Regulatory Monitoring Under the Sarbanes-Oxley Act

Abstract

This paper examines the economic relevance of the factors set forth under Section 408 of the Sarbanes-Oxley Act to guide the enhanced regulatory scrutiny of public company financial disclosures, as required under the Act. We interpret two of the factors, volatility and firm size, as predictors of a public company's relative risk of non-compliance or the prospective loss to investors, conditional upon non-compliance. We use disclosures of material weaknesses in internal controls under Section 404 as indicators of the potential for non-compliance. Our evidence is that the Section 408 factors that we associate with a relatively high risk of non-compliance - high stock-price volatility, and whether a company is emerging with a disparate PE ratio - are good predictors of reported material weaknesses in internal controls. In addition, while Section 408 calls for enhanced review of large firms - those with high market capitalization and a material affect on the economy - we find that relatively few large firms have disclosed material weaknesses in internal controls. The large firms that have disclosed material weaknesses, however, comprise 92% of the market capitalization of all companies disclosing a material weakness. In contrast with the focus of the public debate on the compliance problems of smaller public companies, our evidence points to high volatility as a stronger predictor of compliance problems under the Act than small firm size. Finally, we discuss alternate explanations for our findings and the potential for unintended consequences for shareholders.

Keywords: Sarbanes-Oxley, internal controls, volatility, regulation, monitoring

JEL Classification: G14, G18, G38, M41, M49, L51, G34