Trends and Determinants of Market Liquidity in the Pre- and Post-Sarbanes-Oxley Act Periods

Abstract

Investors and market makers rely heavily on the trustworthiness and accuracy of corporate information to provide liquidity and vibrancy to the capital markets. A rash of financial scandals during the turn of the 21st century eroded investor confidence in public financial information. In response, the Sarbanes-Oxley Act of 2002 (SOX) was enacted to reinforce accountability for public companies and rebuild investor confidence in public financial information. We investigate the trends and determinants of market liquidity in the pre-SOX period, particularly when the wave of financial scandals was reported, and in the post-SOX period when the Securities and Exchange Commission issued rules in implementing various provisions of SOX. We detect wider spreads, lower depths, and higher adverse selection component of spreads in the period surrounding the reported financial scandals, indicating that liquidity measures deteriorated as a result of those scandals. We find that liquidity measures improved following the passage of SOX. The observed improvement in market liquidity in the post-SOX period is positively associated with the quality of financial reports, several firm specific variables (e.g., size), market factors (e.g., price, volatility, volume), and microeconomic events (e.g., NYSE Open Book). The improvements in liquidity measures after the passage of SOX were more pronounced for companies that were closer to compliance than those that were far from compliance with their provisions prior to SOX.

Keywords: Sarbanes-Oxley Act, market liquidity, bid-ask spreads, corporate governance, financial reporting

JEL Classification: D82, G10, G12, G18, M41, M45