Regulator’s Use of Corporate Monitors to Remediate Financial Misconduct 

By | June 8, 2022

Regulators such as the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) are allowed to seek any remedy that is necessary to protect investors following violations of securities law. One remedy increasingly being used is the requirement that violating firms hire a corporate monitor at their own expense, who is charged with supervising the firm’s remediation efforts following financial misconduct. These individuals, who are typically former SEC or DOJ prosecutors, are akin to consultants and are often tasked with improving a firm’s financial reporting practices, internal controls, employee training, and corporate governance. The end goal of this regulatory intervention is to limit future misconduct and protect investors’ interests at the firm.  

Some have called corporate monitors a “stroke of genius” on the part of regulators, as they can achieve desired enforcement outcomes with minimal regulatory cost. In fact, the SEC and DOJ are becoming increasingly reliant on corporate monitors to remediate misconduct. In 2021, the DOJ’s Deputy Attorney General Lisa Monaco made it clear that DOJ prosecutors are “free to require the imposition of independent monitors whenever it is appropriate to do so” and prosecutors should no longer view the imposition of a monitor as “the exception and not the rule.” Given this news, companies are preparing for even greater use of corporate monitors in regulatory enforcement actions in the future.  

Notwithstanding the SEC and DOJ’s position on monitors, there is still considerable debate among legal and business leaders on the merits of requiring firms to hire corporate monitors. Despite their supposed role as a “consultant” to the firm, monitors are imbedded within a corporation at the behest of regulators, which adds an adversarial component to their job. Legal scholars argue that it is difficult to truly collaborate with a firm while simultaneously serving as a regulatory “watchdog.” This conflict leads to monitorships that are focused on technical compliance rather than true change. Moreover, companies have voiced their concerns about monitor accountability, oversight, and cost. 

In light of these concerns, we examine 1,629 SEC and DOJ enforcement actions filed against firms between 1977 and 2020 for violations of the accounting and disclosure provisions of the Securities and Exchange Act of 1934 (Exchange Act) or the bribery provisions of the Foreign Corrupt Practices Act (FCPA) of 1977 to examine the efficacy of these monitorships in practice. We use legal documents associated with each enforcement action to identify the scope, duration, and seriousness of the misconduct, the magnitude of monetary penalties assessed against each respondent, and whether or not a corporate monitor is required as part of the sanction.  

We find 178 unique enforcement actions in which a firm is required to retain a corporate monitor as part of their regulatory sanction (178 of 1,629 = 10.9 percent), with the average monitor’s term set at 20 months. We see that these corporate monitors are most often tasked with “reducing the risk of reoccurrence of misconduct” at the firm.  We see this language, or something similar, in 71 of the 178 enforcement actions that require a monitor (39%). Other commonly mentioned responsibilities of the monitor include reviewing the effectiveness of the firm’s internal controls, record keeping, and financial reporting procedures (69 mentions); reviewing, correcting, or adjusting the accounting practices of the firm (44 mentions); and taking control of the assets of the firm so as to prevent loss to investors (33 mentions). We also see a non-trivial number of monitors that are required to evaluate or take control of firm operations (13 mentions), review the adequacy of a firm’s corporate governance practices (10 mentions), or approve all corporate actions (7 mentions). This descriptive evidence is consistent with corporate monitors having the authority to influence financial reporting practices, governance, and operations at the enforcement firm.  

Using this novel dataset as the starting point, we first explore the factors that are associated with enforcement firms being required to retain corporate monitors following securities law violations. We find that enforcement actions that include bribery allegations or fraud charges have a significantly higher likelihood of requiring a monitor. We also find that firms whose violations are considered more severe, or those in which top management is found culpable, are significantly more likely to be assigned a corporate monitor. The likelihood of a corporate monitor is significantly reduced, however, for firms that undertake an internal investigation into the alleged violation. This proactive step, which often leads to the identification and termination of culpable employee(s), appears to assuage regulators’ concerns about the firm’s ability to fix the problem internally. Finally, a strong commitment to corporate social responsibility (CSR), particularly corporate governance, is associated with a reduced likelihood of the monitorship requirement.  

The imposition of a corporate monitor is only one remedy available to regulators when enforcing securities law violations. Most notably, regulators can impose monetary penalties against the firm, with these fines occasionally exceeding one billion dollars. As such, it is important to examine the interplay between the assignment of a corporate monitor and the imposition of monetary penalties against the violating firm. For instance, do SEC and DOJ staff recommend smaller fines if the firm submits to more intrusive undertakings, such as a corporate monitor? If so, perhaps the direct cost of a monitor is offset by lower assessed monetary penalties.  

Unfortunately, we find no such evidence.  Rather, we see a robust positive association between the imposition of a corporate monitor and monetary penalties, which is consistent with legal theory. Let us explain. Non-monetary sanctions, including the imposition of a corporate monitor, carry higher social costs than monetary penalties. While monetary penalties require only the one-time cost of collection, the monitorship requirement entails ongoing supervision costs, as alluded to in a recent speech by Brian Benczkowski, Assistant Attorney General at the DOJ:  

I want to make it very clear that once a monitor is selected and installed, our work at the Department is far from over. We take seriously our burden of ensuring that monitorships are being carried out properly and effectively…”  

In light of this, regulators should only consider the imposition of a corporate monitor when the highest-imposable monetary penalty fails to generate the desired level of deterrence. We find that, after controlling for the severity of the misconduct, firms with monitors are indeed assessed significantly larger average monetary penalties compared to those without monitors. The average predicted firm monetary penalty for enforcement firms with monitors is $57.8 million compared to $23.4 million for firms without monitors.  

Next, we examine the effect of a corporate monitor on investors’ perceptions of financial reporting credibility. To do so, we analyze changes in the market response to earnings news for enforcement firms that are required to hire a corporate monitor compared to those that are not. The rationale is that investors will respond more strongly to a given level of earnings surprise if they believe the information is of high quality. As such, we expect that the improvements initiated by a corporate monitor at an enforcement firm will increase investors’ perception of the credibility of earnings news in the following fiscal year. Consistent with our prediction, we find that enforcement firms assigned a corporate monitor experience increased financial reporting credibility relative to other enforcement firms.  

In a similar vein, we also examine whether the hiring of a corporate monitor is associated with changes in audit fees at enforcement firms. It is understood that auditors charge lower fees to firms with lower assessed audit risk. Corporate monitors, at least in theory, should improve aspects of the enforcement firm that are sources of audit risk, namely the credibility of accounting information and the adequacy of internal controls.  As such, improvement in these areas should reduce the risk of future misstatement, leading to relatively lower audit fees for enforcement firms that are assigned a corporate monitor compared to those that are not. Our findings confirm this conjecture, as we find a 26 percent reduction in audit fees, or $2,200,000 on average, after an enforcement action for firms with monitors compared to those without monitors.  

Collectively, our evidence suggests that both investors and auditors perceive corporate monitors to be beneficial to the firm. That is, we see an immediate improvement in financial reporting credibility after the assignment of a monitor, as well as a statistically and economically significant reduction in audit fees for enforcement firms that are required to retain a corporate monitor following financial misconduct.  This suggests that the direct monetary cost of hiring a corporate monitor may be partially offset by lower audit fees and an improved reputation in the market.  

Our findings should have important implications for managers, directors, and legal counsel, all of whom have voiced their concern about the prohibitive costs of corporate monitors. Moreover, the debate over the use of corporate monitors as an enforcement tool is still ongoing (Monaco 2021). As such, our study provides timely insights into the determinants and market benefits of corporate monitors.  

Rebecca Files is an Associate Professor of Accounting at the Naveen Jindal School of Management of the University of Texas at Dallas and the Assistant Director of Research at the Institute for Excellence in Corporate Governance.  

Gerald S. Martin is an Associate Professor of Finance at the Kogod School of Business of American University.  

Yan (Tricia) Sun is an Assistant Professor at Central Michigan University’s School of Accounting.  

This post is adapted from their paper, “Forced Remediation: The Use of Corporate Monitors in Sanctions for Misconduct,” 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. 

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