Return and Liquidity Response to Fraud and Sec Investigations

By Morris, Brandon C. L.; Egginton, Jared F. et al. | Journal of Economics and Finance, April 2019 | Go to article overview

Return and Liquidity Response to Fraud and Sec Investigations


Morris, Brandon C. L., Egginton, Jared F., Fuller, Kathleen P., Journal of Economics and Finance


(ProQuest: ... denotes formulae omitted.)

1 Introduction

The Securities and Exchange Commission (SEC) was originally charged with maintaining investor confidence in capital markets by providing its participants with reliable financial information and clear rules of honest dealing. Crucial to the SEC's effectiveness is its ability to enforce securities regulation. Though the SEC has been actively enforcing regulation and combatting financial misconduct for many years, very little is known about the impact on firms of SEC actions during the enforcement process. The extant literature has primarily focused on announcement-day effects of SEC actions such as AAER postings (Dechow et al. 1996; Leng et al. 2011), investigation announcements (Feroz et al. 1991; Karpoff et al. 2008a), financial restatements (Anderson and Yohn 2002; Palmrose et al. 2004), or news of fraud (Karpoff et al. 2012). This paper explores how market quality changes for the firm beginning at the date of alleged financial misconduct through the conclusion of the SEC investigation. By examining the full fraud-to-resolution process, we measure the long-run costs and benefits of fraud and SEC investigations. Understanding both the costs and benefits of financial misconduct may help implement protocols that reduce the incentive of managers to commit fraud in the first place as well as provide guidance for the SEC. As such, we can gain a better understanding of the costs and benefits linked with securities enforcement.

Academics contest whether the benefits of equity regulation outweigh the costs as the empirical evidence appears to be mixed (Zingales 2009; Christensen et al. 2016). Moreover, critics of the SEC argue that market forces and other exogenous technological changes have rendered the agency "obsolete" (Macey 1994), or that the agency is ineffective due to inherent flaws due to its relationship with the U.S. Congress such that securities regulation is vulnerable to cyclical patterns of neglect and "hysterical overreaction" (Pritchard 2004). A bi-partisan report on the 2008 financial crisis blames the SEC for "widespread failures in financial regulation" and cites the SEC as a major contributor of the recession (Angelides and Thomas 2011). Others in the media have also called for the abolishment of the SEC due to its ineffectiveness.1 The mission of the SEC is clear, however many question the agency's ability to provide the market with economic benefits that justify its existence. One of the goals of this paper is to show that securities regulation, by way of enforcement proceedings, can provide measurable benefits to firms and market participants.

To analyze the costs and benefits of fraud and securities enforcement, we compare market quality metrics across three stages of the enforcement process. These metrics include average daily returns, daily price volatility, spreads, and illiquidity. We classify the three stages of the enforcement process as: (1) the violation period, which is the period of time that the company engaged in misconduct until it was initially revealed to the market; (2) the trigger period, which is the time period immediately following the market learning of the misconduct to when it was announced that the SEC had opened a formal investigation; and (3) the investigation period, which is the time period in which the SEC investigated the target firm to the resolution of the investigation. The cost of financial misconduct levied by market participants will manifest itself between the violation period and the trigger period, while the SEC's impact will manifest itself between the trigger period and investigation period.

Using a sample of 327 SEC investigation announcements from 1977 through 20112, we find that the market imposes steep penalties to firms that engage in financial misconduct. Every market quality measure worsens during the trigger period. Daily returns are lower by 15 basis points, price volatility increases by 30. …

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