Discretion in SEC Enforcement
Prof. Xiumin Martin
Professor of Accounting
Olin Business School
Washington University in Saint Louis
This study examines the costs and benefits of the discretion in SEC enforcement against financial misconduct from a social perspective. Exploiting SOX as a shock to the intensity of SEC enforcement in 2002, we estimate a structural model of the interactions between the SEC and the regulated firms, considering three components in the SEC’s perceived cost function: (1) the SEC’s external costs from capital markets (hereafter social costs), (2) the SEC’s enforcement costs, and (3) managers’ benefits of financial misconduct. We first validate that the marginal enforcement costs decline while the marginal social costs increase significantly post SOX. We then conduct counterfactual analyses, which yield three insights. First, the SEC’s heterogeneous preferences play an important role in explaining the cross-sectional variation in its enforcement (41%). Second, removing the regulator’s discretion in enforcement, such as requiring a homogenous penalty schedule, will result in higher frequency of financial misconduct and higher enforcement costs. Finally, the increased inefficiency due to removed discretion is particularly higher among firms with higher social costs. Overall, our study highlights the importance of the SEC’s discretion in policing the financial market.