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SEC REVIEW UNDER SECTION 408 OF THE SARBANES OXLEY ACT OF 2002: DOES IT MAKE A DIFFERENCE

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Title: SEC REVIEW UNDER SECTION 408 OF THE SARBANES OXLEY ACT OF 2002: DOES IT MAKE A DIFFERENCE


1
SEC REVIEW UNDER SECTION 408 OF THE SARBANES
OXLEY ACT OF 2002 DOES IT MAKE A DIFFERENCE?
  • Sharad Asthana Jeff Boone
  • ACCOUNTING, COB, UTSA

April 2009
2
Motivation
  • SEC. 408. ENHANCED REVIEW OF PERIODIC DISCLOSURES
    BY ISSUERS.
  • (a) REGULAR AND SYSTEMATIC REVIEW. - The
    Commission shall review disclosures made by
    issuers reporting under section 13(a) of the
    Securities Exchange Act of 1934 (including
    reports filed on Form 10K), and which have a
    class of securities listed on a national
    securities exchange or traded on an automated
    quotation facility of a national securities
    association, on a regular and systematic basis
    for the protection of investors. Such review
    shall include a review of an issuers financial
    statement.
  • (b) REVIEW CRITERIA. - For purposes of scheduling
    the reviews required by subsection (a), the
    Commission shall consider, among other factors -
  • (1) issuers that have issued material
    restatements of financial results
  • (2) issuers that experience significant
    volatility in their stock price as compared to
    other issuers
  • (3) issuers with the largest market
    capitalization
  • (4) emerging companies with disparities in price
    to earning ratios
  • (5) issuers whose operations significantly affect
    any material sector of the economy and
  • (6) any other factors that the Commission may
    consider relevant.
  • (c) MINIMUM REVIEW PERIOD. - In no event shall an
    issuer required to file reports under section
    13(a) or 15(d) of the Securities Exchange Act of
    1934 be reviewed under this section less
    frequently than once every 3 years.

3
MOTIVATION
  • PRELIMINARY REVIEW
  • (AT LEAST ONCE EVERY 3 YEARS)
  • OUTCOME 1 NO ACTION
  • OUTCOME 2 DETAILED REVIEW
  • FINANCIAL REVIEW (F/S MDA)
  • FULL REVIEW (F/S MDA BUS LEGAL INFO)
  • TARGETED REVIEW (SPECIFIC ? DERIVATIVES)
  • NO FURTHER COMMENT
  • OR
  • ACCOUNTING AUDITING ENFORCEMENT RELEASE (AAER)

4
MOTIVATION (continued)
  • The SEC states that
  • Much of the Divisions review involves reviewing
    the disclosure from a potential investors
    perspective and asking questions that an investor
    might ask when reading the document.
  • The mission of the U.S. Securities and Exchange
    Commission is to protect investors, maintain
    fair, orderly, and efficient markets, and
    facilitate capital formation.
  • The laws and rules that govern the securities
    industry in the United States derive from a
    simple and straightforward concept all
    investors, whether large institutions or private
    individuals, should have access to certain basic
    facts about an investment

5
MOTIVATION (continued)
  • DURING 2004-08, THE DIVISION OF CORPORATE
    FINANCE (SEC) SPENT OVER 429 MILLION ON REVIEW
    OF FILINGS. OF THIS, OVER 300 MILLION WAS SPENT
    ON REVIEW OF 10-Ks.
  • DID THESE REVIEWS
  • MAKE A DIFFERENCE?

RQ
6
OBJECTIVE
  • TO INVESTIGATE THE EFFECTIVENESS OF THE SEC
    REVIEWS OF 10-Ks -
  • IN IMPROVING THE QUANTITY QUALITY OF
    INFORMATION
  • IN EQUALIZING DISTRIBUTION OF INFORMATION AMONG
    INVESTORS
  • THE EFFICIENCY OF THE REVIEWS IN PROVIDING
    INFORMATION VALUE IN EXCESS OF REVIEW COSTS.

7
RESULTS / CONTRIBUTION
  • (1) SEC reviews result in changes in both the
    length and content of 10-K annual reports and
    trigger financial restatements
  • (2) This change in 10-K length and content
    appears to increase the information content of
    the 10-K as measured by return volatility and
    trading activity
  • (3) The increased information content is
    primarily concentrated among small investors
  • (4) The adverse selection spread component
    declines following release of the post-review
    10-K
  • (5) The SEC reviews produce information valued at
    over 84 for every 1 expended in conducting the
    reviews
  • (6) Contributes to the recent debate concerning
    ex ante versus ex post regulation of financial
    reporting.

8
THEORY (1)
  • Consumers perceive public goods to be "free.
    Investors may demand more frequent/ more intense
    SEC reviews than would be demanded if they
    purchased the reviews at a price determined by
    market Demand/Supply dynamics (Chen and Johnson
    2008)? the marginal cost of the SEC reviews
    exceed the marginal benefit.

9
THEORY (2)
  • SEC reviews are an extra layer of financial
    monitoring on top of that done by the independent
    auditor. The auditor has significantly more
    economic incentives than the SEC to detect
    material misstatements in financial statements ?
    SEC reviews are unlikely to result in meaningful
    improvement in 10-K annual reports.

10
THEORY (3)
  • Audited financials can comply with GAAP and yet
    lack an appropriate level of transparency if GAAP
    is slow to respond to innovations in business
    practices ? the SEC reviews can improve 10-K
    annual reports by correcting accounting and
    disclosure deficiencies arising from unsettled,
    emerging accounting and disclosure issues
    ineffectively addressed by extant GAAP

11
PRIOR RESEARCH
  • Ettredge et al. (2008) ? Examine comment letters
    addressing non-compliance with auditor change
    disclosures in Item 4 of Form 8-K ? the
    probability of non-compliance is positively
    associated with the 8-K containing bad news,
    negatively associated with corporate governance
    quality, and not associated with firm size.

12
PRIOR RESEARCH
  • Ertimur and Nondorf (2006) ? Examine comment
    letters issued on registration statements of
    initial public offerings ? Higher managerial
    expertise is associated with fewer comments and a
    faster review ? Little association between
    corporate governance and number of
    comments/review time ?. Hypothesize that firms
    with fewer comments and faster review will have
    lower under-pricing, greater depth, and narrower
    bid-ask spreads.

13
PRIOR RESEARCH
  • Chen and Johnston (2008)? Examine the change in
    earnings announcement for a sample of firms
    receiving comment letters on a 10-K or 10-Q
  • SEC REVIEW ? PRECISION ? EARNINGS REACTION
  • ___________________________________________(KIM
    VERRECCHIA 1997)______
  • UNANSWERED QUESTIONS…
  • ?10-K POST-REVIEW?
  • ?QUANTITY OF INFORMATION?
  • ?QUALITY OF INFORMATION?
  • ?DISTRIBUTION OF INFORMATION
  • ? LARGE V/S SMALL?
  • COSTS V/S BENEFITS OF REVIEW?
  • Ex Ante V/S Ex Post?
  • DO RESULTS HOLD FOR LARGE SAMPLES (gt206)?

14
SAMPLE
  • 36,771 CL (MAY 1ST, 2005 JUNE 30TH, 2008)
  • 16,987 (10-K RELATED)
  • 10,414 (DATA ON COMPUSTAT CRSP)
  • 3,572 CL FIRMS 3,754 NO CL FIRMS

15
RESEARCH DESIGN
  • POST-REVIEW 10-K CHANGES
  • LENGTH ANALYSIS

16
RESEARCH DESIGN
  • POST-REVIEW 10-K CHANGES
  • CONTENT ANALYSIS
  • LEVENSHTEIN_DIFF
  • LEVENSHTEIN (CL) - LEVENSHTEIN (NO-CL)
  • ALSO USE LEVENSHTEIN_CHAR

17
RESEARCH DESIGN
  • POST-REVIEW 10-K CHANGES
  • RESTATEMENT ANALYSIS
  • H3A The number of SEC-triggered restatements is
    greater than expected in the absence of an SEC
    review
  • OR P(Rgtr) gt 0.10

18
RESEARCH DESIGN
  • POST-REVIEW 10-K CHANGES
  • INFORMATION CONTENT ANALYSIS
  • ?CAR CARPOST- CARPRE
  • ESTIMATION PERIOD (-250, -5)
  • TEST PERIOD (-1, 1)
  • Fama and Frenchs (1993) model with the Carharts
    (1997) momentum modification
  • H4A the mean/median value of ?CARgt0

19
RESEARCH DESIGN
  • POST-REVIEW 10-K CHANGES
  • INFORMATION CONTENT ANALYSIS
  • CAT S( )
  • TRist Number of trades on day t for size
    stratum s in firm i
  • µ(TRist) Mean (TRist) in the period (-49, -5)
  • s (TRist) Standard Deviation (TRist) in the
    period (-49, -5)
  • Large ? gt50,000
  • Small ? lt 5,000 (or lt 100share price if gt 50)
  • ?CATsmall CATsmall,post CATsmall,pre
  • H5A the mean/median value of ?CATsmall gt0
  • H6A the mean/median value of ?CATsmall ?
    ?CATlarge
  • Repeat with ?CAS (Cumulative Abnormal Shares)
    H7,8

20
RESEARCH DESIGN
  • CHANGES IN INFORMATION ASYMMETRY
  • ASC ADVERSE SELECTION COMPONENT
  • ?ASC ASC(0 to 59) - ASC(-60 to -1)
  • H9A The mean/median value of
  • ?ASCPOST ?ASCPRE ?0

21
Jeff to discuss results
22
RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
  • Test 1 examine change in length of 10-K
  • Test 2 change in content of 10-K
  • Test 3 restatements

23
RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
  • Test 1 examine change in length of 10-K
  • Test result
  • Mean 10-K length increased by about 6 (Table 5
    Panel A)

24
RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
  • Test 2 change in content of 10-K
  • Test result
  • Greater change in 10-K content (post-review
    versus pre-review 10-K) among CL firms as
    compared to industry/size matched No CL control
    group (Table 5 Panel B).

25
RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
  • Test 3 restatements
  • Test result (Table 5 Panel C)
  • 4.5 restatement rate among CL firms
  • 4.5 162 restatements out of 3,572 CL firms
  • 1.5 restatement rate among No CL firms
  • Probability of observing 162 or more restatements
    given a 1.5 base restatement rate (absent SEC
    review) is very small (prob lt 0.001).

26
RQ Does SEC review of an annual 10-K report lead
to 10-K changes?
  • Conclusion
  • Significant increase in length of 10-K
  • Significant change in content of 10-K
  • More restatements than expected by chance.
  • Answer to RQ Yes.

27
RQ Does new information in 10-K…
  • Add to the information set used by investors?
  • Equalize the distribution of information among
    investor classes?

28
RQ Does new information in 10-K add to the
information set used by investors?
  • Test 1
  • Compare return volatility during post-review and
    pre-review 10-K filing event (-1,1)
  • Compare trading activity during post-review and
    pre-review 10-K filing event (-1,1)
  • Test result (Table 6 Panels A-C).
  • Increase in return volatility (Table 6 Panel A)
  • Increase in number of trades (Table 6 Panel B)
  • Increase in number shares traded (Table 6 Panel
    C)
  • Answer to RQ Yes

29
RQ Does new information in 10-K equalize the
distribution of information among investor
classes?
  • Test 1
  • Compare trading activity associated with new
    information between large and small investor
    classes.
  • Test result (Table 6 Panels B and C)
  • Small investors showed greater increase in
    trading activity than large investors.
  • Suggests that new information in 10-K had
    greater information content for small investors,
    potentially because larger investors already had
    obtained at least some pre-disclosure knowledge
    of the information through private information
    search.
  • Could also mean that the new information was
    commonly interpreted by large investors but was
    subject to varying interpretation by small
    investors.
  • Spread analysis will help distinguish between
    these two competing explanations..

30
RQ Does new information in 10-K equalize the
distribution of information among investor
classes?
  • Test 2
  • Use adverse selection spread component as
    observable indicator of information asymmetry
  • For both post-review and pre-review 10-K filing
    events
  • Measure mean adverse selection spread component
    during 60 days following the 10-K filing event.
  • Subtract mean adverse selection spread component
    during 60 days preceding the 10-K filing event to
    control for across-time changes in spread levels.
  • i.e., 60 day mean less -60 day mean).
  • Mean spread during 60 post-filing period
    (controlling for mean spread preceding the
    filing) should be lower than means spread during
    corresponding pre-review 10-K period if new
    10-K information equalized the distribution of
    information among investors.
  • (slide continues)

31
RQ Does new information in 10-K equalize the
distribution of information among investor
classes?
  • Test 2 (continued)
  • Test result
  • Mean spread during 60 post-filing period
    (controlling for mean spread preceding the
    filing) was lower than mean spread during
    corresponding pre-review 10-K period.
  • Spread analysis suggests that difference in
    trading activity among investor classes was due
    to equalizing distribution of information among
    investors.
  • Answer to RQ Yes

32
RQ Is the information value of SEC review
greater than review cost?
  • Test
  • Determine net change in equity values around
    comment letter issuance dates (two dates
    delivery of letter to registrant and uploading of
    letters to EDGAR) using (-1,1) window.
  • Measure net information value of review as summed
    net change in equity values.
  • Compare net information value of review to review
    cost per SEC budget.
  • Test result
  • 7 billion decline in equity values during
    comment letter issuance event.
  • 87 million cost in conducting reviews
  • 84 information per 1 spent on review.

33
Takeaway
  • SEC reviews are substantive.
  • Provides new information
  • Mitigates information asymmetry among investors.
  • Probably not an instance of overregulation.
  • All of the above surprises me.
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