The Effect of Enforcement Transparency: Evidence from SEC Comment-Letter Reviews

Miguel Duro is Assistant Professor of Accounting and Control at University of Navarra IESE Business School, Jonas Heese is Assistant Professor of Business Administration at Harvard Business School, and Gaizka Ormazabal is Associate Professor of Accounting and Control at University of Navarra IESE Business School. This post is based on their recent paper.

Regulators increasingly rely on policies to disseminate their oversight actions, with the assertion that the disclosure of regulatory oversight activities can enhance the effect of enforcement by increasing third-party monitoring. However, the validity of this assertion has rarely been tested. In this study, we examine the effect of the public disclosure of the Securities and Exchange Commission (SEC) oversight activities on firms’ financial reporting. Specifically, we exploit a major change in the SEC’s policy regarding comment-letter reviews (henceforth “CLs” or “CL reviews”). Contrary to its prior policy, the SEC announced in 2004 that it would begin to publicly disseminate all CLs. From a research-design perspective, our setting provides three strengths: (1) the change was unexpected, (2) affected all public firms (all public firms are subject to CL reviews at least once every three years), and (3) did not modify the underlying regulation, but simply required the disclosure of CLs.

Prior research provides two arguments in favor of disclosing regulators’ oversight activities. First, disclosure could allow market participants to impose “market discipline” (Goldstein and Sapra 2013). In our setting, the disclosure of CLs could strengthen the effect of the reviews on firms’ financial reporting by facilitating market monitoring. Indeed, anecdotal evidence suggests that corporate executives are deeply concerned with investor perceptions of CLs and change their reporting practices in response to them. Second, the public dissemination of oversight actions could affect the reputation of regulators, and thus increase “supervisory discipline” (Goldstein and Sapra 2013). In our context, the SEC may exert more effort to protect its reputation when CLs become subject to public scrutiny.

Alternatively, disclosure of CLs could weaken the effect of the review process if companies infer the SEC’s oversight priorities from the letters sent to peer firms—thereby allowing firms to violate financial regulation in ways that are less likely to be the focus of CLs.

It is also possible that the CL disclosure is inconsequential. One view is that CLs are ineffective and thus their disclosure is unlikely to have an effect. Another view is that, even if CLs are effective, firms could carefully address all comments regardless of whether CLs are publicly disclosed, because failing to do so could lead to negative repercussions such as more frequent reviews or, in the extreme, a costly enforcement action (OIG 2008a). Ultimately, whether the disclosure of CLs shapes the effect of these reviews is an empirical question.

Our empirical tests are based on a novel dataset of CLs related to 10-Ks from 1998 through 2013. While comment letters issued prior to the policy change were not disseminated to the public, we obtain information on these letters through Freedom of Information Act (FOIA) requests. Thus, our sample consists of CLs that were publicly disclosed (which we refer to as “public reviews”) and CLs that were not publicly disclosed (“private reviews”).

To analyze the effect of CLs, we study firms’ quarterly financial reporting around CL reviews. Specifically, we compare the changes in short-window stock market reactions to earnings announcements (i.e., earnings response coefficients or ERCs) during the 360 days following the start of the review (which we refer to as the “treatment period”) to the ERCs during the 360 days prior to the review (the “control period”). To gauge the effect of the policy change, we compare the effect of public reviews to that of private reviews, i.e., we test difference-in-differences among ERCs of earnings announcements along two dimensions: (i) treatment vs. control periods, and (ii) public vs. private reviews.

The results of these tests are consistent with firms producing more informative financial reports following CL reviews after the 2004 policy change. For public reviews, we observe an increase of approximately 10% in ERCs during the treatment period, but do not find substantive evidence of a significant change in ERCs for private reviews.

Next, we explore the mechanisms underlying our primary results. Consistent with disclosure of CLs increasing market discipline, we find that our results are stronger among firms with higher dedicated institutional ownership or more substantive CLs. The intuition for these partitions is that, because dedicated institutional investors monitor firms’ financial reports more extensively, and more substantive CLs attract the attention of investors, managers exert more effort in addressing the SEC’s concerns. While we observe changes in the characteristics of CLs after the 2004 policy change, our evidence does not allow us to unambiguously conclude that the effect is also driven by supervisory discipline. In particular, we observe that after the policy change, CLs are shorter and address fewer financial reporting topics, but the SEC employs relatively more supervisors than before the change.

To corroborate that the increase in ERCs around public CLs is related to reporting changes and additional disclosures prompted by the reviews, we conduct analogous tests using three characteristics of financial reports related to the informativeness of these reports: restatement likelihood, discretionary accruals, and length of narratives. We find that earnings announcements following public reviews (compared to earnings announcements following private reviews) contain fewer discretionary accruals. The associated filings also exhibit lower restatement likelihood and include longer narratives.

Our study shows that the effect of regulatory oversight can be enhanced by the public disclosure of regulators’ oversight actions in the context of CLs. Further, our findings provide evidence on the complementary interaction between private and public enforcement by showing that the disclosure of oversight actions can strengthen the effect of public enforcement through increased market discipline.

Our findings also have several regulatory implications. First, they suggest that the disclosure of oversight activities may help resource-constrained regulators to improve the effectiveness of their oversight; a finding that is especially timely given the current trend to reduce regulators’ budgets. Second, in the context of SEC CL reviews, our results suggest that, consistent with criticism of the CL process, CLs had a weak effect on firms’ reporting and disclosure practices before their public dissemination. However, CLs appear to be effective once they are publicly disseminated. The implications of our findings extend beyond the U.S., as some non-U.S. jurisdictions are currently contemplating the public dissemination of regulatory reviews of financial reporting. In fact, the European Securities and Markets Authority in its 2017 review on guidelines on enforcement of financial information cites this study to encourage communication of enforcement activities with the market.

The full paper is available for download here.

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