Political Connections and SEC Enforcement

Spoiler alert see our article here – Political Spending Results In Fewer SEC Actions, Lower Penalties [Study]

Maria M. Correia
London Business School

April 14, 2014

Journal of Accounting & Economics (JAE), Forthcoming
Rock Center for Corporate Governance at Stanford University Working Paper No. 61

Abstract:

In this study, I examine whether firms and executives with long-term political connections through contributions and lobbying incur lower costs from the enforcement actions by the Securities and Exchange Commission (SEC). I find that politically connected firms on average are less likely to be involved in SEC enforcement actions and face lower penalties if they are prosecuted by the SEC. Contributions to politicians in a strong position to put pressure on the SEC are more effective than others at reducing the probability of enforcement and penalties imposed by an enforcement action. Moreover, the amounts paid to lobbyists with prior employment links to the SEC, and the amounts spent on lobbying the SEC directly, are more effective than other lobbying expenditures at reducing enforcement costs faced by firms.

The importance of the Securities and Exchange Commission (SEC) is widely recognized by the media, and its enforcement activities are under increased scrutiny following the recent wave of corporate scandals; such as Enron, Global Crossing, Halliburton, Harken, Arthur Andersen, Fannie Mae, Freddie Mac, Providian, and Bernard Madoff Investment Securities, to name just a few. However, the accounting literature has not dedicated much attention to SEC enforcement. In fact, while many studies rely on the SEC’s Accounting and Auditing Enforcement Releases (AAERs) to examine the determinants of accounting fraud, they ignore the choice of enforcement targets by the SEC and the impact of political influence on this choice. One notable exception is Kedia and Rajgopal (2011), who find that, because the SEC is resource constrained, it is more likely to investigate firms located close to its offices and with higher visibility. However, while there are anecdotes consistent with firms using political contributions and lobbying to obtain favors from the SEC, there is no systematic evidence on this issue. To assess the likely extent of such behavior, I examine whether firms with political connections have lower SEC enforcement costs in the form of a lower probability of prosecution and lower penalties conditional on being prosecuted.

Theoretical support for the hypothesis that the SEC might be subject to political influence can be found in the regulation models developed by Stigler (1971), Peltzman (1976), and Grossman and Helpman (1994). These models emphasize an exchange relationship: groups of individuals compete for wealth transfers by offering political support in the form of money or votes to regulators. This exchange often takes place in the context of long-term relationships between firms and politicians (Snyder, 1990). The literature on political control of bureaucracies (Weingast, 1984; Weingast and Moran, 1983; McCubbins et al., 1999) further discusses how congressmen can use budget, oversight and the appointment of commissioners to reward (punish) these agencies for decisions that increase (decrease) their constituencies. Gordon and Hafer (2005) show that an association between political spending and reduced regulatory enforcement may be observed in the absence of political interference if firms use political contributions to signal their willingness to fight agency decisions.

The main contribution of this paper is to study SEC enforcement and how it is affected by political influence. The paper also provides additional evidence on whether firms can influence the enforcement decisions of an independent agency through political expenditures.

To test whether political connections effectively reduce enforcement costs, I examine two different stages of the enforcement process: the decision to begin an enforcement action against a firm or its executives, and the regulatory penalties faced by respondents in the enforcement action. This study suggests that, consistent with earlier studies focusing on the Internal Revenue Service (IRS) (Hunter and Nelson, 1995; Young et al., 2001), the Federal Trade Commission (FTC) (Faith et al., 1982; Weingast and Moran, 1993), the Environmental Protection Agency (EPA) (Mixon Jr., 1995) and the Nuclear Regulatory Commission (NRC) (Gordon and Hafer, 2005), politically connected firms are on average less likely to be involved in an SEC enforcement action and face lower penalties if they are prosecuted by the SEC. In particular, long-term PAC contributions and lobbying expenses are associated with a lower likelihood of enforcement for restatement firms. PAC contributions are also associated with lower penalties conditional on an enforcement action being filed.

Full paper via SSRN