Regulators and enforcement agencies continue as always to preach the mantra that corporations should voluntarily disclose instances of misconduct, but a new study is fueling the constant debate about what rewards corporations really get in exchange for confessing their sins.
The study reviewed financial restatements over the course of eight years, and found that the odds of punishment from the Securities and Exchange Commission actually increased for companies that conducted their own investigation and cooperated with the agency—although they ultimately paid smaller fines for doing so.
The study of SEC enforcement was done by Rebecca Files, a business professor at the University of Texas at Dallas. She reviewed more than 1,200 restatements of financial results from 1997 to 2005, where 10 percent (127 cases) resulted in a formal SEC sanction against the company, its executives, or both. In cases where a company conducts its own investigation, Files found that the likelihood of punishment actually rose—probably because the internal investigation cleared the path for the SEC to identify wrongdoers, Files says.
That’s not to say the study invalidates regulators’ gospel of self-disclosure; not all instances of misconduct are alike, and compliance experts are quick to say that controlling for all the variables that exist in the enforcement world—the gravity of the misconduct, past history of behavior, and so forth—can be exceedingly difficult. Nevertheless, the findings do feed into a cynical school of thought among some compliance executives that self-disclosure is not necessarily the easier path that regulators say it is.
On the other hand, Files also found that timely disclosure of accounting problems and a restatement led to smaller monetary penalties a company ended up paying. For each week earlier that the restatement is announced to the public, corporate penalties were reduced by $609,000, and individual penalties by $112,000. On average, the SEC reduced corporate penalties by $37.4 million when the company started its own investigation into the improper accounting.
Files says she did the study because she saw little existing research on how the SEC punishes corporations and executives following a violation of the law. Yes, companies are told by their lawyers and auditors all the time to conduct internal investigations and share the results with the SEC, but “I found little research on whether these actions were actually rewarded by the SEC,” she says. “Knowing the potential costs and benefits of internal investigations will help managers make more informed decisions.”
“The study muddies the waters and suggests that the SEC and the Department of Justice ought to take a closer look at their cooperation policies to make sure results match what they’re telling people.”
—Thomas Gorman,
Partner,
Porter Wright
Files limited her study to financial restatements because they are one of the few violations where it’s easy to distinguish between companies that receive SEC sanctions and those that don’t; other types of violations often aren’t disclosed unless discovered and ultimately sanctioned by the SEC. As such, Files warns that her conclusions might not apply to misconduct such as insider trading or violating Regulation Fair Disclosure.
Others echoed Files’ sentiment that the conclusions are intriguing, but might not be widely applicable. Russ Ryan, a partner in the law firm King & Spalding and a former SEC enforcement attorney, calls the study “a worthy effort to quantify the consequences of two critical decisions companies face when dealing with a restatement.”
Ryan
“If Ms. Files is correct that a company’s cooperation and more transparent disclosure actually increase the likelihood of SEC enforcement action, that is an important and ominous conclusion, even when coupled with her finding that the severity of the punishment is reduced,” he says.
At the same time, however, accounting restatements are only a minority of SEC enforcement actions. Ryan also notes that the study takes the commencement of an internal investigation as a proxy for cooperating with the SEC, which he describes as “a somewhat tenuous assumption.”
Ryan suspects that a better indicator of SEC sanctions is how prominently news of a restatement is reported in the media. That, in turn, depends foremost on the size and prominence of the company doing the restating, rather than when and how the company discloses the bad news in SEC filings and press releases.
ENFORCEMENT FINDINGS
The following excerpt is from Rebecca Files of the University of Texas and her conclusion to the study, “SEC Enforcement: Does Forthright Disclosure and Cooperation Really Matter?”
I investigate SEC enforcement leniency by exploring whether the SEC rewards firm
cooperation and forthright disclosures following a restatement. I find that company-initiated
investigations significantly increase the likelihood of an SEC enforcement action, but decrease
firm-level penalties associated with a sanction. This finding suggests that firms are rewarded for
cooperative behavior, although the reward is manifested through lower penalties rather than a
reduction in sanctions. Managers, auditors, and lawyers may find this result informative as they
evaluate the pros and cons of initiating an internal investigation. Regarding forthright
disclosures, I find somewhat mixed results. Headline disclosure of a restatement increases the
likelihood of an SEC sanction, suggesting that SEC staff is influenced by the visibility of press
release disclosures when choosing its enforcement targets. However, individuals pay
significantly smaller fines when the restatement is disclosed prominently in a press release or on
a Form 8-K or amended filing. Placing restatement information in a Form 8-K or amended filing
also significantly reduces the likelihood of an SEC sanction, but only in the post-2001 period.
Consistent with the Seaboard Report, timely disclosure of a restatement reduces the likelihood of
being sanctioned and results in lower individual and firm penalties.
This is the first study to explore the SEC’s criteria for leniency following a law violation.
Prior research examining SEC enforcement actions or AAERs fail to recognize that the SEC has
a choice in whether to sanction a firm. I attempt to fill this void by examining some of the
criteria used by the SEC when making its choice. This is important given the significant cost of
an SEC sanction to firms, managers, auditors, and investors (Feroz et al. 1991; KLM 2008a,b).
My results also extend prior research (Bowen et al. 2005; Files et al. 2009; Gordon et al. 2009;
Myers et al. 2010) by providing the first evidence on how press release prominence and the type of SEC filing used to disclose a restatement affect the SEC’s decision to issue an enforcement
action. Finally, I provide additional evidence on the benefits of timely disclosure—namely, the
increased potential for SEC leniency.
Although the focus of this study is on SEC enforcement following an earnings
restatement, future research might examine the impact cooperation and forthright disclosures
have on the SEC following other (non-restatement-related) law violations. Additionally, the SEC
has recently renewed its commitment to rewarding cooperation and to providing sufficient
information to the public about the nature and extent of cooperation (SEC 2010). Future research
might explore whether reputational penalties following a law violation are mitigated if
individuals and/or companies are known to have cooperated with regulators.
Source
Univ. of Texas Study on Disclosure (July 2010)
Likewise, former SEC Chief Accountant Lynn Turner, a managing director at LECG, says, “There are a lot of things that go into what sanction the SEC levels against individuals and a firm … I think it is probably absurd to say that cooperation leads to greater sanctions without first understanding the severity of the violations of law that were involved.”
Ryan says the SEC’s appetite for taking an enforcement action against a restatement is first determined by whether the restatement resulted from fraud or an honest mistake, and second by how much money had to be restated. Since most restatements do indeed stem from mistakes and involve relatively small sums, most result in no SEC enforcement at all.
SEC and Justice Department officials have repeatedly touted the value of voluntary disclosure and promised to reward cooperation. Just this January, the SEC rolled out a flock of new policies intended to encourage cooperation, including deferred- and non-prosecution agreements for targets of SEC probes and a so-called “Seaboard Memo for individuals” spelling out how they will be rewarded for cooperating in investigations. Companies and their counsel, however, remain skeptical.
Gorman
“There’s huge skepticism, because it’s so difficult to evaluate what you’re going to get for cooperating,” says Thomas Gorman, a partner in the law firm Porter Wright and a former SEC attorney. “Enforcement officials often say they took cooperation into consideration [in a settlement], but they rarely ever tell you what they thought.”
“The study muddies the waters and suggests that the SEC and the Department of Justice ought to take a closer look at their cooperation policies to make sure results match what they’re telling people,” he says.
Gorman points to two recent cases as good examples of cooperation working to the company’s benefit. First is a July settled enforcement action between the SEC and two executives of Sunrise Living, which manages nursing homes. While the SEC complaint details a financial fraud, Gorman notes that the company consented to a books, records, and controls injunction (rather than a fraud injunction) and paid no penalty.
Another is a settlement from March between the SEC and digital-imaging equipment maker Presstek and its former CEO, over allegations the company made disclosures in violation of Reg FD. In that case, the SEC took the unusual step of detailing some of the remedial measures Presstek implemented that were subsequently taken into consideration by the SEC.
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