Center For The Study of Financial Regulation

Spring 2011 - Issue NO.5

Do SEC's Enforcement Preferences Affect Corporate Misconduct?

by Simi Kedia, Associate Professor of Finance at Rutgers University.

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In the last year or so, the SEC has been excoriated for its failure to detect several high-profile frauds such as those perpetrated by Bernard Madoff and Sir Allen Stanford. These recent failures come on top of the unprecedented increase in the number of firms that misrepresented financial statements in the last decade. In its defense, the outgoing SEC Commissioner, Linda Thomsen, laments the severe resource constraints faced by the SEC in investigating potential miscreants.1 Surprisingly, there is little understanding as to how the resource limitations and political pressures facing the SEC impact a firm’s decision to commit a violation.

The press is replete with stories about the SEC budgetary constraints. Over the period 1995 to 2009, the SEC budget was a mere 0.004 percent of market capitalization. Though it is difficult to determine the correct level of the SEC budget, it is revealing that between 1991 and 2001, the number of cases opened by the SEC’s Enforcement Division increased by 65 percent while the staff grew by 27 percent. An SEC that is constrained in terms of time, effort and enforcement is likely to initiate investigations that are cheaper to implement. A recent GAO report on the SEC’s enforcement process suggests that SEC officials view travel outside their geographic jurisdiction as a significant cost affecting the efficient allocation of their investigative resources.2 This suggests that a resource-constrained SEC has a preference to investigate firms located closer to its offices. This may be justified not only because it takes less time and travel dollars, but also because the SEC is likely to be more knowledgeable about firms located closer to its offices. The closer interactions between the SEC and the executives of firm that are geographically proximate can inform the SEC about potential misconduct in proximate firms.

Resource constraints and political pressure may also make the SEC more likely to pursue cases that have high media visibility. Extensive media scrutiny helps identify the more egregious cases of misreporting, along with unearthing evidence that will facilitate the SEC’s case. This makes targeting of the visible firm with media attention cost effective. Pursuing these visible cases has the added benefit of allowing the SEC to deal with political allegations that the SEC is lax in prosecuting known cases of corporate misconduct.

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My co-author and I find evidence consistent with these SEC preferences.3 In particular, among all the firms that announce a restatement to their financial statements from January 1997 to June 2002, the SEC is significantly more likely to investigate firms that are geographically proximate to its offices. The SEC also is more likely to investigate firms that attract higher media coverage after their restatement announcement. These distinct preferences of the SEC in its enforcement program suggests that firms that observe these SEC preferences are likely to take them into account before deciding to commit a violation.

Along with resource constraints, the SEC faces the potential challenge that firms may not be aware of the SEC enforcement program. As pointed out by Sah, whereas the gains from crime are clear, the costs of committing a violation are ambiguous.4 This uncertainty stems from the absence of public data that can help the manager accurately determine the probability of getting caught, or the expected punishment if caught. Since the decision to engage in illegitimate activities is a function of both the expected costs and benefits of these activities5, differences in the perceived cost of SEC enforcement will be reflected in differences in the firms’ propensity to commit violations. In particular, firms with greater information about the SEC and therefore with a higher expected cost of SEC enforcement are less likely to commit a GAAP violation.

Managers may differ in their knowledge about the SEC enforcement program due to differences in their exposure and prior experience with the SEC. Managers of firms that are located close to SEC offices are likely to be better informed about the SEC. This is because proximity to the SEC’s office may provide managers access to soft information about current SEC policies that are not explicitly documented. These could encompass the SEC decision criteria to begin an investigation, as well as SEC views on when aggressive reporting turns into fraud. Such information about the SEC’s policing function is inherently sensitive and deliberately ambiguous. Further, firms located closer to the SEC offices, say in New York City rather than in Kansas City, may employ accountants and general counsel who have worked with the SEC before or have better access to SEC personnel.6 In short, firms proximate to the SEC are likely to be better informed about the costs of regulatory oversight and hence less likely to adopt such practices. Firms also could learn about regulatory oversight from their prior experience of dealing with the SEC or by observing SEC investigations of other firms in their neighborhood. In particular, if other firms in the county have been subject to SEC investigations in the past, firms are likely to be better informed about the costs of such regulatory inquiry.

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When I examine firms that restated their financial statements over the 1997 to June 2002 period, I find significant evidence that firms with greater exposure to the SEC are less likely to commit a violation. Specifically, firms located closer to the SEC offices, as well as firms in counties that have experienced more SEC investigations in the past, are less likely to commit a GAAP violation.

Substantial research in the aftermath of the accounting difficulties has emphasized the role of the benefits to the executives, as well as the failure of governance mechanisms in deterring misreporting. What has received less attention is the role of the SEC, the primary regulator, in influencing the decision to misreport. Information differences about the SEC enforcement program, as well as the observed preferences of the SEC, also have a significant effect on the choices of firms. Regulation appears to be most effective when it is local. This suggests that the establishment of local SEC offices, or better and widespread disbursement of SEC’s regulatory program might lower the probability of misreporting in the future.


1. Thomsen, L. 2009. Testimony of Linda Chatman Thomsen before the United States Senate Committee on Banking, Housing and Urban Affairs Concerning Investigations and Examinations by the Securities and Exchange Commission and Issues Raised by the Bernard L. Madoff Investment Securities Matter Tuesday, January 27, 2009.

2. General Accounting Office (GAO). 2007. Securities and Exchange Commission. Additional actions needed to ensure planned improvements address limitations in enforcement division -operations. Report no. 07-830

3. Kedia, S and S. Rajgopal, “Do the SEC’s Enforcement Preferences Affect Corporate Misconduct” forthcoming Journal of Accounting and Economics.

4. Sah, R. 1991. Social osmosis and patterns of crime. Journal of Political Economy 99 (6): 1272-1295.

5. See Becker, G. 1968. Crime and punishment: An economic approach. Journal of Political Economy 76 (2): 169-217.

6. Evidence on the preference of labor to continue working in the same geographic region is provided by Kedia, S. and S. Rajgopal. 2009. Neighborhood matters: The impact of location on broad based stock option plans. Journal of Financial Economics 92(1): 109-127.

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