The SEC never reads 74% of filings, putting investors at risk
October 29, 2015,
Congressional negotiators are completing secretive work on a budget compromise. That means the Securities and Exchange Commission along with other federal agencies will soon begin receiving clearer signals about what resources they can count on. Even a best-case scenario doesn’t amount to much. But I’ll make an argument on behalf of the SEC, a government office everybody likes to kick around.
First, a reality check. Even if the SEC receives all of the $1.7 billion President Barack Obama requested, it will be only once in seven years that the agency gets around to examining every investment adviser it regulates. That’s as compared with once a decade now. Forty percent of the registered investment advisers have never been examined at all. And of 49,000 investment company filings a year, just 26% of them get read by regulators, according to the agency’s fiscal 2016 budget request.
So much for meaningful disclosure. So much for meaningful oversight.
Earlier this year, the International Monetary Fund issued the withering assessment that “the number of expert staff” at the SEC (and at the much-smaller Commodity Futures Trading Commission) “does not appear to be sufficient to ensure a robust level of hands-on supervision.” One look at the CFTC’s $322 million budget request makes that clear. “Historic underfunding of the surveillance function has dramatically and adversely impacted or compromised the commission’s ability to protect market integrity and to detect and deter manipulation,” it warns.
About 14.5% of U.S. publicly traded companies engage in fraud in any given year, with the incidence of undetected cheating about three times greater than what comes to light, according to research by finance professors Alexander Dyck, Adair Morse and Luigi Zingales. So it’s not difficult to lose heart at the idea of investor protections. Alternatively, there is much to be said for the IMF’s recommendation that the SEC and CFTC become self-funded, and subject to multi-year budgeting.
The U.S. Government Accountability Office itself says well-designed user fees—like charging for government examinations—“can reduce the burden on taxpayers.” The U.S. Mint, U.S. Patent and Trademark Office, and the Federal Communications Commission are each “fully fee-funded agencies,” according to the GAO. And the Federal Reserve System pays for its own operation, largely through income on its government securities portfolio.
Last week, the SEC reported that it had won $4.2 billion in financial disgorgements and penalties in the fiscal year ended in September, producing a nearly 3-to-1 return on the agency’s budgeted $1.5 billion. (It also collects transaction fees from the self-regulatory organizations it oversees.)
In other words, the SEC could be self-supporting, if it weren’t already turning back most of what it collects to the U.S. Treasury general fund.
The chronic underfunding of the government’s front-line securities regulators is a policy decision, rather than a fiscal one, reflecting suspicions of how much harm heavy-handed inspections, regulations and enforcement can cause to free markets. It’s another reminder that the investor is best served by being his or her own regulator, making careful, informed, self-protecting investment decisions.
Even so, a case can be made for the utility of the financial regulators.
Terrence Blackburne, a former program examiner at the White House Office of Management and Budget, obtained staffing data from the SEC’s Division of Corporation Finance, showing that when examination intensity increased in the agency’s disclosure-review office, publicly traded companies were less likely to engage in earnings management, and issued fewer financial restatements.
The calculations are complicated, and I’ll spare you the details. But Blackburne finds evidence of a “statistically significant and economically meaningful relation between SEC oversight” and the quality of corporate financial reporting.
An intriguing issue raised by Blackburne’s research—particularly in light of the inspection and examination gaps apparent in SEC oversight—is how the workload of the three-dozen disclosure specialists who oversee banks and other financial services firms is so much greater than for the other offices. (It is nearly double that of disclosure specialists devoted to natural resources, for example.)
Average SEC resource allocations per year, 2003-2012
|Healthcare and insurance||32||824||2977.4|
|Information technology and services||33.2||1067.4||2935.7|
|Transportation and leisure||35.1||835.4||4176.2|
|Manufacturing and construction||35.1||842.2||2156|
|Real estate and commodities||31.7||833||2622.7|
|Beverages, apparel and mining||28.4||624||1501.6|
|Electronics and mining||32.9||836||2317.8|
While this might reflect the multi-layer regulation of banks—and potential assistance from other agencies—it’s another measure of how naked the investor is when putting money into a sector riven by civil penalties and criminal verdicts.
Blackburne told me he can’t explain the disparate workloads, and said the agency denied his request for additional records when researching his Ph.D. thesis, “Regulatory Oversight and Reporting Incentives: Evidence from SEC Budget Allocations,” last year at the University of Pennsylvania Wharton School.
Ohio State University accounting specialists Zahn Bozanic, J. Richard Dietrich and Bret Johnson also published recent research showing that so-called comment letters issued by the SEC Divison of Corporation Finance—requesting additional information related to company filings—tend to produce more detailed disclosures, with additional numbers and a less optimistic tone. One example cited is a former party goods retailer’s response to an SEC comment letter, which the agency said offered “significant negative evidence,” seemingly at odds with the original filing.
This finding dovetails with Blackburne’s analysis that enhanced disclosure results in reduced earnings management and fewer financial restatements.
Interestingly, companies that appeal SEC staff requests—or that petition for confidential treatment (meaning no additional information is made available to investors)—do not end up making significant qualitative changes to their disclosures, according to the Ohio State University researchers.
“Firms can and do circumvent the comment letter review process through confidential treatment requests as well as by negotiating directly with the SEC,” they write. Two of them—Dietrich and Johnson—formerly worked at the SEC, though they state that they do not intend for their views to represent the agency’s.
Mihir Mehta, an assistant professor of accounting at the University of Michigan, offers one other recent example of the positive effects of SEC oversight, and it comes from a somewhat surprising direction. The SEC is political by nature. Commission leadership reflects party-oriented appointments by the president, and the inherently partisan House Financial Services Committee leads its oversight.
Nevertheless, Mehta and Wanli Zhao, an associate professor of finance at Southern Illinois University, found that public companies headquartered in or near the districts of Senate Banking and House Financial Services committee members tend to produce better financial statements—and be less prone to SEC enforcement actions—than otherwise comparable companies from outside of committee-member districts. They believe that companies in geographic proximity to powerful lawmakers are careful to “limit exposure to political costs.”
As this contrasts with the idea that corporate lobbying and congressional influence minimize regulatory influence—rather than enhance it—I asked Mehta how he responded to his own findings. “The first thing we did was re-check the data to make sure we weren’t wrong,” he said, “because we were surprised.”
Unfortunately, once the local lawmaker leaves the Senate or House oversight committee, the quality of a company’s financial reporting declines, he found.
In the W.C. Fields movie “The Bank Dick,” the town drunk is given the job of bank detective after a stickup man haplessly falls over the bench he is occupying.
The financial chicanery in the script is both hilarious, and instructive.
“Was I in here last night, and did I spend a $20 bill?” Fields asks his bartender, at one point. When the mixologist responds yes, Fields says, “What a load that is off my mind. I thought I’d lost it.”
The SEC has been one of the more frustrating—sometimes infuriating—agencies to watch over the years, as the darker corners of society seemed often to be beyond its reach; and even beyond its interest. But the work of Blackburne, now an assistant professor of accounting at the University of Washington, along with the research at Ohio State University and the University of Michigan shows that the agency is providing a needed public service, and one that more than pays for itself.
“In recent years, the securities markets have grown increasingly complex and opaque. There has been a proliferation in sophisticated tools and trading methods used in the markets, including the use of high frequency trading, complex algorithmic trading, and off-exchange trading venues,” the SEC budget report states.
We can express doubts about how that money is spent. And we all must be on guard for ourselves. But there’s no denying that we need this cop on the beat.