Tuesday, May 20, 2008

Delisting: A solution to SOX woes...or not.

The current mortgage and overall credit market crisis can be partly attributed to the lack of adequate regulation. Even when regulation is put in place it is not always effective. The increasing number of disclosures related to write offs and losses that once seemingly invincible companies are making today ultimately point towards weak internal controls . The Sarbanes Oxley Act was put into place in order to prevent lapses in the internal control environment of a company that could potentially have an adverse impact on a company’s financial statements. There have been cases of companies exiting the U.S. stock exchanges only to rid themselves of the ‘high SOX compliance cost’. Recently, I talked to a senior employee of a foreign company who happened to mention that his company (of U.K. origin) was contemplating delisting from the stock exchange in the U.S., solely attributing this decision to the high cost of SOX compliance. Christian Leuz, an accounting professor at the University of Chicago’s Graduate School of Business found 484 firms that had delisted from a major U.S. exchange between 1998 and 2004. Out of the total companies that delisted, 370 delisted between 2002 and 2004. According to Leuz, not every delisting can be attributed to SOX, yet most companies have citied high SEC reporting costs as the primary motivator behind the delisting.

Basically, there are two ways in which a foreign company can get listed on any U.S. exchange.
1. They can issue shares by registering with the SEC thereby listing their shares either exclusively or primarily on U.S. exchanges.
2. A foreign company can issue an American Depository Receipt (ADR) backed by shares issued in their home country.

According to Steven Siesser, chairman of the Lowenstein Sandler’s specialty finance group, overseas companies are staying out of the U.S. stock market because of SOX related concerns citing high compliance costs, officer liabilities and burdensome internal control requirements.

However, a deeply contrary view has been presented in a paper by a group of researchers from Northwestern University, The Chinese University of Hong Kong, USC and the University of Massachusetts. Their research indicated that foreign companies that ultimately delisted from the U.S. stock exchanges had weak governance characteristics to begin with. Good governance is measured by the number of independent directors on the board, nature of their shareholding, segregation of voting and ownership rights. They have also concluded through their analysis that foreign companies that delisted from the U.S. stock exchanges ultimately suffered a sharper decline in their share price. Shareholders perceived compliance with SOX as a form of an enhanced investor protection tool. A direct result of delisting was a sharper decline in their share price given the negative perception that the delisting had in the minds of their shareholders. This ultimately lends credence to the theory that if the delisting from U.S. stock exchanges was motivated by cost considerations (i.e. increased SOX compliance) there would have been an expected price increase as a result of the delisting and not the opposite effect.

The authors of this paper were also driven to conclude that the delisting decision was driven to a larger extent by the controlling manager’s or controlling shareholders desire to protect their interests that would not have been possible due to the internal control requirements that SOX stipulated. Their research indicates that U.S. capital markets have not lost their competitiveness due to large SOX compliance costs but possibly due to SOX requirements that take away sole control from ‘corporate insiders’.

Please feel free to send in your comments on this post and thoughts on delisting as a way to get away from SOX.