Innovation and Corporate Governance: The Impact of Sarbanes-Oxley

Abstract

This Article shows that innovation is a process that has specific characteristics, that these characteristics give rise to an important corporate governance tradeoff, and that complying with the Sarbanes-Oxley Act (SOX) likely impacts this tradeoff to the detriment of innovation.

Innovation is a process that results in new goods, services, methods of production, and forms of business organization. Innovation can vastly improve the welfare of consumers, investors, firms, and the economy. Decentralization and an emphasis on strategic internal control are governance structures that facilitate innovation. The ultimate purpose of these structures is to induce managers to overcome myopia and undertake the types of long-term, risky, dynamic, and knowledge-intensive activities that result in innovation.

Innovation-facilitating structures and activities may, however, also increase the ability of managers to benefit themselves at the expense of investors. Value-maximizing companies must therefore negotiate the tradeoffs between reducing myopia and preventing managerial opportunism. SOX requires all public companies to increase objective monitoring of managers by outsiders to reduce opportunism. However, a substantial portion of innovative companies likely maximize value by placing a greater emphasis on proximate monitoring by insiders than SOX permits. The law thus upsets the optimal governance balance in such companies and likely undermines their ability to provide the most value to investors and consumers.

Keywords: innovation, corporate governance, Sarbanes-Oxley Act, entrepreneurship, knowledge, internal control, financial reporting, accounting, board of directors, independence, myopia, agency costs, strategic renewal, proximity, objectivity

JEL Classification: D23, G18, G30, G38, K22, L21, L51, M13, M40, M51