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Investors may lose out if Supreme Court kills SOX, study suggests 

Controversial since its enactment in 2002, the Sarbanes-Oxley Act may soon meet an untimely end if the U.S. Supreme Court rules the Public Company Accounting Oversight Board, established by the bill, to be unconstitutional. But although such an eventuality would be welcome in executive suites or board rooms of many U.S. companies, it could also be bad news for investors, a new study suggests.

The research, in the current issue of the American Accounting Association's Accounting Review, finds that section 403 of the act has brought a significant measure of "timeliness and transparency" to insider stock trades. Not only does the rule "potentially reduce information asymmetry between corporate insiders and investors," the study finds, but "the costs of compliance appear to be lower than the cost of other provisions of SOX, and the benefits are most likely to accrue to small firms, for which insider transactions are most informative."

Comments Francois Brochet of Harvard Business School, who carried out the research, "Given the rule's clear benefits for investors and its low cost and simplicity for companies, it would be a shame to see it killed. Since the constitutional challenge to the SOX has nothing to do with this provision, it would be worthwhile to restore it on its own, should that become necessary."

Section 403 of SOX requires corporate officers, directors, and major shareholders to report changes in their ownership of company stock to the Securities and Exchange Commission within two business days of transactions. Previously, disclosure was required within 10 days of the end of the calendar month in which the trade took place, meaning that it might take as long as 40 days for the transaction to be reported. The new study, drawing on a sample of more than 50,000 filings of insider trades over the 10-year period 1997 through 2006, reveals the average time it took insiders to file purchases and sales with the SEC was 19.35 days pre-SOX and 1.38 days post-SOX.

And this expediting of reporting has made a substantial difference to investors, the study suggests.

When insiders made stock purchases before SOX, the price of company shares rose an average of 0.59% more than market norms over the three-day period consisting of the filing date and two subsequent business days; after SOX the abnormal return over those same three days was 1.89%, more than triple the pre-SOX return. Meanwhile, the three-day trading volume rose from 1.03% above normal before SOX to 12.03% above normal post-SOX.

"Clearly, average investors have been in a much better position to react to insider purchases since SOX's enactment than they were before,"  Brochet says. "Before SOX, much of the positive effect of the purchases had already been dissipated, probably through information leaks, before the transactions even became public knowledge."

When it comes to insider sales, the pattern of volumes and stock-price movements is somewhat more complex than it is for purchases.

The three-day volume, as expected, is substantially greater post-SOX, rising from a pre-SOX mean that is no greater than the market norm to a mean that is 1.7% above the norm. But the three-day decline in share price is actually slightly more modest after SOX (-0.11%) than it was before SOX (-0.28%). In fact, when stock prices are monitored from the date of insider sales to as much as 10 days after the filing date, the returns were much less negative post-SOX than they were pre-SOX -- about -0.4% post-SOX compared to about -2.4% formerly.

Why should this be? Brochet offers several reasons, each reflecting credit on section 403.

One reason is that abnormal stock-price movements following insider sales are inversely related to the amount of time between the actual sales and their filing with the SEC: the longer the time, the more negative the returns. Brochet comments in explanation: "The more time passes between transactions and filings, the more likely it becomes, as word leaks out, that investors will think bad news is being kept under wraps. By considerably shortening this period of uncertainty, section 403 greatly reduced this effect."

Another reason for smaller post-SOX price declines following insider sales, Brochet concludes, is that SOX made managers more wary than they previously were of opportunistic sales, such as those prompted by bad earning numbers or other negative news. In other words, there has likely been less insider selling in advance of bad news post-SOX than there was beforehand.

Brochet buttresses this conclusion through an analysis of firms' litigation risks, as determined by a range of factors including market value of equity, daily stock turnover, and stock volatility. In companies with a low risk of litigation, Brochet finds, insider sales produced three-day price declines post-SOX that were on average about 0.5% greater than was previously the case, reflecting the more rapid dissemination of news post-SOX. But in firms with a high risk of litigation, the three-day returns were about the same before and after the bill's passage, which suggests that insiders in such firms tended to be particularly wary of opportunistic sales post-SOX.

Asked to elaborate, Brochet adds: "By making opportunistic sales clear to the average investor much more quickly than was previously the case, provision 403 probably helped bring about a reduction of the kind of insider sales most likely to occasion sharp stock-price drops. This development, most pronounced in companies with a high litigation risk, has tended to dilute the overall negative effects that insider sales have on market returns."

Asked for an illustration of how expedited reporting of insider trades can be of benefit to investors, Brochet cites the case of Jeffrey Skilling, former CEO of Enron, who made nine sales totaling 168,668 shares of the company between November 1 and November 29, 2000. Over the course of these trades, the report of which was received by the SEC on December 8, the stock fell from $83.24 on November 1 to $74.19 on November 29, meaning that an investor who bought the stock on November 1 for about $83 would probably not have known about the CEO's heavy selling until the stock had dropped about 11%.

"Post-SOX, that investor would have known within two days, during which the stock hardly fell at all, that the CEO had sold more than 72,000 shares on November 1," Brochet says. "That certainly seems a considerable improvement, particularly given the subsequent fate of the company, over being in the dark for more than five weeks."

The study, entitled "Information Content of Insider Trades before and after the Sarbanes-Oxley Act," is in the March/April issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include Accounting Horizons, Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation Association, and The Journal of Management Accounting Research.

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