113 See Merle Erickson et al., How Much Will Firms Pay for Earnings That Do Not Exist?

Evidence of Taxes Paid on Allegedly Fraudulent Earnings, 79 ACCT. REV. 387, 389 (2004)(finding that firms that restated their financials following SEC allegations of accounting fraud

from 1996 to 2002 paid $320 million in income taxes as a result of overstating earnings by

approximately $3.36 billion).114 See Joshua Chaffin & Peter Thal Larsen, Called to Account,FIN.TIMES,Aug. 6, 2003, at

15 (Spurred on by WorldComs apparent success, . . .[some competitors] made foolish

acquisitions [while o]thers wasted billions of dollars building networks to carry a wave of datathat did not arrive.); James Surowiecki, SARBOXED In?, NEW YORKER,Dec. 12, 2005, at 46

(WorldComs deception . . . led to the misallocation of billions of dollars in capital across an

entire industry, and rearranged the lives of tens of thousands of workers.).115 J. Gregory Sidak, The Failure of Good Intentions: The WorldCom Fraud and the Collapse

of American Telecommunications After Deregulation,20 YALE J.ON REG.207,235(2003).116Gil Sadka, The Economic Consequences of Accounting Fraud in Product Markets: Theory

and a Case from the U.S. Telecommunications Industry (WorldCom), 8 AM. L. & ECON. REV.439,463(2006).

117 Simi Kedia & Thomas Philippon, The Economics of Fraudulent Accounting2 (Jan. 2005)(unpublished manuscript), available at http://ssrn.com/abstract=687225.

118 Id. at 4.


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even extensive costs.119In theory, SOX 404 should prevent and detect many misstatements,

some accidental and some fraudulent.120 But how much fraud will be

prevented cannot be known with precision. SOX 404 has beencompared to a metal detector at an airportyou know how much itcosts, but you will never be able to measure how many airplanes itprevents from flying into buildings.

No major domestic corporate scandals have been uncovered sinceSOX was implemented, other than the options back-dating scandal thatoccurred almost exclusively before July 2002. Although SOX criticshad predicted a huge explosion of SOX-driven litigation, once SOX 404was largely implemented, class action securities filings began decliningsubstantially. There were fewer suits in 2005 than in 2004,121and frommid-2005 through 2006, filings dropped 40% below the prevailing 10-year average.122 The filings in 2006 were the lowest in more than adecade,123 and claimed only $198 billion in shareholder losses, ascompared with an annual average over the previous ten years of $683billion.124 Grundfest has suggested that a prime reason there are fewerfraud suits for smaller dollar amounts is that SOX has deterred fraud.125Obviously, class action filing level is only the roughest indicator of thedrop in actual fraud.126 It reflects non-SOX influences as well as the

119 Richard Breeden has noted (colorfully) that [t]he cost of 404 in the aggregate from every

single public company is about one ten-millionth of the cost of executive compensation. I donthear anybody saying we should get rid of executive compensation. Glass, Lewis & Co., Getting

It Wrong the First Time9 (March 2, 2006) (quoting a Reuters report on a Breeden speech).120 See A Price Worth Paying?, supra note 9 (quoting Dennis Nally, chair of PwC, to the

effect that SOX should lead to fewer incidents involving accounting fraud); J. Robert Brown,Jr., Criticizing the Critics: Sarbanes-Oxley and Quack Corporate Governance,90 MARQ.L.REV.

309, 326 n.53 (2006) [hereinafter Brown, Criticizing] (suggesting that although reforminginternal controls will not prevent all fraud, . . . reducing the control of the CEO and CFO overthe finances by empowering the audit committee and accounting firms will prevent some

instances of it); Nelson, supra note 105, at 8 (noting that improvement in internal controlsmandated by SOX 404 should reduce the level of pre-audit misstatement that auditors must

detect and increase the amount of effort auditors expend on auditing. Sound controls and more

auditing should prevent and detect many misstatements).Critic Robert Clark concedes that SOX may deter or allow detection of some frauds but

gives several reasons why its impact may be modest. See Clark,supra note 16, at 29-30.121 CORNERSTONE RESEARCH, SECURITIES CLASS ACTION CASE FILINGS 2006: A YEAR IN

REVIEW 3(2007).122 Id. at 1.123 Id. at 3; see also TODD FOSTER ET AL.,NERA ECON.CONSULTING,RECENT TRENDS IN

SHAREHOLDER CLASS ACTION LITIGATION: FILINGS PLUMMET, SETTLEMENTS SOAR 1 (2007)

(2006 federal [securities fraud class action] filings are at the lowest level since 1996a year that

was itself unusually low because many filings were moved to state courts in an attempt to bypassthe restrictions imposed by the 1995 passage of the [PSLRA].).

124 Joseph A. Grundfest, The Class-Action Market,WALL ST.J.,Feb. 7, 2007, at A15 (noting

that the $198 billion figure excludes claims from the one-time options back-dating cases).125 Id.126This is especially so because the number of SEC enforcement actions rose substantially


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impact of other provisions of SOX (increases in penalties for fraud,improved corporate governance,127 more generous SEC budget, etc.).Nonetheless, it seems unlikely that SOX 404 is unconnected to this

large drop in fraud litigation. A significant reduction in securities fraudcan produce benefits measured in the billions of dollars and dwarf eventhe most extravagant estimates of SOX 404s implementation costs.128

Is there any evidence that SOX 404 is uncovering frauds? As ithappens, yes. SOX 404, coupled with SOX 403, that requiredcompanies to report grants to executives within two business days(substantially narrowing the window for abuse),129 helped limit theopportunity that executives had to backdate stock options.130 Bernile etal. studied the market reaction to backdating and concluded thatshareholders in 100 companies involved in the scandal had lost $100billion to $250 billion in market value.131 Although the executivesprofited just a small percentage of that number, the authors noted that[b]ecause options backdating is so blatantly wrong and corrupt, and thepractice usually involves the companys top executives, the agencycosts of a publicly traded company increases dramatically on any newsof such a scandal.132 Even at the low end of the scale, avoided losses

during the period, although this was likely due in substantial part to an increase in resourcesprovided by SOX. GOVT ACCOUNTABILITY OFFICE, FINANCIAL RESTATEMENTS: UPDATE OFPUBLIC COMPANY TRENDS,MARKET IMPACTS,AND REGULATORY ENFORCEMENT ACTIVITIES 6

(2006). Still, the McKinsey Report attributes the decline, in part, to enactment of SOX.MCKINSEY REPORT,supra note 3, at 74.

127 CORNERSTONE RESEARCH,supra note 121, at 9 ([T]he lower number of filings and

associated market capitalization losses may in part be a result of improvements in corporate

governance following high profile filings such as Enron and WorldCom and the passage of theSarbanes-Oxley Act of 2002.).128 Id. at 1(If market capitalization losses are measured as of the last day of the class period,

typically the day on which the alleged fraud is disclosed (Disclosure Dollar Loss), the lossesdecreased by 44 percent from $93 billion in 2005 to $52 billion in 2006. If market capitalization

losses are instead measured by the largest capitalization decline experienced during the classperiod (Maximum Dollar Loss) then losses decreased by 19 percent from $362 billion in 2005 to

$294 billion in 2006. These dramatic declines are even starker when options backdating claims

are excluded from the sample on the theory that these cases are unlikely to be repeated.).129 See Fleischer,supra note 18, at 7.130 See Jie Cai, Executive Stock Option Exercises: Good Timing or Backdating?1 (Feb. 2007)

(unpublished manuscript), available at http://ssrn.com/abstract=951693 (noting that the pricepattern of stock options that indicates backdating weakened considerably after SOX was passed);

Fleischer,supra note 18, at 25(Sarbanes-Oxley stopped the [backdating] practice by limiting theopportunity to backdate and implementing internal controls on the executive compensation

practice.).131Gennaro Bernile et al., The Effect of the Options Backdating Scandal on the Stock-Price

Performance of 110 Accused Companies11 (Simon School of Business, Working Paper No. FR06-10, 2006) (Dec. 21, 2006), available at http://ssrn.com/abstract=952524.

132 Id. The authors go on to note

[i]ncreased agency costs means that the cost of equity capital will increasesignificantly, as the marketplace discounts the increased riskiness of investing in the

stock of afflicted firms. This would explain why stock prices decline so much even


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of $100 billion would likely pay for all SOX 404 audits for large publiccompanies for a generation.

The tightening up of internal controls also enabled many

companies to detect (or perhaps made it difficult for them to continue toconceal) illicit payments that violate the FCPAs anti-bribery rules.133By improving enforcement of FCPA antibribery provisions, SOX 404should improve the allocation of assets in the global economy, ensuringthat around the world, government contracts are more likely to go to thebest qualified bidder, not the most flagrantly dishonest.134

Finally, HealthSouths CFO resigned in August of 2002 rather thansign the SOX 302 certification. That resignation led directly to theunraveling of HealthSouths multibillion dollar fraud.135

Overall, there is substantial evidence that SOX 404 has helpedrevive U.S. capital markets, reform corporate governance (which carriesa broad range of benefits), and improve market liquidity, financialreporting accuracy, and fraud detection. The costs of implementingSOX 404 are very large in an absolute sense, but much more modestrelative to potential benefits stemming from improved marketefficiency, better asset allocation, and fraud avoidance. Perhaps forthese reasons, a survey of directors recently indicated that 81 percentof senior executives reported SOX 404 compliance as a success and 76percent of senior executives believe SOX 404 compliance has motivatedimproved internal controls.136

III. THE INDICTMENTS AGAINST SOX404

A law that has seemingly obtained its objectives, both short-term(restore investor confidence) and long-term (improve financialtransparency, market liquidity, corporate governance, and fraudprevention) will normally be considered a success, or at least receive the

though future cash flows are not much affected by options backdating. Agency costs

reduce stock prices by causing discount rates to increase, rather than affecting future

cash flows from operations.Id.at 12.

133 See Michael T. Burr, Corporations Caught in Rising Tide of FCPA Enforcement, CORP.

LEGAL TIMES, Nov. 2005, at 22.134 SeeSteven R. Salbu, Bribery in the Global Market: A Critical Analysis of the Foreign

Corrupt Practices Act,54 WASH.&LEE.L.REV.229, 249 (The payment of bribes is wasteful

and inefficient and has been found to be associated with low economic growth . . . .).135 See Steven M. Salky & Adam L. Rosman, SOX on Trial,DEAL,June 6, 2005 (noting that

CFO Weston Smith initially resigned rather than sign the SEC-required certification in August

2002).136 Sarbanes-Oxley at Four: Protecting Investors and Strengthening Markets, Hearing Before

the H. Comm. on Fin. Servs., 109th Cong. 2 (2006) (statement of Rep. Michael Oxley).


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benefit of the doubt in that regard. Yet, SOX 404 has been barragedwith denunciations since its inception. This section focuses upon thetwo primary categories of complaint: (a) the direct cost for companies

that must implement and maintain its provisions, and (b) the indirectimpact upon the competitiveness of U.S. securities markets.

A. Direct Costs of Implementation and Maintenance

Even plentiful benefits flowing from SOX 404 may not outweighits implementation and maintenance costs that have greatly exceededthe SECs original expectations.137 One commonly reported number isthat the cost for implementing SOX in 2004 was $4.36 million for theaverage public company.138 Another study found SOX 404 costsaverage $4 million for large companies139and $1.2 million for smallerfirms.140 Although SOX 404 costs have been undeniably high, thefigures reported in these surveys cannot necessarily be trusted becausethe respondents had every reason to exaggerate SOXs costs.141Certainly some of these expenses would have been incurred even in theabsence of SOX because the Enron-era scandals highlighted widespreadproblems with public companies internal controls that simply had to beaddressed.142 Some corporate managers have admitted that manyinternal control expenditures have been for improvements that firms hadfor years needed and wanted to make. Although SOX finally required

137

The SEC erred badly when it guessed that SOX would cost issuing firms only $91,000, onaverage. Cone, supra note 58. Commissioner Atkins has admitted that the Commission

underestimated by a factor of 20. SeePaul S. Atkins, Commr, Sec. & Exch. Commn, Speech bySEC Commissioner: Remarks Before the Securities Regulation Institute (Jan. 19, 2006), available

athttp://www.sec.gov/news/speech/spch011906psa.htm.138 CCMRREPORT,supranote 4, at ES-5.139 CRA Intl, Inc., Sarbanes-Oxley Section 404 Costs and Implementation Issues: Spring

2006 Survey Update 10 (Apr. 17, 2006), http://www.s-

oxinternalcontrolinfo.com/pdfs/CRA_III.pdf.140 The Trial of Sarbanes-Oxley; Regulating Business, 371ECONOMIST 69(Apr. 22, 2006). A

July 2004 survey of financial executives indicated that smaller firms would spend an extra $3

million to comply with SOX, and that firms with over $5 billion in revenue would spend anaverage of $8 million. Fin. Executives Intl,FEI SpecialSurvey on Sarbanes-Oxley Section 404

Implementation(July 2004), http://www.404institute.com/docs/SOXSurveyJuly.pdf.141 See Kara Scannell & David Reilly, SEC Seems Unwilling to Exempt Little Guys From

Internal Controls; There May Be a Saner Approach,WALL ST.J.,Apr. 6, 2006, at C1 (quoting

Robert Kueppers, deputy chief executive of Deloitte & Touche LLP as saying Weve all seen

cost numbers that are overblown attributed to 404).142 SeeJeremy Grant,Fears Over Cost of Company Inspections,FIN.TIMES (London),Nov. 7,

2006, at 31 (quoting Mark Olson, chair of the PCAOB as noting that there had been a rising

expectation of an enhanced control environment so that [e]ven if there had not been 404 youwould still see more energy and more effort and therefore more cost directed towards enhanced

controls).


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those expenditures, it is unfair to attribute them wholly to SOX 404.143One major component of the reported costs is the increase in

average audit fees, which among Fortune 1000 companies rose by an

average of $2.3 million from 2003 to 2004.144 Publicly traded bankshave claimed an increase in audit fees of seventy five percent.145 Theseare substantial increases, even though, looked at in the aggregate,auditing remains a bargain, less than 1/10 of one percent of aggregateclient sales.146 Furthermore, there are many other causes of thisincrease in audit fees, including: (a) post-SOX, auditors are being morethorough because they are genuinely worried about being heldaccountable for their screw-ups as they might not have been for awhile after passage of the PSLRA in 1995,147(b) SOXs provisions onnon-audit services ended low-balling to attract consulting fees,148 and(c) Arthur Andersens demise reduced competition. Nonetheless, thereis no doubt that SOX requires more auditing and therefore is responsiblefor a substantial part of the large increase in audit fees.149

However, even if one accepts the critics figures, that in 2005public companies spent $6.1 billion to comply with SOX and attributesthem all to SOX 404,150 this figure is only the tiniest fraction of publiccompany revenues.151 Home Depot, which recently paid a failed CEO

143 SeeOHara,supra note 109, at D1 (quoting Kurt Schacht, managing director of the Centrefor Financial Market Integrity at the CFA Institute as saying [w]hat youre seeing in essence is

deferred maintenance, the fixing of internal controls that have been neglected);Mark Trumbull,Fraud Law Spurs Backlash, Then Buy-in, CHRISTIAN SCI.MONITOR, Apr. 7, 2006, at 3 (citing anAMR Research survey in which 75% of executives indicated that their investments in

compliance procedures would support other activities).144

Susan W. Eldridge & Burch T. Kealey, SOX Costs: Auditor Attestation Under Section 404,at 2 (June 13, 2005), available at http://ssrn.com/abstract=743285.145 Stephen V. Falanga, Sarbanes-Oxley Impact on Banks Under Review, METROPOLITAN

CORP.COUNS., Apr. 2006, at 16.146 Francis,supra note 111, at 360.147After the PSLRA, the number of class action lawsuits filed annual against auditors went

from more than a hundred to fewer than ten. There is substantial evidence that audit qualitydeclined and [t]he most plausible inference from this particular evidence is that the decline was

mainly a reaction to a reduction in the liability threat faced by auditors as a result of the SupremeCourts Central Bankdecision . . . and the [PSLRA]. Langevoort, Social Construction, supra

note 2, at 9.148 SeeAndras Marosi & Nadia Massoud, Why Do Firms Go Dark? 6 (2004) (unpublished

manuscript), available at http://ssrn.com/abstract=570421 (noting that SOXs restrictions on

consulting has reduced the potential for cross-subsidization of audit fees); Dale R. Rietberg,

Note,Auditor Changes and Opinion ShoppingA Proposed Solution, 22U.MICH.J.L.REFORM211, 220 (1988) (quoting auditors explaining their motivation for low-balling).

149See, e.g.,Sharad Asthana et al., The Effect of Enron, Andersen, and Sarbanes-Oxley on the

Market for Audit Services 22-23 (June 2004), available athttp://ssrn.com/abstract=560963.150Richard W. Rahn, Destructive Government,WASH.TIMES,June 16, 2005, at A18 (citing

the $6.1 billion figure as total SOX compliance costs for regulated firms in 2005); Richard W.

Rahn,Destructive Government,WASH.TIMES,June 16, 2005, at A18151 See Cone, supra note 58 (noting that $8 million for a firm with at least $5 billion in

revenue is just a drop in the bucket). Still, the price tag for small firms is much higher on a


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$210 million just to leave,152 has complained about the $1 million itmust pay to support the PCAOB each year,153 even though this is but.0000012 of its annual revenue of $81.5 billion. 154 Put another way,

SOXs total costs are but an insignificant percentage of the $7 trillionthe stock market lost between 2000 and 2002, but has regained sinceSOX was enacted. Much of that original decline was caused bycorporate scandals of the type SOX 404 aims to prevent.155 SOX 404costs are but a small percentage of the $70 billion that Enronshareholders lost, the $50 billion that Global Crossing shareholders lost,and the more than $100 billion that WorldCom shareholders lost, all dueto fraud.156 These numbers suggest that if SOX 404 can prevent justone big fraud every decade or so, it can pay for itself.

Additionally, SOX 404 costs have generally come downsubstantially after initial implementation, which is more expensive thanannual maintenance. A 2006 study found a 44% drop for largercompanies and a 30% drop for smaller firms.157 Two important reasonsfor the decline are (a) software improvements making the internalcontrol monitoring process more efficient, and (b) firms becoming alittle more relaxedfor a time firms all overdid it because no CEO orauditor wanted to be the

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