Is Investor Protection the Top Priority of SEC Enforcement?

A paper I recently posted on SSRN, “Is Investor Protection the Top Priority of SEC Enforcement? Evidence from Actions Against Broker-Dealers,” provides the first empirical account of SEC enforcement efforts against the firms at the center of the current market turmoil: investment banks and brokerage houses. It suggests that the SEC favors defendants associated with big (listed) firms compared to defendants associated with smaller firms. Moreover, the paper finds tentative support for the hypothesis that SEC officials favor prospective employers.

The paper uses a new dataset of all SEC actions against broker-dealers in 1998, 2005, 2006, and the first four months of 2007. It presents systematic data on the types of violations the SEC pursues, the typical sanctions it imposes, and the enforcement venues (courts and administrative proceedings) and settlement patterns in its actions. More importantly, the paper investigates whether the SEC treats large and well-known investment houses more favorably than small broker-dealers. Because the SEC may choose to pursue a broker-dealer by either filing a civil lawsuit or by initiating administrative proceedings before an administrative law judge, the paper first explores the factors that determine the agency’s choice of venue. Courts are a worse forum for finance professionals, since, conditional on a finding of violation, a court is more likely than an administrative law judge to ban defendants from the securities industry. The paper finds that, for the same violation and comparable levels of harm to investors (proxied by disgorgement awards), big firms and their employees are more likely to avoid courts and face administrative proceedings instead.

The paper then turns to administrative cases, which the SEC controls more directly than court cases. Again, the paper finds that, for the same violation and comparable levels of harm to investors, big firms and their employees are less likely to receive a ban from the securities industry, compared to small firms and their employees. Some theories could justify the differential treatment of large and small firms, on the basis of systemic risk considerations or concerns about unduly penalizing entire firms because of limited violations. However, no public policy justification exists for the preferential treatment of individual employees in large firms.

Despite controls concerning violation types and levels of harm, it is possible that big firms’ conduct is systematically less reproachable than small firms’ conduct, because of better compliance systems, higher quality personnel and sophisticated clients. To address these concerns, the paper presents qualitative evidence on a subset of cases where these concerns would be greatest: cases involving a failure to supervise subordinates. It finds that small- and big-firm violations are so similar in terms of fact-patterns, types of supervisory failures, and specific omissions, that they are virtually indistinguishable from a law enforcement perspective.

Finally, the paper tentatively links the above results with concerns about the post-SEC career trajectories of agency officials, who find employment in big firms’ compliance departments or in premier law firms. The paper shows that big firms headquartered in favorable locations receive lower sanctions than big firms around the country, indicating that SEC officials may respond to future employment prospects. The paper also provides some evidence that variation in the quality of legal representation between big and small firms cannot account for the observed differences in sanctions, because these differences persist even for cases where both big and small firms are likely to hire outside counsel.

The paper is available here.