The process of producing and disseminating financial reporting disclosures often involves multiple parties, each of whom is under the authority of a specialized regulator. For example, certain information in 10-K filings is provided by third parties who operate under a different regulator than the SEC. Despite the prevalence and importance of multiple pairs of regulator and regulated in information production and dissemination, little is known about regulatory effectiveness in these circumstances. In a new paper, we investigate the interaction of two important financial regulators – the SEC and FINRA – focusing on conflict of interest disclosures by fairness opinion (FO) providers in mergers and acquisitions (M&A).
Analyzing how the SEC and FINRA interact in enforcing the conflict of interest disclosure in FOs is important because of the relevance of FOs in M&A transactions. FOs, provided by investment banks, are important in target boards’ M&A due diligence. FOs may provide incremental information, impose constraints on equity values, and discipline transactions. However, they can instead be biased and uninformative, particularly when there are conflicts of interest between the FO client’s management and the investment bank providing the FO.
The SEC and FINRA each provide regulatory guidance on conflict of interest disclosure (see Figure 1 for the illustration of the setting). The SEC has authority over the company, while FINRA has authority over investment banks acting as FO providers. FO providers have the most information about their conflicts of interests with a client, and they communicate this information to the firm’s board. Firm managers then disseminate conflict of interest information under their firm’s reporting requirements as an SEC registrant.
Figure 1
The SEC does not require FO conflict of interest disclosures in all M&A transactions but has long required such disclosures in mergers and deals requiring shareholder votes. The SEC comment letter process is the primary enforcement mechanism for disclosure violations in M&A filings. However, due to the strict timeline of the SEC’s review and the complexity of M&A filings, SEC staff may lack the time and resources to thoroughly investigate undisclosed conflicts of interest or low-quality disclosures.
In contrast, since late 2007, FINRA has required its members (i.e., investment banks) to disclose conflicts of interest for all M&A transactions to a client firm’s board when writing FOs. FINRA evaluates investment banks’ internal control effectiveness in ensuring compliance with FINRA regulations and operates under SEC oversight. However, FINRA is a self-regulatory organization (SRO), and some critics question whether SRO incentives result in under-enforcement. Moreover, the primary mechanism for disclosing conflict of interest information to investors is through SEC filings. As FO providers do not directly disclose information to investors, it is possible for an FO provider to include a conflict of interest disclosure in their FO, only to have management remove or modify it when creating the related SEC filing.
It is unclear how the SEC and FINRA interact with each other, as they oversee different entities involved in the same transaction. On one hand, given that FO providers are the most informed about their conflicts of interest, FINRA regulation likely increases the certainty of an FO-client manager about conflict of interest information. When that happens, the SEC can better enforce informative disclosures. On the other hand, the SEC and FINRA have overlapping mandates over the same transaction and may to some extent fulfill each other’s roles. When FINRA starts regulating the same area, the SEC may delegate some regulatory responsibilities to FINRA. The SEC’s enforcement of firm disclosures could become less intensive, anticipating that FINRA will specifically target FO providers, particularly since FINRA operates under SEC oversight. However, as FINRA has its own expertise and authority over a different regulated entity than the SEC does for conflict of interest disclosures, it may not be as successful as the SEC in fulfilling the responsibilities shifted to it.
We examine how firms’ conflict-of-interest disclosure compliance changes after different types of regulatory oversight are introduced. We measure disclosure compliance using self-constructed indices of disclosure quality. We collect data on whether firms disclose conflicts of interest in their SEC filings and manually code information about their FO providers’ conflicts of interest, including financial, business, and personal relationships and contingent fees. High-quality disclosures are unambiguous about whether a conflict of interest exists and give specific information about the nature of the conflict of interest and how it is mitigated.
Depending on the type of M&A transaction and its year, we can observe conflict of interest disclosures under the jurisdiction of zero, one, or two regulators. We find an increase in the quality of FO conflict of interest disclosures with a single regulator relative to no regulator, demonstrating the efficacy of both FINRA and the SEC. However, when examining the interaction, we find a negative association between the presence of dual oversight and the quality of FO conflict of interest disclosure. The results suggest that the SEC delegates some enforcement responsibility to FINRA once the latter becomes involved in conflict of interest disclosure regulation and that the effectiveness of SEC enforcement decreases enough to outweigh FINRA’s impact. We also observe a stronger negative association between dual oversight and conflict of interest disclosure quality when the SEC faces resource constraints. Instead, the negative effect is reduced when there is a greater demand for protecting shareholders, as in the case of contentious deals, greater concerns about the quality of the registrant’s disclosure (due to prior comment letters or restatements), and the presence of a private bidder.
Taken together, our evidence shows that, although oversight from more regulators may increase the strictness of a regulation’s enforcement or could provide multiple dimensions of regulatory expertise, the involvement of multiple regulators can also lead to contradictory or duplicative requirements. By showing this, our study contributes to the literature on the regulatory design of financial reporting disclosures, especially when disclosures have negative implications. Moreover, we advance our understanding of the effectiveness of FINRA enforcement and its interaction with the SEC in enforcing the same disclosure. Beyond M&A transactions, the SEC works with FINRA to see that underwriters provide sufficient disclosure of the underwriting terms and conflicts within the S-1 registration statement filing. We find that adding FINRA’s regulation to SEC enforcement is associated with a decrease in the quality of the conflict of interest disclosures. These results suggest that differences in the specialized knowledge of the SEC and FINRA are not so large as to lead to an enhanced conflict of interest disclosure quality when both oversee a given conflict of interest disclosure.
This post comes from professors Phil Berger at the University of Chicago’s Booth School of Business, Rachel Geoffroy at The Ohio State University, Claudia Imperatore at Bocconi University, and Lisa Yao Liu at Columbia Business School. It is based on their recent paper, “How Do Multiple Regulators Regulate? Evidence from Fairness Opinion Providers’ Conflict of Interest Disclosures,” available here.