A Study of Firms Surrounding the Threshold of Sarbanes-Oxley Section 404 Compliance

Abstract

This study examines firms surrounding the Sarbanes-Oxley Section 404 market value compliance threshold. We hypothesize that firms around the compliance threshold will behave opportunistically to reduce their market value to avoid compliance with Section 404. We examine a sample of firms with market float surrounding the compliance threshold in the period 2004-2005 and find evidence to support our hypothesis. We document that firms around the threshold reduce their market value temporarily during threshold measurement quarters, whereas control firms experience increasing market value, while in the following quarters market value is increasing. Dampened stock returns and insider trading function to reduce the float. We consider this opportunistic evidence of regulatory avoidance, confirming small firms’ beliefs regarding the net costs of the regulation. Additionally, we find that the likelihood of avoidance increases with the power of the CEO and decreases with the strength of the monitoring of the CEO, which suggest that avoidance is more likely to happen in firms with poor corporate governance mechanisms.

Keywords: Sarbanes-Oxley Section 404, Regulatory Avoidance, Small Firms

JEL Classification: G34, G38, G32