Pankaj K. Jain

The Sarbanes-Oxley Act of 2002 and Capital-Market Behavior: Early Evidence*

The Sarbanes-Oxley Act of 2002 (“the Act”) was enacted in response to numerous corporate and accounting scandals. It aims to reinforce corporate accountability and professional responsibility in order to restore investor confidence in corporate America. This study examines the capital-market reaction to the Act and finds a positive (negative) abnormal return at the time of several legislative events that increased (decreased) the likelihood of the passage of the Act. We interpret this finding as evidence supporting the notion that the Act is wealth-increasing in the sense that its induced benefits significantly outweigh its imposed compliance costs. We also find that the market reaction is more positive for firms that are more compliant with the provisions of the Act prior to its enactment.

The Sarbanes-Oxley Act of 2002 and Market Liquidity

Investors rely heavily on the trustworthiness and accuracy of corporate information to provide liquidity to the capital markets. We find that the rash of financial scandals caused a severe deterioration in market liquidity in the form of wider spreads, lower depths, and a higher adverse selection component of spreads vis-a-vis their benchmark levels. Regulatory responses including the Sarbanes-Oxley Act of 2002 (SOX) had inconsequential short-term liquidity effects but highly significant and positive long-term liquidity effects. These liquidity improvements are positively associated with the improved quality of financial reports, several firm-specific variables (e.g., size), and market factors (e.g., price, volatility, volume).

The Sarbanes-Oxley Act of 2002 and Security Market Behavior: Early Evidence

The Sarbanes-Oxley Act of 2002 (the Act) was enacted in response to numerous corporate and accounting scandals, and was aimed at reinforcing corporate accountability and professional responsibility in order to restore investor confidence in corporate America. This study examines the market reaction to the Act and finds a positive (negative) abnormal return at the time of several legislative events that increased (decreased) the likelihood of the passage of the Act. We find that the Act was wealth-increasing on average, and that the market reaction is more positive for more compliant firms with effective corporate governance, reliable financial reporting, and credible audit functions prior to its enactment. Investors interpreted the Act as good news and led toward the restoration of investor confidence in public financial information. Overall, our results suggest that the induced benefits of the Act significantly outweigh its imposed compliance costs.

Clean Sweep: Informed Trading Through Intermarket Sweep Orders

An intermarket sweep order (ISO) is a limit order that automatically executes in a designated market center even if another market center is publishing a better quotation. An investor submitting an ISO must satisfy order protection rules by concurrently submitting orders to the markets with better prices. We find that ISOs represent 46% of trades and 41% of volume in our sample. ISO trades have a significantly larger information share despite their small trade size relative to non-ISO trades. Post trade return analysis suggests that informed institutions are the main users of ISO trades.

Investor Recognition, Liquidity, and Exchange Listings in the Reformed Markets

We examine multiple facets of firms decisions to list on the NYSE. Although the average Nasdaq spreads are now comparable to the average NYSE spreads, we find that firms continue to switch from Nasdaq to the NYSE, and that they experience positive cumulative abnormal returns on listing. Using a simultaneous system of equations approach, we establish that enhanced investor recognition mainly explains this phenomenon. A logistic regression suggests that corporate listing choice is consistent with these findings, since eligible unlisted firms already have high volumes and recognition and might not benefit as much as do firms that actually switch.

Short Selling: The Impact of SEC Rule 201 of 2010

Despite its sizeable compliance costs, we are unable to document any clear benefits of SEC Rule 201 in ensuring fair valuations and price stability, promoting higher liquidity and execution quality, or preventing a sudden flash crash or prolonged market crises. Our daily and intraday analysis of data both before and after Rule 201 finds that short sellers are naturally more active before the occurrence of negative returns, not after significant price declines. Our simulation results show that Rule 201 further curtails short selling during normal periods, but is not binding on short sellers during the volatile period of the 2008 financial crisis.

The Predictive Power of Limit Order Book for Future Volatility, Trade Price, and Speed of Trading

We investigate the information content of the limit order book (LOB) on the Tokyo Stock Exchange, the world’s second largest order-driven exchange1. Microstructure parameters, such as the current cost-to-trade 1% of average daily volume and order book slope, consistently and significantly predict future price volatility, trade prices, and speed of trading. The shape of the LOB on the bid side carries more predictive power than that on the ask side. We also document that the average trade size is the driving force in the standard volume-volatility relationship.

Does High-Frequency Trading Increase Systemic Risk?

In 2010, the Tokyo Stock Exchange, the largest stock exchange headquartered outside of the United States, introduced a new trading platform, Arrowhead. This platform reduced latency and increased co-located, high-frequency quoting and trading (HFQ) from zero to 36% of trading volume. During tail events representing extreme market conditions, low-latency correlated HFQ may lead to systemic risks such as flash crashes, which has not been sufficiently addressed in the literature. In this paper, our study provides a framework to assess whether HFQ increases systemic risks and points to the need for incorporating correlations and CoVaR methods in regulating these risks through circuit breakers and other regulations.

Government as the Firm’s Third Financial Stakeholder: Impact on Capital Investment Decisions, Capital Structure, Discount Rates, and Valuation

We extend Myers’ (1974) adjusted present value method and modify Modigliani and Millers (1958, 1963) capital structure propositions by adding government as the firms’ third major financial stakeholder. Government is a major stakeholder because it collects income taxes, is instrumental in establishing the business environment, and provides business infrastructure to corporations. We assume that governments stake is an implicit form of capital and, consequently, any return or benefit derived by the firm from this implicit capital will affect firm value. As a result, tax structure significantly impacts relative stakeholder values, capital investment decisions, and capital formation. Only in the special case when the firm receives explicit benefits and when the return on governments implicit capital is equal to the firms cost of equity capital will corporate taxes not impact firm value and capital investment decisions. Although tax irrelevance and the conservation of value principle may hold true within a domestic economy with a homogenous tax structure, our three-stakeholder model demonstrates that corporate income taxes become relevant for investment decisions in a globally competitive economy with heterogeneous tax structures. Thus, our model addresses the apparent inconsistencies between existing theory, which characterizes corporate taxes as nondistortionary, and empirical findings, which demonstrate that taxes reduce investments, growth, and valuation ratios.

Government as the Firm's Third Financial Stakeholder: Impact on Capital Structure Discount Rates and Valuation

We extend Myers’ Adjusted Present Value method (Myers, 1974) and modify Modigliani and Miller’s capital structure propositions (MM 1958, 1963) by adding government as the third major financial stakeholder. Stockholders, bondholders and government (federal and state) each possess a stake in the firm because of the potential to receive future cash flows. Given MM however, have major effects on relative stakeholder values and appropriate discount rates. Considering the three stakeholder model helps clarify the controversy over appropriate discount rates for each stakeholder’s cash flows, the social discount rate and tax structure. We further extend our models in an intertemporal framework that allows for reinvestment of earnings and firm growth. This extension provides clarification and has significant implications regarding firm valuation, capital investment and capital structure policy. We demonstrate that the corporate tax burden ultimately falls on shareowners and government is the beneficiary, whether the tax incidence is at corporate or individual level. However, corporate taxes may significantly impact domestic corporations’ abilities to compete in a global economy. In an intertemporal framework, shifting the tax burden from corporations to individuals and lowering the overall tax rates may increase government’s tax revenues through corporate growth despite a reduced proportional stake in firms.