Is the SEC blind?

by Stuart Wallace December 4 2010, 18:07

 

How does the SEC determine where to deploy its resources? What criteria does the SEC use to decide which companies to monitor and which to ignore?

Answers to these questions and more were recently presented to the Illinois Corporate Colloquium by Cindy Alexander, an economist at the SEC. In her working paper, “Regulating Monitoring Under the Sarbanes-Oxley Act”, Ms. Alexander and her coauthor Kathleen Hanley examine the usefulness of two factors used by the SEC in determining which companies to monitor: firm size and stock price volatility. Their findings suggest the answer to my title question is, decidedly, no.

Section 408 of the Sarbanes-Oxley Act of 2002 identifies company size and stock price volatility as two factors, among others, that the SEC should use as indicators of potential problems with a company’s financial reporting. Section 404 of Sarbanes-Oxley requires companies to publicly disclose “material weaknesses” in their internal controls over financial reporting. Disclosures of “material weaknesses” are used as indicators of the (low) quality of financial reporting and the risk of non-compliance with Sarbanes-Oxley. Indeed, the market does respond negatively to the disclosure of “material weaknesses” in internal controls. (p. 9) The authors correlate the disclosure of “material weaknesses” with firm size and stock price volatility to “test the practical usefulness of the Section 408 factors as indicators of company-specific risk and potential harm to investors from false financial reporting.” (p. 2) In doing so, Alexander and Hanley come up with some interesting results.

First, a company’s size is not a good predictor that the company will disclose a “material weakness” in its internal controls over financial reporting. Large companies are actually half as likely to disclose a “material weakness” than small companies. (p. 14) But company size is a good indicator of the potential harm to investors from false financial reporting. The average market capitalization of large firms disclosing “material weaknesses” is 11 times greater than that of small firms disclosing “material weaknesses.” (p. 3) Thus, large companies are less likely to make false financial reports than small companies, but hurt investors more when they do.

Second, the volatility of a company’s stock price is a good predictor that the company will disclose “material weaknesses” in its internal controls. While smaller companies tend to have more volatile stock prices, the authors find that volatility is a good predictor of “material weaknesses” even when controlling for company size. (p. 17) Thus, large, low-volatility companies are least likely to disclose “material weaknesses” while small, high-volatility companies most often make such disclosures.

These results suggest that the SEC is looking in the right places for potential harms to investors, at companies representing the most likely risk of harm and those representing the biggest potential harm. However, “the failure of the SEC to catch some of the most egregious wrongdoing that surfaced after the financial crisis of 2007 and 2008”,   Edward Wyatt, “For Whistle-Blowers, Expanded Incentives” has served as the impetus for new approaches to protecting investors, including a proposed financial whistle-blower program. This program would reward whistle-blowers whose information leads the SEC to obtain a sanction of more than $1 million. Opponents of the program like former SEC chairman Harvey L. Pitt claim it “contains the seeds for undermining corporate governance and internal compliance systems” implemented in response to Sarbanes-Oxley.  So, the SEC can’t uncover the most “egregious wrongdoing” and it undermines its own regulations with conflicting policies?

Section 408 of the Sarbanes-Oxley Act directs the SEC to monitor both the companies most likely to have problems with their financial reporting and companies representing the biggest potential risk to investors. The financial whistle-blower program does not undermine SEC monitoring or the corporate compliance programs initiated in response to monitoring because it offers potentially higher rewards to employees who “go first to their corporate compliance departments.”  Thus, the whistle-blower program simply recognizes that the SEC has limited resources and can’t monitor every company. So, who should the SEC monitor?

If small companies’ stock prices are volatile because they are innovative, then monitoring them may incentivize their managers to sacrifice innovation for stock price stability. But regulatory monitoring also improves investor confidence, thus potentially allowing small and innovative companies to raise more capital than they would without monitoring. Small companies also present a relatively small potential risk of harm to investors. Large companies represent a relatively large potential risk of harm to investors, but they are far less likely to cause harm through false financial reporting in the first place.

What all this suggests is that the SEC should focus its monitoring on large companies with volatile stock prices. In other words, the SEC should monitor the companies representing a combination of both 1) the greatest likelihood of non-compliance with Sarbanes-Oxley and 2) the greatest potential harm to investors. This approach would avoid hindering small companies that present little potential risk to investors. It would also keep the SEC from attempting to monitor every large company and thus ballooning into a giant, unnecessary bureaucracy. The SEC’s proposed financial whistle-blower program also serves this interest by incentivizing employees at all companies to report illegal activity. It appears the SEC is concerned about both its internal efficiency and its effectiveness. The SEC is clearly not blind.

 

The full recommended citation to “Regulating Monitoring Under the Sarbanes-Oxley Act is: Alexander, Cindy R. and Hanley , Kathleen Weiss, Regulatory Monitoring Under the Sarbanes-Oxley Act (October 2, 2007). Available at SSRN: http://ssrn.com/abstract=1022161


 

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