Firm Innovation and Institutional Investment: The Role of the Sarbanes-Oxley Act

Abstract

This paper investigates the effect of the Sarbanes-Oxley Act (SOX) on the relation between institutional ownership (IO) and firm innovation. We find that US firms investing in innovation attract more institutional capital post-SOX. Prior literature identifies two SOX effects on the average US firm that could drive this relation, that is, a decreased level of information asymmetry (direct effect) and the consequent increased market liquidity (indirect effect). Our findings overwhelmingly support the direct effect. In particular, we find that the positive relation between IO and innovation post-SOX is mainly driven by passive and dedicated institutional investors. These investors benefit greatly from a reduction in the firm’s information asymmetry but receive little gain from improvements in market liquidity, given their long-term trading horizon. Our results are robust to different model specifications, including difference-in-differences tests, which alleviate concerns about the impact of confounding effects to our conclusions. Taken together, our findings indicate an important policy effect of SOX, namely, the strengthening of institutional investor support for firm innovation.

Keywords: Institutional investors; Sarbanes-Oxley Act; Firm Innovation; Information Asymmetry.

JEL Classification: G11, G20, G38, O32, O33