The Debt-Equity Choice When Securities Regulations are Scaled by Equity Values: Evidence from SOX 404

Abstract

We study the effects of scaling regulatory requirements by equity values on firms’ subsequent financing choices. When larger market values of equity result in being subject to costly regulation, smaller firms have incentives to shift their sources of financing toward debt and away from equity. We use the Sarbanes-Oxley Act of 2002 (SOX) as a setting to provide evidence of such incentives. Smaller firms were granted several reprieves and eventually exempted from the internal control requirements of SOX Section 404, which many consider the most costly and onerous aspect of SOX. Using a difference-in-differences design, we show that relative to control firms, firms below the regulatory threshold have increased propensities to issue debt, decreased propensities to issue equity, and increased leverage levels in the post-SOX period. These results are consistent with smaller firms altering their financing choices and capital structures to maintain their exempt status and demonstrate an unintended consequence of scaled regulatory regimes.