Over the last several decades, financial regulators have increaAdd Newsed governance and reporting requirements for publicly listed firms, frequently with the goal of improving the reliability of financial information available to investors. The implicit assumption in such regulation is that the benefits of improved financial reporting to financial statement users exceed the direct and indirect costs borne by the implementing firms. Former SEC Chair Mary Jo White articulated this trade-off in a 2016 speech at the SEC-Rock Center’s Silicon Valley Initiative: “[P]art of the SEC’s mission is to facilitate capital formation, so it is important that our rules and regulatory actions create an environment that fosters innovation and growth. But entrepreneurs and issuers…should also recognize that protecting investors is at the core of the SEC’s mission.”
We examine the trade-off between fostering innovation and protecting investors in the important context of young life-cycle firms, those whose current strategic priorities require significant capital investments financed through debt or equity issuances and whose operations are not yet profitable. These firms make large investments in R&D, pursue an innovation strategy focused on creating new markets and ideas (“explorative innovation”) and are, accordingly, important for economy-wide growth. We expect that young life-cycle firms are more vulnerable to the potentially negative innovation consequences of implementing financial regulation than are more mature firms, for two reasons. First, young firms focus on explorative innovation, which is best developed in a decentralized, flexible environment that may be encumbered by the top-down governance and control systems required by financial regulation. Second, because young life-cycle firms have limited excess operating cash flows, any direct costs required for implementing financial regulation could be diverted from investments in innovation. We also predict that young life-cycle firms are less likely to improve financial reporting as a result of financial regulation because a significant portion of young life-cycle firms’ value stems from intangible assets that are not recorded or disclosed in financial statements under current accounting rules. Ergo, financial regulation is less likely to improve disclosure for young life-cycle firms.
We use the implementation of the Sarbanes-Oxley Act of 2002 (“SOX”), which among other provisions required an audit of internal controls (Provision 404(b)), as the setting to test our predictions. Using a sample of firm-years from 2001-2007, we find that, in response to mandatory SOX 404(b) implementation young life-cycle firms reduce R&D intensity and file both fewer and less impactful patents than do more mature firms. However, we find no incremental improvement in financial reporting for young life-cycle firms after implementation. Taken together, these results suggest that young life-cycle stage firms suffer more negative innovation consequences without any corresponding financial reporting benefits after implementing financial regulation. We also compare young life-cycle firms required to implement SOX 404(b) with young life-cycle firms exempt from SOX 404(b) requirements and find our inferences are unchanged. This finding suggests that implementing financial regulation likely causes the results, as opposed to macroeconomic trends during the sample period that would have affected all young life-cycle firms similarly.
Though we do not find evidence of improved financial reporting as measured by lower restatement rates and accrual quality, the possibility remains that there are some other benefits of implementing financial regulation for young life-cycle firms. To explore this possibility, we use stock market returns to gauge the market’s assessment of the costs versus benefits of financial regulation for young life-cycle firms. Examining short-window returns around events that increased the likelihood that SOX would become law, we find that young life-cycle firms had incrementally greater negative market returns than more mature peer firms. The negative returns around these events suggests that investors expected SOX to be incrementally costly for young life-cycle firms. To assess whether unanticipated benefits accrued to young life-cycle firms we examine future market-adjusted returns following SOX implementation; we fail to find any evidence of benefits from SOX implementation.
We also explore whether the negative innovation consequences we document are more likely due to disruptions to young life-cycle firms’ innovation process or direct implementation costs. Our results suggest both factors are at play. Specifically, we find that young life-cycle stage firms invest less in R&D and pursue innovation portfolios that are less risky, are more narrowly focused, and apply less generally after SOX implementation and that the reductions in innovation we document persist beyond just the year of implementation, suggesting that young life-cycle firms adjust the nature of the innovations they pursue.
Academic literature has documented that implementing regulation is costlier for small firms than for larger firms (e.g., Albuquerque and Zhu 2019, Engel et al. 2007, Iliev 2010). We confirm that the effect we document is not just a “small firm” effect but is distinct and incremental. This is important because it is often assumed that young firms are small firms and that size-based regulatory exemptions will provide relief for both types of firms. Our research shows, however, that young life-cycle firms can be too large to qualify for size-based regulatory exemptions and, because of their unique strategic direction, reap less benefits and incur greater costs than other firms regardless of their size. Our work highlights young life-cycle stage firms as an important segment of our economy that experience incremental innovation costs to financial regulation and little (or no) benefits. Recognizing that a firm’s strategic direction can influence its response to and consequences from financial regulation is an important consideration for regulators and market participants alike.
This post comes to us from professors Abigail M. Allen and Melissa F. Lewis-Western at Brigham Young University’s Marriott School of Business and Kristen Valentine at the University of Georgia.” It is based on their recent paper, “The Innovation and Reporting Consequences of Financial Regulation for Young Life-Cycle Firms,” available here.