The Debt-Equity Choice When Regulatory Thresholds are Based on Equity Values: Evidence from SOX 404

When larger market values of equity result in being subject to costly regulation, 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 audit 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 just 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 firms altering their financing choices to maintain their exempt status and demonstrate an economic consequence of regulatory regimes that are tiered by equity values.