Government Preferences and SEC Enforcement by SSRN
Harvard Business School
April 13, 2015
Q2 Letter: Baupost won big in Q2 with PG&E, eBay, Liberty Global
Seth Klarman's Baupost recorded "strong" gains for the second quarter, although precise numbers were not included in the July 23 letter to investors, which was reviewed by ValueWalk. Klarman said that during the first quarter, they were "substantial purchasers of securities," while during the second, they were "significant net sellers" due to the strong rally. Read More
I examine whether political influence by the government as a response to voters’ interest in employment conditions is reflected in the enforcement actions of the Securities and Exchange Commission (SEC). I find that large employers are less likely to be subject to an SEC enforcement action, after controlling for firm size, accounting quality, distance to SEC office, and political contributions, among other factors. Next, I show that large employers are less likely to face an SEC enforcement action in presidential election years if they are headquartered in politically important states. I also find that firms that employ a larger proportion of a congressional district’s total workforce and are located in districts with high unemployment rates are less likely to be subject to an SEC enforcement action if the incumbent congressman serves on a committee that oversees the SEC. These findings suggest that voters’ interests are reflected in SEC enforcement.
Government Preferences And SEC Enforcement – Introduction
The Securities and Exchange Commission’s (SEC) enforcement actions have been subject to increased scrutiny following the SEC’s failure to detect several frauds such as those executed by Bernard Madoff and Sir Allen Stanford (see e.g., Henriques 2009; Waas 2012). A growing literature in accounting examines the reasons for such failure in SEC enforcement by investigating the SEC’s choice of enforcement targets. These studies indicate that the resource constraints of the SEC, as well as political pressure arising from firms’ political connections on the SEC, affect the agency’s choice of enforcement targets (Correia 2014; Kedia and Rajgopal 2011; Yu and Yu 2011).
While these studies recognize that the SEC and its enforcement actions are subject to political influence, they do not consider that such influence by the president and Congress (“government”) may also reflect voters’ interests—independent of firms’ political connections. Yet, economists such as Stigler (1971) and Peltzman (1976) have long emphasized that the government influences regulations and regulatory agencies to reflect both voters’ and special interests in order to maximize political support. In this paper, I investigate whether the government’s influence on the SEC reflects voters’ interests.
One of the main factors that drives voters’ political support are employment conditions, which are shown to systematically affect future electoral outcomes (Hibbs 2006; MacRae 1977). To promote these conditions governments of both parties have long supported large employers through, for instance, bailouts, tax favors or subsidies in order to prevent huge job losses or the destabilization of an entire industry (Adams and Brock 1987a, 1987b, 2004).
The SEC’s enforcement actions can significantly jeopardize the employment conditions as these actions can have devastating consequences for firms and therefore employment. In particular, sanctions directed by the SEC in combination with negative market reactions result in huge reputational and financial costs for the firm, and can ultimately lead to bankruptcy of the convicted firm (Feroz, Park, and Pastena 1991; Karpoff, Lee, and Martin 2008a, 2008b).2 As job losses can be a direct consequence of bankruptcy, SEC enforcement actions not only affect the economic wealth of a firm’s shareholders, but also that of a firm’s employees.
The government has a range of control devices at its disposal to align the SEC’s decisions with government’s goals (Weingast 1984). In particular, Congress sets the SEC’s budget and oversees the agency, while the president appoints SEC commissioners with the advice and consent of the Senate (SEC 2013a; Weingast 1984).3 As the SEC has limited resources, it cannot investigate all firms and consequently has to make choices in its enforcement actions (SEC 2013b). Such choices are influenced by the politically-appointed commissioners as they control the enforcement process. In particular, the commissioners set the SEC’s enforcement priorities, which constrain staff’s initial investigations, and authorize every enforcement action, allowing them to overrule staff’s enforcement recommendations (SEC 2013b, 2014a). In their decisions, commissioners and senior SEC staff might consider the harm to employees that an enforcement action can create. For instance, Robert Khuzami, the former Director of the SEC’s Division of Enforcement, states that the SEC has to ask itself “under what circumstances [it] should indict an entire institution for the misconduct of some number of its employees” as such action may cause harm to innocent employees (Orol 2013).4 In line with Khuzami’s statement, Mary Jo White, the current Chair of the SEC, argues that prosecutors should consider the direct and collateral consequences such as the harm to employees when they make a decision as to whether to indict a company as their decision should be “thoughtful and in the public interest” (SEC 2014c).
See full PDF below.