A new UT Dallas School of Management study of federal securities regulation has good and bad news for companies that have misstated their earnings.

The study shows that companies who are proactive about self-disclosure are more likely to be sanctioned by the Securities and Exchange Commission, the federal agency charged with enforcing the nation’s securities laws. But the upside of being  cooperative is likely to be a lower penalty, according to the research by Dr. Rebecca Files, an assistant accounting professor.

Files studied 1,249 financial restatements made between 1997 and 2005, paying particular attention to how the SEC dealt with securities law violations.

“The SEC provides a set of guidelines it uses to determine whether or not to pursue violations,” Files said. “These documents also provide some guidelines for what the SEC is going to reward or penalize following a given law violation.”

Files initiated her study to quantify what happens in the real world.

The study, titled “SEC Enforcement: Does Forthright Disclosure and Cooperation Really Matter?”, approaches the issue from the perspective of the manager, who is likely to wonder, “Can we take certain actions following a law violation that will help limit our penalties from the SEC and the likelihood of being sanctioned?”

With that idea in mind, she began studying SEC documents, focusing on four characteristics:

  • Company-initiated investigations into misstatements.
  • Timely disclosure of restatements in press releases.
  • Prominent disclosure of restatements in the headlines of press releases.
  • Prominent disclosures of restatements in a Form 8-K, an amended SEC filing.

“This report focuses specifically on restatements, because it is one of the few law violations for which I can distinguish between companies that receive an SEC sanction and those that don’t,” Files said. “Other types of law violations are often not disclosed unless discovered and ultimately sanctioned by the SEC.  It’s important to note that my results may not generalize to other law violations, such as Regulation FD violations or insider trading.”

According to her report, the SEC is likely to reward timely, well-publicized self-disclosures through reductions in the amount of penalties. At the same time, company-initiated investigations actually increase the likelihood of an SEC sanction.

“The most likely reason [that penalties are reduced] is because company-initiated investigations reduce the SEC’s costs pretty significantly,” Files said. “The information is usually gathered by the firm and its own investigators, thus reducing the SEC’s costs not only to identify violations but to gather details about each case.”

The study also concluded that firms are more likely to be sanctioned when they prominently disclose their restatements in the headline of a press release. SEC investigators routinely scour press releases and seem to be heavily influenced by disclosures that have high visibility.

“The results of the study do not necessarily suggest that the SEC is responding inefficiently to the overwhelming number of securities violations,” Files said. “They could suggest, though, that cooperation is rewarded less often than previously thought.”

Files said that the study was not intended to make any value judgments regarding the SEC, noting that the commission continuously makes adjustments in the way it regulates the security industry, including increasing the number of staff to better and more proactively investigate violators — especially in the aftermath of the Bernie Madoff investment scandal.

“I undertook this study to provide managers and businesses with information that wasn’t readily available to them,” Files said. “Although it’s probably in the SEC’s best interests to remain as tight-lipped as they can be about the process, that’s certainly not what managers want. They want to know what types of rewards that they can expect — and not expect — to gain from self-disclosure. My study helps fill in some of those gaps.”