The Benefits of SOX and the Rise and Fall of Restatements

We use our post today to take the opportunity to return to another common theme of this Blog, the impact (usually positive) of SOX on the financial markets.

Those trying to find a negative impact of SOX have been stymied on numerous fronts.  We have a Dow Jones Average hovering up around 50% since the Enron low (despite the impact of oil prices) and even a tech stock rally going on, with Apple, Google and Research in Motion (makers of BlackBerries) all hitting record highs this year. 

We have a decline in the number of securities class action suits being brought, data confirmed by two different sources, and the continued existence of the cross listing premium, demonstrating that foreign companies listing in the US and meeting the higher corporate governance requirements (including those imposed by SOX) see their share prices rise. 

The most recent addition to the column concerns restatements.  Section 404 essentially required more rigorous internal controls.  Moreover, the provision did not leave the matter entirely to management.  Outside auditors had to review the controls and "attest" to their efficacy.  As one might expect, the implementation of tougher standards in this area resulted in the discovery of problems, something that has led to a dramatic increase in the number of restatements.  They have increased every year since the adoption of SOX. 

But presumably as companies get their internal controls in order, the expectation would be that the number of restatements ought to fall.  In 2006, while they increased again, they actually fell among larger companies, those that had been subject to Section 404 for the longer period.  Restatements for companies with a market capitalization of over $750 million fell by 25%.  So where was the growth?  Entirely among micro cap companies, those companies not yet subject to but preparing for the requirements of Section 404. 

One would expect, however, that ultimately the number of restatements would begin to fall as all classes of companies got their internal controls in order.  In fact, initial data from Glass Lewis, as reported by BNA's Corporate Law Daily (Sept. 25, 2007) suggests that this is the case.  According to the BNA report:

• Glass Lewis observed that so far in 2007, restatements are down across the board, with a total of 999 as of Sept. 12, compared to 1,103 for the same period in 2006. Fewer companies gave notice of a restatement by filing an 8-K report, Glass Lewis observed, with a total of 500 companies filing such reports through Sept. 12. More than half of those companies (271) had market capitalization of $75 million or less.

No doubt the year end data, when it comes out, will likewise reinforce this trend. 

We can't give SOX all of the credit for these developments, but we can observe the relationship.  Financial statements are likely getting more accurate, instances of fraud are falling and investors are flocking to the markets.  These days, for those opposing SOX, its hard to find an opening.