The Securities Exchange Act grants the SEC ample authority and discretion to investigate and seek sanctions related to violations of the securities laws, with the goal of protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation (SEC, 2013). To be sure, this is the SEC’s stated objective. Like most regulatory agencies, though, the SEC is subject to resource constraints – as well as to pressures from both the political and business spheres, which might steer it away from the fulfillment of its mission.
We directly assess the SEC’s objectives, as revealed by the observed SEC regulatory policies, by analyzing the SEC’s enforcement actions against firms’ financial reporting concerning the 13(b) provisions of the Exchange Act.   We start with a theoretical model, in which the SEC considers three types of costs when making enforcement decisions: (1) the SEC’s perceived social costs of financial misconduct (associated, for example, with its impact on investors’ confidence and trust); (2) the SEC’s perceived enforcement costs (associated, among other things, with the political and administrative costs of conducting investigations and imposing penalties); and (3) firms’ expected benefits of committing financial misconduct (or, equivalently, the negative of the firms’ costs of reducing financial misconduct). The first two costs relate to the SEC’s own concerns and are referred to as “regulator preferences.” We assume the benefits of financial misconduct are known to the firm managers but not to the regulator, so there is information asymmetry between the two. The SEC’s objective is to minimize the sum of the three aforementioned costs for each firm by choosing an enforcement schedule. Given such a schedule, the firm chooses the level of financial misconduct to maximize its net payoff.
In evaluating the above model, we exploit a shock to the extent of enforcement on large firms due to the enactment of the Sarbanes-Oxley Act (SOX) in 2002. Anecdotal evidence, prior research, and our own data suggest that the SEC strengthened enforcement against large firms, and firms’ financial reporting quality improved post-SOX (e.g., Cox and Thomas, 2005). Based on this evidence, we focus our analysis on large firms with a market capitalization above the median for each year in Compustat. In our estimation, the pre-SOX period spans from 1996 to 1999, and the post-SOX period ranges from 2002 to 2005. We measure financial misconduct using a widely accepted accounting measure, unsigned discretionary accruals, which are also used by the SEC to assess a firm’s accounting quality and are known to be associated with accounting misstatements (Dechow, Ge, Larson, and Sloan, 2011). We measure SEC penalties using the market reaction surrounding enforcement announcements and recover the objective functions of firm managers and the SEC using SOX as a shock to the strength of SEC enforcement. Our estimation indicates a significant increase in marginal social costs post-SOX and significant decrease in marginal enforcement costs. The evidence is consistent with the decline in market confidence shortly after SOX (Financial Executives Research Foundation, 2005), and the decline in the of misreporting cases due to enhanced public enforcement (Cohen et al., 2008).
We conduct three counterfactual analyses to evaluate the outcomes of alternative enforcement policies. The first addresses the scenario of a regulator with homogenous preferences (i.e., having the same marginal social costs and marginal enforcement costs) across all firms. We find that homogenizing the regulator’s preferences would decrease the heterogeneity in enforcement by 75 percent, suggesting that a substantial amount of disparity in SEC enforcement is due to the heterogeneity in regulator preferences. Next, we evaluate the outcomes of a scenario in which the SEC faces lower enforcement costs. Specifically, we find a 10 percent decrease in marginal enforcement costs leads to an increase in average penalty costs by 6.0 percent and a decrease in average earnings management by 0.8 percent. The modest elasticity of earnings management to marginal enforce costs suggests that expanding the SEC’s budget might have a limited impact on financial misconduct. Last, we limit the regulator’s discretion by making the penalty schedule the same for all firms. We show that adopting such a policy would result in unambiguously undesirable outcomes, including higher enforcement cost but little effect on earnings management, relative to the baseline policy that involves discretion. Given the regulator’s preferences, removing its discretion by imposing one-size-fits-all enforcement policies would lead to worse outcomes.
Our study finds that removing the SEC’s discretion in enforcement can lead to undesirable outcomes, and it thus informs the policy debate of whether financial regulators should be granted discretion. Our findings also shed light on the efficacy of expanding the SEC’s budget in financial fraud prevention. Finally, as our framework does not allow us to estimate the preferences of a social planner, we caution readers not to make inferences about social welfare based on our findings.
 Securities and Exchange Commission (SEC). “What We Do”. SEC.gov. U.S. Securities and Exchange Commission. (2013). Retrieved March 24, 2017.
 We follow the framework of Kang and Silveira (2021), who study the role of discretion in the enforcement of water quality regulation in California.
 Kang, K., and B.S. Silveira. “Understanding Disparities in Punishment: Regulator Preferences and Expertise.” Journal of Political Economy 129(2021): 2947-2992.
 Cox, J. D., and R.S. Thomas. “Public and Private Enforcement of the Securities Laws: Have Things Changed Since Enron?” Notre Dame Law Review 80 (2005).
 See https://www.sec.gov/news/speech/2012-spch121312cmlhtm for more information on the SEC’s use of unsigned discretionary accruals.
 Dechow, P.M., W. Ge, W., C.R. Larson, and R.G. Sloan. “Predicting Material Accounting Misstatements.” Contemporary Accounting Research 28 (2011): 17-82.
 Financial Executive Research Foundation (FERF). Special Survey on Sarbanes-Oxley Section 404 Implementation. Morristown, NJ: Financial Executives International and Financial Executives Research Foundation, 2005.
 Cohen, D.A., A. Dey, and T.Z. Lys. “Real and Accrual‐Based Earnings Management in the Pre‐and Post‐Sarbanes‐Oxley Periods.” The Accounting Review 83 (2008): 757-787.
This post comes to us from postdoctoral researcher Chuan Chen at the University of Wisconsin-Madison and professors Yanrong Jia at Baruch College’s Zicklin School of Business, Xiumin Martin at Washington University in Saint Louis’ Olin School of Business, and Bernardo Silveira at the University of California, Los Angeles. It is based on their recent article, “Assessing the Objective Function of the SEC against Financial Misconduct: A Structural Approach?” available at here.