seclogoA number of factors might be supposed to affect the SEC’s exercise of its judgment in deciding which firms to investigate. Some possibilities that immediately come to mind are the nature and seriousness of the suspected problem; the way the problem came to the agency’s attention; and the availability of resources to investigate the problem. However, at least according to a recent academic study, some other, more unexpected factors might be at work as well. Among other things, the SEC’s determination of which companies to investigate may be the result of political pressure arising from the electoral process.


In his December 22, 2014 paper entitled “Government Preferences and SEC Enforcement” (here), Harvard Business School Professor Jonas Heese examines the question whether the SEC’s determinations of which firms to investigate reflect political pressure on the SEC from the White House and Congress in response to voters’ interests, and in particular voters’ interests in full employment.


Because prior electoral research shows that employment conditions significantly affect electoral outcomes, elected government officials have an incentive to foster employment to ensure political support. An SEC enforcement action can significantly affect a company’s financial health and thus its ability to continue to maintain its labor force, and so the SEC’s enforcement actions could significantly interfere with the goal of elected officials of promoting employment. Heese asked whether political pressure as a response to voters’ interests for employment is reflected in the SEC’s decisions of which firms to investigate.


Heese used “labor intensity” as a proxy to identify firms that contribute to employment conditions and examined whether the SEC reduces its enforcement actions for labor-intensive firms. In his paper, Heese uses the term “labor intensive” to mean large employers and smaller businesses that employee a large number of people in relative terms and contribute to future employment. In the paper’s appendix, Heese explains that labor intensity itself is measured as a ratio of a firm’s number of employees to its total average assets, as compared to the comparable ratio for firms within the same SIC Code category.


Heese reviewed a sample of firms from the period 1982 to 2012 that were sanctioned by the SEC for violating Generally Accepted Accounting Principles as reported in Accounting and Auditing Enforcement Releases (AAER) and all other firms that did not receive an AAER over that period. He found that labor-intensive firms were less likely to be subject to an AAER. This conclusion held even after controlling for a firm’s size, performance, accounting quality, political contributions, the government’s partisanship, union membership, and other factors. This conclusion, Heese says, is “consistent with my hypothesis that voter’s interests drive political pressure on the SEC.”


Heese then sought to determine if he could identify any variations in the apparent enforcement sensitivity to voters’ interests. What he found was that SEC enforcement behavior changed during presidential election years. Specifically, the lower likelihood of SEC enforcement actions against labor-intensive firms is more pronounced in presidential election years and is concentrated in “politically important states” – i.e., closely contested states with high Electoral College counts.


Moreover, Heese also found that the lower-likelihood of SEC enforcement for labor-intensive firms is more pronounced if the firm is headquartered in a district of a senior congressman who serves on a committee that oversees the SEC.


In order to determine the stage in the process at which the SEC adjusts its enforcement actions against labor-intensive firms in order to accommodate elected officials’ preference for employment, Heese also examined whether labor-intensive firms are less likely to receive a comment letter. He found that labor-intensive firms are less likely to receive a comment letter, “suggesting that the SEC allocates fewer resources to reviews of labor-intensive firms, which might lead to fewer enforcement actions against those firms.”


There is the possibility of course that labor-intensive firms were investigated less frequently because of higher quality accounting at those firms. Heese used several various accounting quality factors that other academics have developed to control for a firm’s accounting quality. After running several tests to investigate whether labor-intensive firms have a better accounting quality and therefore fewer SEC enforcement actions, Heese found consistent evidence across all of the various factors used that labor-intensive firms actually have a lower accounting quality than their less-labor intensive peers. This suggests that the lower level of enforcement activity against labor-intensive firms cannot be explained by these firms having a higher accounting quality.


Heese suggests there are a number of ways the political pressures might influence the SEC’s decisions on which firms to investigate. The SEC is of course dependent on Congress’s budget decisions, and the budget decisions can be used to reward or punish agency decisions. With the advice and consent of the Senate, the President appoints SEC commissioners and can thus impact which political views are represented in the SEC. The commissioners and other key SEC employees often have political careers and their careers often depend on political support from the incumbent government. Finally, congressman and members of the presidential administration can actively intervene with an SEC investigation. As a result, Heese says, the SEC is likely to act in accordance with the preference of elected officials to foster employment, and thus to exercise its judgment of which firms to investigate in a way that favors labor-intensive firms.


It is hardly a surprise that an agency that is run by political appointees might be subject to politics. However, the suggestion that the political process might regularly influence the determination of which firms the SEC might investigate is something of a surprise. It does seem that if the regulated firms are to respect the SEC’s investigative and enforcement processes, the SEC should work hard to maintain the appearance of impartiality and even-handedness.


I will say that this paper, likely many academic papers these days, is thick with the language of mathematics. Because of the technical nature of much of the paper, it is very difficult for me to assess many of the critical aspects of the author’s analysis. Essentially, I am able to read and understand only his conclusions. As for the validity of his techniques and analysis, I am simply unable to judge.


Special thanks to Joe O’Neil of the Peabody & Arnold law firm for sending me a copy of Professor Heese’s paper.