The Securities and Exchange Commission (SEC) is the primary securities regulator for U.S. public companies, so its oversight effectiveness is critical for well-functioning capital markets. However, the regulator’s Division of Enforcement, which handles the investigation and prosecution of possible securities violations, has frequently been criticized and characterized as ineffective by the media, congressional members, and even its employees. These criticisms, which were especially common in the wake of the Bernie Madoff Ponzi scheme scandal, often focus on the poor performance of the SEC’s Enforcement leadership and staff. For example, U.S. Senator Bob Menendez stated that Enforcement officials were “grossly untrained, uncoordinated, and lazy in their investigations.” Additionally, the SEC’s Inspector General once stated that the SEC’s “investigators lacked the expertise to ask the right questions.” An independent watchdog agency referenced the “unthinkable incompetence” of the SEC when discussing several of the Division’s shortcomings.
One of the most prevalent criticisms of the SEC is its staff’s lack of practical financial industry experience, which is troubling given the SEC’s role as a financial regulator. For instance, Harry Markopolos, who uncovered the Madoff Ponzi scheme, claims that the SEC’s personnel are “merely lawyers without any financial industry experience” and “totally untrained in finance,” which he characterizes as “financial illiteracy” (as highlighted in articles in Business Insider and the Wall Street Journal, among other outlets). Additionally, in his testimony before Congress following the unveiling of the Madoff fraud, he stated the following:
Since the SEC only hires unqualified, uneducated people without financial industry experience, all they want to do is check pieces of paper to make sure all the paperwork that existing (outdated) securities law requires is being complied with. Is it any wonder, given the current SEC staff, how major financial felonies go unpunished . . . ?
His assessments are based on the fact that he presented SEC staff with detailed evidence of Madoff’s fraud, and the SEC failed to open a formal investigation for almost a decade. However, there is no evidence within the academic literature to indicate whether the financial experience of SEC Enforcement officials impacts SEC investigations. In a new study, I examine whether the financial experience of the SEC’s regional directors impacts the SEC’s investigation process.
In addition to the anecdotal evidence above, I rely on the upper echelons theory to develop my expectations. This theory posits that the background characteristics of senior decision-makers impact organizational outcomes. SEC regional directors head the SEC’s regional offices, which conduct most of the regulator’s investigations into possible securities violations. I expect regional directors who previously worked in financial roles to be better equipped to process complex financial transactions and reports because of their backgrounds, so I expect these directors to open more investigations.
My empirical analyses leverage a unique, hand-collected dataset of SEC regional director backgrounds from SEC press releases to determine whether regional directors had financial experience (i.e., professional experience in finance or accounting) based on their pre-SEC work experience. Descriptive evidence reveals that fewer than 20 percent of SEC regional directors in my sample have prior financial experience, which suggests that there could be some merit to criticisms about a lack of financial experience for key SEC officials.
To examine the potential impacts of the SEC regional director’s financial experience on SEC investigations, I obtained data on SEC investigations from Blackburne et al. (2021), the academic study that originally obtained the data from a Freedom of Information Act (FOIA) request. My primary results show that SEC regional directors with financial experience are significantly more likely to open an investigation than directors without financial experience (after controlling for region-, director-, and company-specific factors). This difference in investigation likelihood is approximately 29 percent (relative to the average investigation likelihood), suggesting that the effect size is meaningful. Stated differently, a company overseen by a financial director is 1.2 percentage points more likely to be investigated by the SEC, which is a meaningful difference given the baseline 4.2 percent likelihood of investigation in my sample.
I perform several additional analyses to support my conclusions and further investigate the impacts of the director’s financial experience. First, I obtained information on SEC investigation classifications from a FOIA request and found that regional directors open more investigations involving fraud or disclosure, but I failed to find evidence that they open more investigations involving more technical legal matters. Second, I find that the impacts of financial experience are more pronounced when the company’s financial complexity is higher. Third, I find that financial experience allows regional directors to complete investigations more quickly, suggesting that increased efficiency could explain my primary result. Finally, I find evidence that regional financial directors also open more consequential investigations in addition to opening more investigations. In sum, my results suggest that SEC regional directors with financial experience conduct more investigations and that these investigations are more efficient and consequential.
My study could interest regulators, market participants, and academics. First, my findings suggest that the opinions of market participants and commentators about the importance of financial experience within the SEC could be valid. The study also provides new evidence for the SEC and similar regulators. The SEC has recently signaled an increased focus on aggressive enforcement (see, e.g., a recent Wall Street Journal article), and the SEC’s then-Director of Enforcement, Stephanie Avakian, discussed the Division’s focus on shortening investigations and stated in the 2020 SEC Annual Report that the regulator “will continue to look for ways to accelerate the pace of [its] investigations.” The results of my study suggest that hiring more senior decision-makers with financial experience could be one avenue for the regulator to pursue to achieve these goals, which is an important implication since the SEC does not currently appear to advertise financial experience as a preferred background for regional director positions. Finally, my paper adds to the growing academic literature on SEC investigations and the limited evidence in accounting and finance about individual regulators.
James (Justin) Blann is an outgoing Postdoctoral Research Scholar in the W.P. Carey School of Business at Arizona State University and an incoming Assistant Professor in the Scheller College of Business at the Georgia Institute of Technology.
This post was adapted from his paper, “Does the Financial Experience of SEC Regional Directors Impact SEC Investigations?” available on SSRN.