An Examination Of The Impact Of The Sarbanes-Oxley Act

An electronic copy of this paper is available at: http://ssrn.com/abstract=956020

An Examination of the Impact of the Sarbanes-Oxley Act

on the Attractiveness of US Capital Markets for Foreign Firms*

Peter Hostak

Charlton College of Business

University of Massachusetts at Dartmouth

Emre Karaoglu

Leventhal School of Accounting

University of Southern California

Thomas Lys**

Kellogg School of Management

Northwestern University

Yong (George) Yang

School of Accountancy

The Chinese University of Hong Kong

April 30, 2007

* Financial support from the Research Grants Council of the Hong Kong Special Administration Region, China

(Project No. CUHK4623/06H), Charlton College of Business, and the Accounting Research Center at The Kellogg

School is gratefully acknowledged. We thank Mingyi Hung, Bin Ke, Jim McKeown, Gordon Richardson, Katherine

Schipper, TJ Wong, and workshop participants at The Chinese University of Hong Kong, Northwestern University,

and Pennsylvania State University for valuable comments.

** Corresponding author. (847) 491-2673, tlys@northwestern.edu

An electronic copy of this paper is available at: http://ssrn.com/abstract=956020

1

An Examination of the Impact of the Sarbanes-Oxley Act

on the Attractiveness of US Capital Markets for Foreign Firms

Abstract

We document that the passage of the Sarbanes-Oxley Act (SOX) coincided with an increase in

voluntary delistings of foreign firms traded as American Depository Receipts (ADRs) from US

stock exchanges. We examine the extent to which these delistings were motivated by firms’

costs of complying with SOX or by managers’ or controlling shareholders’ (MCOs) loss of

control rents that resulted from corporate governance mandates of SOX. We show that

compared to foreign firms that maintained their ADRs, foreign firms which voluntarily delisted

have weaker corporate governance, had a less negative stock market reaction when SOX was

passed, and suffered a significant price decline in their home-markets when they announced their

intention to delist. Taken together, our results are consistent with our hypothesis that foreign

firms with weaker corporate governance delisted to avoid complying with the corporate

governance mandates of SOX. In contrast, our evidence is not consistent with the delistings

being motivated by firms’ (as opposed to MCO’s) compliance costs with SOX.

1

An Examination of the Impact of Sarbanes-Oxley Act on the

Attractiveness of US Capital Markets for Foreign Firms

1. Introduction

Congress passed the Sarbanes-Oxley Act of 2002 (SOX) with the main objective of

restoring investors’ confidence (including the accuracy and reliability of corporate disclosures)

in US capital markets following the governance failures occurring in the preceding decade. To

this end, SOX established more stringent standards for internal controls, auditing, disclosure, and

management conduct and accountability. However, while proponents argue that SOX was

necessary,1 the evidence to date suggests that the expected net benefits of SOX are negative

purportedly as a result of large direct and indirect compliance costs (Zhang, 2006 and DeFond,

Hung, Karaoglu, and Zhang, 2006). We use a sample of foreign-domiciled firms (henceforth,

foreign firms) traded in the US as American Depository Receipts (henceforth ADRs) to analyze

the tradeoff between the cost of compliance with SOX and governance benefits of SOX.

Foreign firms can avoid complying with US listing requirements by delisting. However,

the associated costs (e.g., due to the loss of liquidity) are likely to be much smaller than those of

US firms (which must either comply with SOX, go private, or trade on the “pink sheets” see

Engel, Hayes, and Wang (2006) and Leuz, Triantis, and Wang (2006)) because after delisting,

foreign firms are still publicly traded in their home countries (and hence do not incur costs due to

loss of liquidity). As a result, voluntary delisting decisions constitute a lower hurdle for foreign

firms and thus, can more clearly reflect the trade-off between the costs of compliance with SOX

and the benefits of improved governance. Although not perfect (because by delisting, foreign

firms still forgo the benefits of being listed in the US), the delisting decisions by foreign firms

1 See, for example, opening statement of Candice Miller, Chairman, Subcommittee on regulatory affairs, April 5,

2006.

2

provide a more transparent metric by which to study the impact of SOX as the significant costs