SEC Enforcement

In the paper, SEC Enforcement: Does Forthright Disclosure and Cooperation Really Matter? forthcoming in the Journal of Accounting and Economics as published by Elsevier, I investigate SEC enforcement leniency by exploring whether the SEC rewards firm cooperation and forthright disclosures following a restatement. I develop models that explain SEC sanctions and SEC monetary penalties, and then assess the incremental impact of cooperation and forthright disclosures. I consider a firm to have cooperated with the SEC if it voluntarily initiates an independent investigation into its misconduct. Forensic accountants, legal counsel, or independent committees of directors usually perform the investigations and the firm subsequently passes the information on to the SEC.

I follow the SEC’s 2001 Seaboard Report in defining forthright disclosures as those that are timely, complete, and effective. Timeliness captures the speed with which managers release information to market participants, and it is defined as the number of days between the end of the violation period and the first public announcement of the misconduct. I define complete and effective disclosures in two ways, with both capturing the visibility of misconduct-related disclosures to investors and the SEC. The first identifies where information about the misconduct is placed within a press release. I consider information disclosed in the headline of a press release (rather than the text or footnotes) to be the most effective form of disclosure, as it increases the likelihood that investors and SEC staff will notice and react to the information (Files et al. 2009; Gordon et al. 2009). The second identifies the type of SEC filing used to report the misconduct, with disclosure in a Form 8-K or an amended periodic filing considered the most effective.

I find that company-initiated investigations significantly increase the likelihood of an SEC enforcement action, but decrease firm-level penalties associated with a sanction. This finding suggests that firms are rewarded for cooperative behavior, although the reward is manifested through lower penalties rather than a reduction in sanctions. Managers, auditors, and lawyers may find this result informative as they evaluate the pros and cons of initiating an internal investigation.

Regarding forthright disclosures, I find somewhat mixed results. Headline disclosure of a restatement increases the likelihood of an SEC sanction, suggesting that SEC staff is influenced by the visibility of press release disclosures when choosing its enforcement targets. However, I find some evidence that individuals pay significantly smaller fines when the restatement is disclosed in a Form 8-K or amended filing. Placing restatement information in a Form 8-K or amended filing also significantly reduces the likelihood of an SEC sanction, but only in the post-2001 period. Consistent with the Seaboard Report, timely disclosure of a restatement reduces the likelihood of being sanctioned and results in lower individual and firm penalties.

This is the first study to explore the SEC’s criteria for leniency following a law violation. Prior research examining SEC enforcement actions or AAERs fail to recognize that the SEC has a choice in whether to sanction a firm. I attempt to fill this void by examining some of the criteria used by the SEC when making its choice. This is important given the significant cost of an SEC sanction to firms, managers, auditors, and investors. My results also extend prior research (Bowen et al. 2005; Files et al. 2009; Gordon et al. 2009; Myers et al. 2010) by providing the first evidence on how press release prominence and the type of SEC filing used to disclose a restatement affect the SEC’s decision to issue an enforcement action. Finally, I provide additional evidence on the benefits of timely disclosure – namely, the increased potential for SEC leniency.

Although the focus of this study is on SEC enforcement following an earnings restatement, future research might examine the impact cooperation and forthright disclosures have on the SEC following other (non-restatement-related) law violations. Additionally, the SEC has recently renewed its commitment to rewarding cooperation and to providing sufficient information to the public about the nature and extent of cooperation (SEC 2010). Future research might explore whether reputational penalties following a law violation are mitigated if individuals and/or companies are known to have cooperated with regulators.

The full paper is available for download here.