An Examination of SEC Investigative Bias among Foreign Registrants and Domestic Registrants with Foreign Operations

Southern Business Review, Winter 2009 by Maguire, Karen A

The objective of this study is to examine country- specific factors that are related to the Securities and Exchange Commission's (SEC) issuance of foreign- related Accounting and Auditing Enforcement Releases (AAERs). Foreign- related AAERs include sanctions issued against foreign firms registered in the U.S. and against domestic firms with foreign operations. The country- specific factors examined include the foreign countries' accounting models, perceived level of corruption, and relative economic presence in the U.S. market. An investigative bias exists if the SEC is not investigating these alternative forms of risk in proportion to their existence within these populations of firms. Failure to scrutinize any portion of these firms exposes stakeholders to the additional risk of unchecked intentional misstatements.

Research on the international investigative patterns of the SEC is important for three reasons. First, multinational corporations are the fastest growing population among publicly-listed firms. In 1988, only 26 foreign firms were registered with the SEC. By 1998, this number had increased to more than 1,100 (SEC Annual Report, 1998). The SEC signaled its recognition of the rapidly expanding international marketplace when it formed the Office of International Affairs (OIA) in 1989. The OIA was given "primary responsibility for the negotiation and implementation of informationsharing agreements and for developing legislative and other initiatives to facilitate international cooperation" (SEC Annual Report, 1990: 20).

Second, fraud is an expensive international problem. Worldwide fraud losses are estimated at five cents for every dollar spent (Kerber, 2008). Recognition of this problem is evident as early as the Securities and Exchange Act of 1 934. Discussing the need for regulation, the Act recognizes that securities prices are established by transactions throughout both the U.S. and foreign countries and that these prices are susceptible to manipulation (SEC, 1934). Evidence of this manipulation is that publicly-traded companies suffer median losses from fraud of $142,000 per incidence of fraud (ACFE, 2008).

Third, while the SEC has important enforcement responsibilities, it possesses limited resources. One of the reasons the SEC was formed was "to ensure the maintenance of fair and honest markets'' (Securities and Exchange Act, 1934, Section 2). Although the SEC is the only organization within the U.S. government to generate excess revenues over expenses, as with any government entity it must operate with a limited amount of resources. The Sarbanes-Oxley Act (U.S. Congress, 2002) recognizes that the SECs resources are stretched in an increasingly high risk environment. The Act requires public accounting firms to pay to the SEC both registration and annual fees, and issuers to pay annual accounting support fees to support the investigative activities of the Public Company Accounting Oversight Board, which is under the jurisdiction of the SEC (U.S. Congress, 2002). Not only must investigative resources be stretched to address new and increased risks, but the costs of learning how to investigate within new accounting models and business environments uses resources that would otherwise be devoted to investigations.

Given resource constraints, growth in international business, and increasing fraud risk, the SEC may not be investigating alternative forms of risk in proportion to their existence within the population of listed firms. The SECs objectives of prevention and deterrence are compromised to the extent that intentional misstatements are overlooked for any portion of the registrant population.

As a first study in this area, it evaluates whether accounting models, corruption, and economic presence are macro-level risk factors that explain the issuance of AAERs, and whether these relationships suggest an investigative bias by the SEC. These three factors are employed in this study to represent different types of risk to an investor, risk which may threaten the goal of "the safeguarding of securities and funds related thereto" (Securities and Exchange Act, 1934, Section 2). Anchoring and adjustment theory was used to predict that the SEC is more likely to issue AAERs for companies that use a familiar, US-based accounting model than for companies that use an unfamiliar model. Use of the Fair Presentation/ Full Disclosure model - the same type employed within the U.S. - is predicted to be positively related to the issuance of an AAER. Use of either the Legal Compliance or Inflation-Adjusted accounting models is predicted to have a negative relationship with AAER issuance. The theory of differential association was used to predict a positive relationship between countries with higher levels of perceived corruption and AAER issuance. Finally, a positive relationship is predicted for firms with larger relative market presence in the U.S. economy.

This study makes two contributions to the existing literature. First, although prior research (e.g., Beasley et al., 1999, 2000) evaluates AAER composition (e.g., types of respondents and misstatements), no study has tested whether macrolevel risk factors can explain the SECs issuance of AAERs. Second, while numerous papers have discussed the regulatory environment faced by foreign firms (e.g., Breeden, 1994; Cochrane, 1994; Decker, 1994) the literature lacks study of SEC investigations of international firms and tests for association with unique risk factors in international markets. This study's results should increase knowledge in both of these research areas.