In 2012, Mary L. Schapiro, the chairwoman of the Securities and Exchange Commission,  argued that market participants had “short memories” and that the SEC as a result had to take regular enforcement actions “so that people don’t forget that they have [regulatory] obligations and that somebody is watching and […] willing to hold them accountable.”

Schapiro’s claim has intuitive appeal: If the capital markets regulator does not enforce its rules with some regularity, potential wrongdoers may interpret the resulting inactivity as a reduced risk of apprehension and commit more wrongdoing. In our recently published paper “Short Memories? The Impact of SEC Enforcement on Insider Leakage,” we examine whether the argument finds support in practice.

We exploit the unique properties of Regulation Fair Disclosure (Reg FD) – an SEC regulation that aims to prohibit insiders’ disclosure of information to selected investors in favor of broad public disclosure methods – to examine how insiders adapt their behavior after SEC enforcement actions. Our paper contributes to the literature on the importance of public enforcement, studies of how insiders deploy private information, and the literature evaluating the effectiveness of Reg FD itself.

We formulate three hypotheses about the deterrent effects of SEC enforcement actions. To test them, we construct correlation metrics for gauging the propensity towards informed trading ahead of earnings announcements and study whether corporate insiders reduce their information leakage behavior after SEC enforcement actions. We study quarterly earnings announcements of S&P500 stocks and use 20 years of market data (January-1995 to December-2015) covering the 5 years before Reg FD was introduced and the first 15 years thereafter.

Our paper has three main findings. First, we find that SEC enforcement has a significant and immediate deterrent effect on insider leakage. This is new to the literature, since prior studies have used SEC resource data to serve as proxies for enforcement intensity rather than actual enforcement actions.

Secondly, we find evidence that enforcement actions undertaken after long periods of SEC inactivity have a more significant effect on leakage. This is consistent with theory predicting that insiders gauge the likelihood of apprehension by studying the regulator’s activity levels, increasing information leakage when they perceive the regulator to be inactive and decreasing it when the regulator is active.

Finally, we study the effect of SEC escalations – three occurrences when the SEC decided to deploy stronger sanctions for Reg FD violations than it ever had previously. We label as escalations the Reg FD proposal itself in 1999, the first time the SEC fined a corporate insider under Reg FD in 2003, and the first time the SEC required a corporate insider to pay the fine out of personal (instead of corporate) funds in 2010. We find evidence that SEC escalations led to particularly notable drops in leakage and estimate that SEC escalations changed leakage behavior for approximately 24 months.

Our paper offers a more dynamic evaluation of the effectiveness of Reg FD than the previous research, which compared market data before and after its introduction. Our paper also demonstrates the importance of recurring interventions by capital market regulators for maintaining deterrence of undesirable behavior. Finally, our findings support Schapiro’s claim that corporate insiders have “short memories”.

This post comes to us from Dr. Sid Ghoshal of the University of Oxford, Dr. Martin Bengtzen of King’s College London, and Professor Stephen Roberts of the University of Oxford. It is based on their recent paper, “Short Memories? The Impact of SEC Enforcement on Insider Leakage,” published in the Journal of Law, Finance and Accounting and available here.