On the Importance of Internal Control Systems in the Capital Allocation Decision: Evidence from SOX

Abstract

I examine the effect of information frictions across corporate hierarchies on internal capital allocation decisions using the Sarbanes-Oxley Act (SOX) as a quasi-natural experiment. I find that after SOX, the capital allocation decision in conglomerates is more sensitive to the performance reported by their business segments. The effects are most pronounced in conglomerates that are prone to information problems and agency conflicts within the organization. In addition, conglomerates’ productivity and market value relative to stand-alone firms increase after SOX. These results support the argument that inefficiencies in the capital allocation process are partly due to information frictions across corporate hierarchies.

Keywords: Internal Capital Allocation, Internal Capital Markets, Internal Control Systems, Asymmetric Information, Agency Conflicts, Sarbanes-Oxley Act

JEL Classification: D22, D82, G30, G31, G34, G38