Regulators face near-zero competition and exit threats. Thus, agency problems are more likely to occur when information asymmetry exists between regulators and constituents (Stiglitz 1999; Coffee 2007). If information asymmetry exacerbates moral hazard in the regulatory context, then the question is whether regulatory transparency can reduce moral hazard and improve regulator accountability. After all, regulators would not want the public to perceive them as shirkers or ineffective. In this paper, we add to this discussion by providing evidence on financial-market regulators. Specifically, we investigate whether and how publicly releasing the U.S. Securities and Exchange Commission (SEC) staff’s review work output (i.e., comment letters) affects their work input (i.e., effort).
The SEC regularly reviews registrant filings and sends comment letters to firms when questions arise during the review. In June 2004, the SEC announced in a press release that comment letter correspondence for reports filed after August 1, 2004 would be publicly released on EDGAR. This increased transparency on the comment letters (i.e., SEC reviewers’ work output and their identities) might prompt greater public monitoring and scrutiny of the letters. If the SEC reviewers anticipate or believe that greater transparency increases public scrutiny of their work output, they will likely increase their review effort.
On the other hand, we recognize that publicly releasing comment letters might not increase review effort for at least four reasons. First, before the regime shift, one can request comment letters under the Freedom of Information Act (FOIA). Thus, reviewers might have already weighed in on the public monitoring afforded by FOIA. As a result, publicly releasing comment letters on EDGAR might not change the SEC reviewers’ perception of external scrutiny. Therefore, their work input might not change. Second, existing findings from the consumer market suggest that regulatory transparency on inspection outcomes can make regulators less strict to avoid confrontation with the regulated entities (Becker and Stigler 1974; Jin and Leslie 2003). If the SEC reviewers become more lenient and exert less effort under the new regime, we will not observe an increase in their review effort. Third, Duro, Heese, and Ormazabal (2019) indicate that publicly disclosing comment letters improves market discipline and financial reporting quality for firms that receive comment letters. If the SEC reviewers see market discipline as a substitute for regulatory oversight, they might exert less effort. Finally, like every entity, the SEC has its own internal performance evaluation. Public scrutiny may be less substantial than the internal performance evaluation already in place before the regime shift. Consequently, we might not observe a significant change in the review effort.
A challenge in examining whether transparency affects effort is that regulators’ effort is unobservable. This unobservability is a fundamental cause of moral hazard in the workplace and presents a significant empirical challenge in research studies. We overcome this challenge by using a unique dataset that tracks the SEC’s EDGAR access to capture their employees’ effort. We find that both the number of unique filings accessed and the proportion of documents accessed per filing by the SEC staff increase significantly under the new regime. The increase in the number of unique filings accessed suggests that the SEC staff members increase their effort to review more filings and conduct more cross-filing checks under the new regime when comment letter correspondence is publicly released on EDGAR. The increase in access to the proportion of documents per filing suggests that the SEC staff members check for more information when they review each filing. These main effects are incrementally stronger for firms with comment letters that are expected to attract greater investor or public monitoring. Furthermore, under the new regime, reviews are more timely. Upon the regime switch, the likelihood of a restatement (receiving a comment letter) decreases (increases) for filings that are reviewed. After receiving a comment letter, a firm with signs of potential fraud is more likely to be investigated, and this effect becomes more pronounced under the new regime.
Proponents of regulatory transparency argue that the government usually has an information advantage over its citizens. Thus, members of the general public can benefit from basing their decisions on information disclosed by the government. In addition, transparency can increase public participation and monitoring, thereby improving public institutions’ performance. On the other hand, opponents caution that regulatory transparency can make practitioners less willing to put in the effort or take risks when questioning potential wrongdoing, which results in lax monitoring and oversight in the consumer market (Stiglitz 1999; Blinder 1999; Becker et al. 2012). Overall, our results suggest that disclosing regulators’ work output can mitigate moral hazard (i.e., increase regulators’ work input), improving their work performance.
Rui Guo is an Assistant Professor at the Accounting Department at Xiamen University.
Xiaoli Tian is an Associate Professor at the McDonough School of Business at Georgetown University.
This post was adapted from their paper, “Regulatory Transparency and Regulators’ Effort: Evidence from Public Release of the SEC’s Review Work,” available on SSRN.
