Does the Revolving Door Affect the SEC’s Enforcement Outcomes?

Simi Kedia is a Professor of Finance and Economics at Rutgers Business School.

In the paper, Does the Revolving Door Affect the SEC’s Enforcement Outcomes?, which was recently made publicly available on SSRN, my co-authors (Ed DeHaan of the University of Washington, Kevin Koh of Nanyang Technological University, and Shivaram Rajgopal of Emory University) and I examine whether revolving doors are associated with compromised regulatory oversight by the SEC. In particular, we investigate whether regulatory enforcement against financial reporting fraud is influenced by the future job prospects of prosecuting SEC lawyers. Revolving doors lead to both the SEC hiring officials from firms that they regulate as well as SEC officials leaving to work for firms that are regulated. The revolving door exists because (i) the SEC needs industry specific expertise to regulate its constituents effectively, and (ii) regulated firms value experience and knowledge of complex regulations to minimize their cost of compliance.

However, revolving doors can compromise enforcement outcomes if: (i) prior experience with industry makes SEC personnel unduly sympathetic to industry’s interests; or (ii) the prospect of future employment makes SEC personnel go easier on violations by regulated firms. The media, members ofCongress, academics, former employees of the SEC and investors have all raised questions about the impact of the revolving door on the SEC’s efficacy and independence. Indeed, the current SEC chairwoman, Mary Schapiro (2009, page 28) testified that the SEC must seek to avoid conflicts created by employees “walking out the door and going to a firm and leaving everybody to wonder whether they showed some favor to that firm during their time at the SEC.” A GAO report (2011) contends that even the mere appearance of a conflict of interest could undermine confidence in the enforcement process at the SEC. Despite the inherent importance of the SEC’s revolving door phenomenon, there is surprisingly little systematic evidence on the topic. Our paper attempts to provide such evidence by examining whether SEC lawyers’ future career prospects influence their enforcement efforts while at the SEC.

Crucial to whether revolving doors enhance or compromise regulatory effort is the reason why the regulator is being hired by industry. If the SEC official is being hired for his knowledge of the complex regulatory environment and technical expertise, he will have an incentive to invest in his human capital at the regulatory agency to increase his future prospects in industry, which, in turn, will make him enforce regulations more aggressively (Che 1995). Moreover, as Salant (1995) suggests, SEC personnel might follow aggressive enforcement practices to signal their competence to their prospective employers. We label these arguments as the “human capital hypothesis”. In contrast, if the SEC official is being hired for his ability to lobby and influence decision makers at the agency, he is likely to under-emphasize oreven compromise enforcement outcomes to curry favor with prospective employers (the “rent-seeking hypothesis”).

We discriminate between these hypotheses by investigating whether and how future job opportunities influence SEC lawyers’ regulatory enforcement outcomes. For each lawyer that prosecuted financial reporting fraud on behalf of the SEC, we hand-collect data on whether he left the SEC and, if so, thename of his future employer. The rent-seeking hypothesis implies that lawyers that leave the SEC to work for a private law firm, hereafter referred to as“revolvers,” will be associated with lenient or lax enforcement while at the SEC. In contrast, the human-capital hypothesis implies that revolvers will be associated with aggressive enforcement while at the SEC.

We use four proxies of aggressive enforcement effort. The first is the monetary value of the damages collected by the SEC, as a percentage of the shareholder losses from the misconduct. The second is whether the SEC wins versus settles the case. However, our win versus settle results should be interpreted with caution as 93% of cases are settled and it is unclear whether settling is driven by lax or aggressive enforcement. The third outcome is whether, in addition to prosecuting his own administrative and civil charges, the SEC lawyer refers the case to the Department of Justice (DOJ) for simultaneous criminal proceedings. The fourth outcome is whether the SEC lawyer pursues individual charges against the CEO of the firm, an outcome considered aggressive because (i) naming individual officers antagonizes influential people who might hinder the SEC lawyers’ future employment prospects and (ii) individuals are likely to defend more rigorously than when only the company is named (Eagelsham 2011).

We obtain case docket information for all available SEC civil litigation enforcement actions against financial reporting fraud filed between the years 1990-2007. We then search through Bloomberg Law databases, supplemented with LexisNexis Court Link, to collect data on the names of the SEC lawyers prosecuting each case, the defendant law firms, the parties charged, the monetary damages and the outcome of the case. We rely on the LexisNexis Academic database, the Marindale Company’s database, Freedom of Information Act requests, and general web searches to gather data on the age, education, and the identity of the post-SEC employer of each SEC lawyer identified above. Our final sample includes 336 unique lawyers that worked on 284 SEC enforcementcases over the sample period.

About 58% (or 196) of the 336 lawyers continue to work for the SEC by the end of the sample period. About 11%, or 37 lawyers, leave the SEC to join employers other than law firms, and the remaining 31% of the lawyers quit to join private law firms (referred to as “revolvers”). The revolver lawyers potentially work for law firms that represent clients before the SEC and are hence most likely to face conflicts of interest. However, our initial testsprovide no evidence that the revolver lawyers’ enforcement outcomes differ from those of non-revolver SEC lawyers. Note that some revolver lawyers leave the SEC to join firms that frequently represent clients before the SEC, while other revolvers join lawfirms that specialize in areas other than SEC regulation. The revolver lawyers’ SEC experience, whether it be expertise in SEC regulation or in lobbying decision-makers, should be more relevant for law firms that specialize in SEC matters and actively practice before the SEC (labeled as “SEC specialist firms”). We identify each firm’s level of SEC specialization based on the count of the number of cases the firm defends against the SEC in our sample. Further examination of the data reveals that enforcement outcomes are significantlymore aggressive for revolver lawyers that join SEC specialist firms.

This effect is also economically significant. Revolver lawyers that join SEC specialist law firms that defend twice against the SEC relative to law firms that defend only once, equivalent to a move from the median to the 75th percentile, are associated with an increase of 15.9% in damages, an increase of 4.2% in the likelihood of criminal proceedings, and an increase of 4.4% in the likelihood of naming the CEO as a defendant. However, we find that revolver lawyers joining SEC specialist firms are less likely to win or more likely to settle the case. As mentioned earlier, winning a case is a somewhat ambiguous measure of aggressive enforcement. Overall, the evidence is consistent with the human capital hypothesis.

We next investigate two potential sources of cross-sectional variation in the data. First, the lawyer’s last year of employment at the SEC is likely to be associated with magnified conflicts of interests. If the lawyer has already developed a reputation for tough enforcement, then such a reputation is potentially less likely to be affected by his behavior in the last year. Hence, we would expect the revolver lawyer’s last year at the SEC to be associated with weaker enforcement. We find some support for this conjecture. Second, younger SEC lawyers that are investing actively in their careers are potentially more responsive to external job market pressures relative to mature SEC lawyers with established reputations. We do not find significant evidence that younger revolver lawyers who join SEC specialist firms are associated with tougher enforcement outcomes relative to older lawyers.

Finally, we investigate whether defendant law firms that have hired several SEC lawyers in the past and, hence, boast of large SEC alumni, are able to extract milder enforcement outcomes for the clients they represent against the SEC. We find no evidence of such influence. This result further supports the earlier inference that revolving doors are not associated with lax enforcement outcomes.

The full paper is available for download here.

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