Do SEC Comment Letters Provide Useful Information?

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To ensure compliance with disclosure and accounting requirements, the SEC periodically reviews reporting companies’ filings, including the Form 10-K.  While the SEC is required to review the filings of every reporting company at least once every three years, it may (and does) choose to review some companies more frequently.  For example, according to the SEC’s annual reports, the SEC has reviewed an increasing percentage of companies each year since 2006, with 52 percent of registered companies being reviewed in fiscal year 2013.

As described further on the SEC’s “Filing Review Process” website, the review does not guarantee whether filings are complete, nor does it evaluate the economic substance of transactions for investment purposes.  Instead, the review targets the sections of the filings where the company’s disclosures appear to be “materially deficient in explanation or clarity.”  These issues are identified based on the reviewer’s understanding of disclosure or accounting guidance, or based on inconsistencies with other information the company has previously disclosed.

Many reviews result in no comments at all.  However, when the review identifies potentially deficient disclosures or accounting treatment, the SEC issues a “comment letter” to the company, and the company is required to respond in a timely manner.  Often, the SEC’s comment is resolved once the company provides additional information in the form of a response letter.  Other times, the company may decide to amend or restate previous filings to address the SEC’s comment.  Regardless, once the SEC is satisfied with the company’s response, the SEC publicly discloses (on the EDGAR website) the original SEC comments and also the company’s response letter(s), in UPLOAD and CORRESP filings, respectively.

Prior accounting research examines many aspects of the SEC review process, including determinants of receiving a letter, insider trading activity during the non-public portion of the review process (i.e. before the letter correspondence between the SEC and the recipient firm is revealed to the public), and subsequent changes in disclosures or accounting policies. In general, this research finds that the review process leads to improved disclosure and financial reporting quality. However, very few studies have directly examined whether investors, or other stakeholders, find the comment letter process to be useful.

In our study, Examining the Usefulness of the SEC Filing Review Process: Evidence from Debt Contracting, we tackle this question from the perspective of debt holders. Specifically, we examine whether private lenders, namely banks, respond to a company’s receipt of a 10-K comment letter by charging higher interest rates on new loans. We expect banks to respond by increasing interest rates on new loans because correspondence between the SEC and a company can reveal information that was not previously publicly available.  Even if lenders had access to this information independent of the SEC’s comment letter (since they can access private information), the comment letter could emphasize previously overlooked information or increase uncertainty about the quality of a company’s disclosures.

We chose the private debt setting because prior research shows that comment letter correspondence filings (i.e., UPLOAD and CORRESP files) on the EDGAR website are accessed at much lower rates than the respective 10-K filings, and also because the volume of information disclosed in UPLOAD and CORRESP filings makes it difficult to observe meaningful stock market reactions.  In addition, because private banks can obtain information from companies prior to the public disclosure, we can design our study to isolate whether banks are responding to: 1) the publicly (or privately) available information prior to the receipt of the comment letter, or 2) the increased uncertainty or new information revealed during the open comment letter period.  We can then also examine whether this has a lasting effect after the comment letter has been resolved.

Our findings suggest that banks charge higher interest rates for new loans in the period leading up to the receipt of a comment letter, suggesting that they independently identify the material deficiencies also identified by the SEC.  However, interest rates increase significantly after the borrowing company receives a comment letter, suggesting that banks find the information revealed during the comment letter process to be useful beyond information already available in the 10-K filing. Finally, while there is a slight decline in rates for new loans contracted after the comment letter has been resolved, these rates still remain higher than the pre-comment letter period, suggesting that information revealed during the comment letter process has some lasting effect on debt pricing.

We find that our results are stronger when the review identifies material accounting errors, issues subject to managerial discretion, issues related to collateral valuation, and also when the number of lenders involved in the syndication is higher.  Additionally, our results suggest that comment letters are useful to both new lenders and lenders with an existing relationship with the company.

Our findings should be of interest to directors responsible for oversight of company resources, because we show that on average, interest rates are higher for new loans contracted during the open comment letter period. Additionally, because private debt holders react with heightened uncertainty during the open comment letter period, our findings support calls for enhanced disclosure during the SEC review process to allow equity shareholders and public debt holders an equal opportunity to react during the SEC review.

The preceding post comes to us from Lauren M. Cunningham, Assistant Professor of Accounting and Information Management at the Haslam College of Business, University of Tennessee, Roy Schmardebeck, Assistant Professor of Accountancy at the Robert J. Trulaske, Sr. College of Business, University of Missouri, and Wei Wang, PhD student at the Robert J. Trulaske, Sr. College of Business, University of Missouri. The post is based on their recent paper, which is entitled “Examining the Usefulness of the SEC Filing Review Process: Evidence from Debt Contracting” and available here.