Conflicted Regulators

Independence is an important feature of financial reporting oversight, contributing to public trust in capital markets. To guard against conflicts of interest that may impair independence, regulatory agencies typically have policies restricting employees’ financial and personal relationships with regulated entities. For example, workers moving from the private to the public sector are often subject to cooling-off periods that exclude them from decisions involving their prior employers for some time. Although such cooling-off policies are commonplace, there is little empirical evidence on the optimal design of such policies, such as their scope and length. In a working paper, we explore how prior employment affiliations of examiners in the Securities and Exchange Commission’s (SEC) filing review program affect the strictness of their oversight.

The SEC’s Division of Corporation Finance (DCF) reviews registrants’ financial statements to “deter fraud and facilitate investor access to information” (SEC 2019). A large fraction of examiners conducting these reviews are accountants, most of whom previously worked at one of the Big 4 public accounting firms (Deloitte, EY, KPMG, and PwC). These Big 4 accounting firms conduct most public company audits, meaning that DCF accountants may review financial statements audited by their former employer (i.e., connected examiners). To identify connected examiners, we use FOIA requests to collect information on the professional backgrounds of over 250 DCF accountants. We then study the effects of these connections on the outcomes of over 19,000 financial statement reviews.

We find that review teams with connected examiners are significantly less likely to detect errors in the filings under review. Among a sample of reviews of financial statements that are known to contain an error (as evidenced by a subsequent restatement), teams with connected examiners are about 30% less likely to catch the error. We also find connected examiners make fewer accounting comments and push back less on companies’ responses. Our results indicate that connected examiners catch fewer errors because (1) they are less likely to ask questions on financial statement areas that are later restated, and (2) even when they ask questions in those relevant areas, their comments are less likely to induce the company to restate the financial statements. We also show that these effects attenuate over time and when SEC examiners have more work experience between their public accounting job and joining the SEC.

Our study has important implications for financial regulators, where the “revolving door” of workers is a common occurrence. Cooling-off policies are typically short-term—the SEC restricts the connections we study only during examiners’ first year of employment—and pertain to direct oversight of former employers. In contrast, examiners in our setting review the financial statements of prior employers’ clients, not the work of their prior employers directly. We find that even indirect prior employment affiliations can negatively affect oversight, and that these effects can persist for several years. Although the background and potential conflicts of interest among senior regulators often garner significant attention (see e.g., Cox and Thomas 2019), our findings illustrate that the independence of regulators performing day-to-day oversight activities also has meaningful effects on regulatory outcomes.