SarbOx, Revisited

Editors’ Note: MarketMinder doesn’t make individual securities recommendations. Those mentioned herein merely represent a broader theme we wish to highlight.

Chatter over regulation is a near-constant in the commentariat. But still, there seems to be an awful lot of chatter about regulatory risk right now. New UK Prime Minister Liz Truss has pledged to review the Bank of England’s mandate and overhaul the financial regulatory system, stirring fear. On our shores, the Securities and Exchange Commission has proposed broadening the definition of a securities dealer in a way that could ensnare entities investing their own money. And who can forget the ongoing global tussle over the definitions of “green” investing? Crypto regulation talk continues to simmer in much of the world. Some people favor these initiatives. Others oppose them, warning of decades-long economic and market consequences. This article isn’t about which sides are right. Rather, a simple point: Regulatory changes that bring big downstream consequences can have strong near-term effects. But it is a mistake to project or think they will have a very long-term market impact. Rather, their second, third and fourth-order side effects typically fade into the backdrop.

To see this, consider a US regulatory overhaul that turned 20 this summer: The Public Company Accounting Reform and Investor Protection Act, better known as the Sarbanes-Oxley Act of 2002. Or SarbOx, for short. Congress conceived it in February 2002 as a response to the accounting scandals at Enron, Tyco International, WorldCom and others, and after a short debate—including waffling back and forth between versions—a more extreme House version passed in overwhelmingly bipartisan fashion that summer, before receiving then-President George W. Bush’s signature at July’s end. Accounting fraud, of course, was already illegal, but lawmakers determined that its seemingly widespread nature rendered the extant rules insufficient—it needed to be illegal-er. So Congress added a bespoke public accounting regulator, cracked down on auditors’ conflicts of interests, made CEOs and CFOs criminally liable for inaccurate reports and ratcheted up public companies’ reporting requirements.

Critics warned the bill would impose steep compliance costs, diverting companies’ cash from investment and growth-oriented endeavors to an internal auditing bureaucracy—and hitting smaller publicly traded firms disproportionately. They also hypothesized that US stock exchanges would become less attractive listing destinations and might slow the Initial Public Offering (IPO) market as a whole. The last 20 years have proven many of these concerns right. The most visible consequence—the one everyone talks about—is the broad decline in the number of publicly traded US companies. In 1998, the Wilshire 5000 Index, which includes all publicly traded US firms, had over 7500 constituents. Now it has about 3500. Some companies upped stakes, relisting abroad through mergers. Others, like Dell Computer, went private. Many failed. And, crucially, the replacement pipeline clogged. According to University of Florida Professor Jay Ritter, who maintains a treasure trove of data, there were 4,472 IPOs from 1990 through 2000. From 2001 through 2021, there were just 2,569—little more than half the previous decade. Or, if you prefer: The annual average dropped from 406.5 in the 1990s to 122.3 in the 21^st century. The median age of an IPO (measured from founding date to IPO date) also jumped by a few years, on average.

It is likely wrong to pin all of this on SarbOx, given it passed in the wake of the dot-com bubble’s implosion. By the end of the 1990s, companies were going public with little more than a website and an idea, then racking up steep losses while burning through cash on hand. That logically created a hangover and made investment banks and companies alike pickier about going to market. But absent SarbOx, there doesn’t appear to be a good reason for all of the infamous “Unicorn” startups with multibillion dollar valuations to have stayed private for so long, delaying the cash-out for early investors and founders and delaying or negating employees with options getting the windfall that attracted them there. Counterfactuals are always unknowable, but there is a strong argument that Airbnb, Uber, the artist formerly known as Facebook and legions of others would have gone public much earlier in their lifecycle in a SarbOx-free world. Yes, Congress eased these rules for smaller firms under 2012’s Jumpstart Our Business Startups (JOBS) Act, but many costs and complications with going public remained. Why would a company shift resources from expansion to compliance and add criminal liability for errant financial reports to its CEO and CFOs’ list of career risks?

The incredibly shrinking IPO market is simply the first-order consequence. It doesn’t take much imagination to see others. The so-called FAANG stocks’ sheer size is one. If SarbOx didn’t exist, would the founders of Instagram and WhatsApp have sold their businesses to Facebook? Or would they have gone public and added some good old-fashioned competition to the marketplace? It is always rather grating when politicians complain about huge monopolies gobbling up the competition, without considering how they and/or their predecessors contributed to the perceived mess.

Those big unicorn valuations are another potential consequence—or, more specifically, the huge booms and busts in private companies’ valuations. The WeWorks of the world that got bid sky-high as hype-fueled VCs jumped in at prices that translated to exponentially high market values, which many companies then used to get bloated. There is this weird trend in Silicon Valley, where I grew up and still live, for startups to have a mentality of, if VCs think my company is worth this much money, then we should be a really big company and live that reputation. In many cases, it leads to these companies having to endure several rounds of layoffs before they go public, if they even survive that long. Some end up selling the assets and intellectual property, helping early investors get some compensation and leaving employees with worthless stock options (and, if they exercised those options, giant tax bills).

This is just a theory—and, again, unprovable—but I have a strong hunch that those huge booms wouldn’t have happened if the companies were able to go public earlier in their lifecycles. Private markets are illiquid and inefficient, which interferes bigtime with price discovery. If the Theranos saga and trial of Elizabeth Holmes taught us anything, it is that deep-pocketed angel investors can fall for hype and make unwise investment decisions. In public markets, that mentality is countered by all those with a different thesis on the company, including sellers and short-sellers, making the share price a much more measured reflection of the company’s value.

So in my view, it seems fair to argue that SarbOx created more losers than winners, made markets less efficient, reduced competition in Silicon Valley and created some pretty big market distortions. In other words, an example of the severe long-term consequences that many warn will ensue from big regulatory changes now. But, crucially, this did not make the stock market a bad place to invest. Rather, markets quickly priced in the damage, then moved on. Then-Rep Oxley introduced the House’s version of the bill on Valentine’s Day in 2002. The Senate and House bills were reconciled that July 24. In the interim, the S&P 500 fell -24.0%, extending the bear market that accompanied the Tech bubble’s collapse.^[i] Stocks would continue falling through early October. But then the market got over it. A new bull market was born, and even with 2007 – 2009’s global financial crisis and the other bear markets we have endured in the intervening 20 years, the S&P 500 has returned 582.3% since Bush signed SarbOx.^[ii] Perhaps investors have paid opportunity costs during this span, in the forms of missed returns on companies that never went public, but those what-ifs and hidden costs faded into the structural backdrop.

None of this is to dismiss regulatory risk as a market driver in the near term. But the key is to be clear-headed enough to determine when markets have priced these risks and not to be afraid to invest once that has happened.