The Deterrence Effects of SEC Enforcement and Class Action Litigation

The following post comes to us from Jared Jennings of the Department of Accounting at the University of Washington; Simi Kedia of the Department of Finance & Economics at Rutgers University; and Shivaram Rajgopal, Professor of Accounting at Emory University.

In the paper, The Deterrence Effects of SEC Enforcement and Class Action Litigation, we study whether SEC enforcement actions are associated with significant change in behavior of peer firms towards greater compliance. As complete compliance is not feasible, a rational enforcement policy implies enforcement efforts that maximize deterrence. Maximum deterrence is also explicitly mandated in directives from the US Congress as one of the main objectives of the SEC’s enforcement policy. Private securities class action litigation, though it does not aim to explicitly deter others, also has the potential to generate deterrence as such enforcement is more frequent and imposes higher monetary sanctions than the SEC.

We study accrual based earnings management in peers, operationalized as firms in the same industry, as the targeted firm in the aftermath of SEC enforcement and litigation to ascertain the existence and magnitude of deterrence. The results suggest significant reduction in accruals for peer firms of targets that are subject to SEC enforcement and/or litigation. Such reversal of accruals is not only highly statistically significant but also economically important. On average, every peer firm reduces discretionary accruals to the tune of 14% to 22% of its average ROA. This evidence of significant deterrence is robust to different definition of industry. It is also not isolated to events in a few years. Significant evidence of deterrence is seen in sub-samples and also over the extended time period from 1976 to 2006.

The results also inform target selection criteria that are associated with greater deterrence. We find that proxies for target visibility are associated with incrementally higher deterrence only when targets are subject to both SEC enforcement and litigation. When targets are subject to either SEC enforcement or litigation, proxies for target visibility are not associated with incremental deterrence. In contrast to target characteristics, target industry characteristics have greater incremental impact on deterrence for peer firms. SEC actions in competitive industries and litigation in populated industries are associated with incrementally greater impact on peer firms. Finally, we find that isolated enforcements efforts in an industry do not have any effect on peer firms. Changing behavior of peer firms likely requires sustained and repeated enforcement activity.

Our paper makes several contributions to the extant literature. We are among the first to investigate whether public enforcement via SEC enforcements and private enforcement via class action lawsuits deter aggressive reporting choices at peer firms. Our results do not find support for the recent criticisms that the SEC has been ineffective. A large literature documents problems and issues with class action litigation such as the potential for frivolous lawsuits and the substantial, arguably deadweight costs, they impose on target firms. We are, to our knowledge, the first to find a significant positive role for litigation, i.e., in deterring peer firms from adopting aggressive reporting practices.

The full paper is available for download here.

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