Sunday, January 1, 2012

Is the cost of complying with SOX worth it?

When I team-teach a portion of our Business Ethics class in the Rollins MBA program, one of the presentations by a team in the class is on the pros and cons of SOX.   The side that discusses the cons always questions the cost/benefit of compliance with SOX.   After the presentation, I ask the class to determine the percentage of stock traded, as a percentage of the shares outstanding, in a publicly traded company on the New York Stock Exchange in a given week.   I'll suggest a large company and tell them to go to Yahoo or some other site for this information.  They usually find that the number of shares traded in a given week for that company is 2-3% of the outstanding shares in the company.

Then, I ask the class to tell me the market cap for that company based on the quoted price per share at that time and most of the class gets the answer right - the share price times the number of shares outstanding.

Then, I ask them to predict the effect on the price per share if the New York Times or the Wall Street Journal has a headline that the SEC is accusing one of more executives of that company of wrongdoing.  The students are usually at a loss at predicting the price decline that will occur, but some find a few companies where that has happened recently and excitedly announce that the price per share went down 10-30% in one day resulting in a decline in the market cap by several billion dollars.  So, the alleged wrongful (unethical by definition) conduct may have reduced the wealth of the shareholders in that company by several billion dollars.  How could this be?

Because stock prices are set by transactions at the margin (only 2-3% of the outstanding shares per week) in normal trading.  But, when a public relations disaster hits, it would not be unusual for more than 5% of the outstanding shares to be traded in one day driven by institutional sellers.  So, what is the lesson in my Business Ethics class?

Unethical conduct by one or more executives in a publicly held company can result in a reduction in shareholder wealth by hundreds of millions (or billions) of dollars when the wrongdoing may only have benefited the executives by a few million dollars or less.  So, the value of the increased oversight by the board of directors and the audit committee caused by compliance with SOX should by measured by avoiding the reduction in shareholder value if wrongdoing is prevented.  But, how can shareholders know if wrongdoing is prevented?  They can't; but, in my experience, the invisible hand on the executives of the company due to SOX is a form of insurance against wrongdoing and the premium paid is the cost of complying with SOX.  Based on the public relations disasters many companies have faced when wrongdoing is discovered, the premium for reducing the likelihood of wrongdoing by complying with SOX is well worth it.