Does Industry Employment of Active Regulators Weaken Oversight?

By | January 31, 2022

Industry employment of active regulators has long raised the concern that it weakens oversight, as regulators might receive financial compensation from firms in exchange for reduced oversight. In response, most public regulators have implemented policies that require regulators to resign from industry employment upon taking office, effectively prohibiting industry employment for active regulators. In contrast, self-regulatory organizations (SROs) often allow regulators to retain industry employment during their tenure at the SRO. Despite these stark differences in employment policies for active regulators, there is no systematic evidence on the question of whether industry employment of active regulators actually weakens oversight. My recent paper addresses this question by studying the enforcement actions of the Financial Reporting Enforcement Panel (FREP), the German regulator responsible for enforcing public firms’ compliance with accounting standards. The FREP allows its senior regulators, i.e., members of its Nomination Committee, members of its board, and the Head of Enforcement, to serve on boards of public firms during their FREP tenure. In my study, I examine the effect of board directorships of active FREP regulators on FREP enforcement actions and firms’ accounting choices. 

Financial Reporting Supervision of Publicly Listed Firms in Germany 

Founded in May 2004, the FREP is a private, industry-operated association that acts as a SRO, which is overseen by a government agency called the Federal Financial Supervisory Authority, also known as BaFin. The FREP is responsible for examining whether the financial statements of publicly listed firms in Germany comply with accounting rules and standards. To that end, the FREP regularly reviews public companies’ financial reports. While most FREP reviews are regular reviews of firms’ disclosures and accounting policies (comparable to the comment-letter reviews conducted by the U.S. Securities and Exchange Commission’s (SEC’s) Division of Corporation Finance), FREP reviews can also be investigations into accounting misstatements or possible accounting fraud (comparable to the investigations conducted by the SEC’s Division of Enforcement). If a review concludes without error findings, the review is closed and no information is publicly disclosed. In the event of an error finding, the error is publicly disclosed by the Federal Financial Supervisory Authority in the German Electronic Federal Gazette. 

The Arguments 

From a theoretical standpoint, the effect of board directorships of FREP executives on enforcement outcomes is not clear. On the one hand, it could weaken enforcement as firms try to avoid these costly events. Appointing FREP executives as directors could be an effective mechanism to avoid enforcement actions, because FREP could lobby for reduced enforcement. Such companies could exploit the reduced enforcement by engaging in more aggressive reporting choices. Under this view, I would expect to find a lower likelihood of being subject to a FREP enforcement action and more aggressive reporting choices following the appointment of a FREP executive.

Alternatively, board directorships of FREP executives could strengthen oversight of connected firms and improve financial reporting for at least three reasons. First, the FREP has high independence and integrity requirements for its executives. If regulators with these qualities join boards, it could improve connected firms’ compliance with reporting rules. Second, FREP executives are likely to have extensive technical expertise, as required by the FREP. Thus, firms seeking to improve their compliance with reporting regulations may appoint FREP executives to benefit from their knowledge. Third, FREP executives could have incentives to improve connected firms’ compliance with accounting regulation or refuse to join boards of companies with questionable accounting practices. Under this alternative view, I would expect to find a lower likelihood of being subject to a FREP enforcement action and less aggressive reporting choices following the appointment of a FREP executive. Ultimately, whether directorships of FREP executives affect enforcement actions and firms’ financial reporting are empirical questions.

The Findings

Empirically, I examine changes in enforcement and reporting outcomes after a FREP executive joins the board of a public firm. I find that firms are less likely to face enforcement actions after they appoint the FREP’s Head of Enforcement or a FREP board member to their board. These appointments reduce the likelihood of receiving an enforcement action to zero. Next, I examine whether directorships of FREP executives affect firms’ financial reporting. These tests are important to distinguish whether the lower enforcement likelihood is driven by increased compliance with accounting regulation or capture. Specifically, I examine the effect of firms appointing a FREP executive to their board on 1) the likelihood of receiving a qualified audit opinion, 2) the likelihood of having an above normal risk of accounting manipulation as measured by an F-Score larger than 1, and 3) firms’ discretionary accruals.[1] I find that firms exhibit higher income-increasing abnormal accruals and are more likely to receive a qualified audit opinion and to have an F-Score larger than 1 after they appoint an active FREP regulator to their board. These findings are most robust in firms that appoint the FREP’s Head of Enforcement, but typically also appear in firms that appoint a FREP board member or a member of FREP’s Nomination Committee. Taken together, my findings are consistent with the view that directorships of active regulators weaken oversight. These findings are also economically important as the market value of the firms that appointed an active FREP regulator represents approximately one third of the market capitalization of all German publicly listed firms, highlighting that an economically important fraction of the publicly listed firms in Germany benefited from reduced enforcement.


My study provides evidence that concurrent industry employment of regulators can weaken enforcement; a finding that improves our understanding of how different types of employment ties between regulators and firms shape oversight. More broadly, these findings also extend our understanding through which channels firms can influence regulators – an important but understudied area. My paper also sheds light on regulatory oversight by self-regulatory organizations, which oversee large parts of the capital market in most countries. One important difference to public regulators is that SROs typically allow regulators to retain their industry employment during their tenure at the SRO. While German policy-makers decided to revoke FREP’s supervision authority as of January 2022 due to its failure of effective oversight in the Wirecard scandal and its conflicts of interest, SROs in many countries still allow industry employment of its regulators.[2] In the U.S., for example, the Financial Accounting Foundation, the Financial Industry Regulatory Authority, and the New York Stock Exchange are SROs that allow industry employment of their senior regulators and could be subject to similar conflicts of interest.

Jonas Heese is the Marvin Bower Associate Professor of Business Administration at Harvard Business School. 

This blog post is adapted from his paper, “Does Industry Employment of Active Regulators Weaken Oversight?” available on SSRN.

The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.

[1] The F-Score measures the likelihood that a firm engaged in earnings misstatement, and is based on an analysis of the financial characteristics of misstating firms (see Dechow et al. 2011 for details).

[2] Wirecard AG, a German payment processor and financial services provider, was involved in an accounting scandal in 2020. In June 2020, Wirecard filed for insolvency after the Financial Times reported that Wirecard inflated its cash reserves by approximately €2 billion. The scandal raised questions about the efficacy of BaFin (the federal agency overseeing the FREP) and FREP as well as other corporate governance mechanisms in Germany, such as external auditors and the board of directors. 

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