The impact of securities law enforcement on investors’ valuation of public companies has important implications for the design of capital market regulation. Academic theories indicate that public enforcement helps constrain firm insiders, who have access to information unavailable to outsiders, from maximizing their own objectives at the expense of investors (a conflict known as an ‘agency problem’). These theories suggest that enforcement’s ability to constrain bad behavior can help investors receive a greater share of a firm’s cash flows and can lower the discount rate (the interest rate used to value a firm’s stream of expected cash flow). In short, enforcement may improve both of the traditional inputs to a firm’s valuation (cash flows and discount rate). However, some researchers question whether public regulators really do help solve agency problems. They maintain that regulators are often incompetent, or are ‘captured’ by influential coalitions, and argue that inefficient public enforcement may simply create compliance burdens, which neither protect investors nor enhance valuation.
The debate over the effects of enforcement on valuation has been difficult to resolve, partly because variation in enforcement is usually contaminated by other factors. Measures of legal strength across countries tend to be correlated with many other cross-country differences, so it is hard to determine the source of measured differences in valuations. Changes in enforcement across time are often explained by the behavior of firms, or else they coincide with market factors (booms, busts, or other failures that rouse regulators to action). This makes it hard to separate changes in the level of enforcement from the factors that prompt enforcement activity. It’s also challenging to distinguish between changes in firm value that result from enforcement and ones that originate from other sources (such as macroeconomic conditions, or firm-specific news).
To shed light on how enforcement may affect valuation, I use a setting that is less likely to suffer from these problems. Over the past few decades, the rate of SEC enforcement actions toward U.S.-listed foreign firms have gone from almost nonexistent to a level comparable to that for domestic firms. There is no evidence that this increase resulted from changes in firm behavior, market cycles, or other confounding factors. Instead, the SEC appears to have gained traction after the events of 9/11, when it expanded its working relationships with the foreign authorities in order to track financing for illicit activities like terrorism. These relationships were solidified through formal information-sharing agreements intended to facilitate cross-border enforcement. This change in enforcement is unique because it is arguably unrelated to the capital markets. Consistent with this notion, the tests in my study indicate that the increase in the number of enforcement actions cannot be explained by proxies for firm malfeasance or other predictors of litigation; and the timing of these actions does not appear to be correlated with other events that drive systematic changes in value.
This transition from infrequent to frequent enforcement, occurring independently of changes in capital markets, provides an excellent laboratory in which to study enforcement and valuation, because it signals that the SEC really is getting tougher on malfeasant managers. This reduced tolerance for misconduct may curtail the ability of managers to expropriate from or mislead outside investors, and this could lead investors to raise valuations. At the same time, compliance burdens, which may not enhance firm valuation, could also increase.
The net impact of the increased enforcement can be inferred from security returns of firms that are subject to it yet not accused of wrongdoing—that is, returns of ‘nontarget’ U.S.-listed foreign firms. I infer the net valuation effects of enforcement using tests of the non-target firms’ changes in value during 10-day windows surrounding SEC enforcement events against other U.S.-listed foreign firms, which I call ‘target’ firms. These short windows allow me to more accurately measure enforcement-related valuation changes than would longer windows or differences in firm valuations measured by market-to-book ratios or Tobin’s Q. They should capture the effects of enforcement on valuation, be they positive or negative. The scattershot timing of SEC enforcement actions helps to rule out the possibility that I misattribute the changes in value to enforcement. Alternative sources that are the true sources of changes in value would have to coincide with multiple enforcement actions whose timing has no discernable pattern.
My results indicate a net increase in value associated with increases in enforcement. That is, during the 10-day windows surrounding SEC enforcement against a foreign firm, the nontarget foreign firms experience positive stock returns (even after economic effects attributable to U.S. and home markets are purged). This finding is consistent with investors (on average) viewing the benefits of additional SEC protection as outweighing any related increases in compliance costs. The magnitude of the returns during these windows varies predictably based on the firms’ home-country regulatory strength: firms from countries with low regulatory quality experience the greatest benefits. This cross-sectional evidence strengthens the inferences because it is consistent with larger reductions in agency conflicts, expropriation, and other investment risks in those countries where such risks are perceived as most prevalent. Finally, the magnitude of the response declines over time. This is consistent with the market gradually adapting its expectation of SEC oversight to the new enforcement regime.
In sum, I examine the link between enforcement and firm valuation using a research setting that appears to address some of the challenges that earlier authors encountered in identifying these concepts. My findings highlight the dynamic nature of the enforcement setting. The threat of SEC enforcement is significant for U.S.-listed foreign firms and has increased in recent time periods. I use the enforcement events to construct an event study of nontarget firms that offers sensible measurement of both enforcement and changes in firm value. The event study results show that (a) more robust enforcement can increase firm value, (b) enforcement benefits are greater for firms from countries with regulatory weakness, and (c) the response to enforcement declines as investors adjust to a new enforcement policy.
This setting rules out many alternative explanations. Nonetheless, the results do not support the idea that more oversight always enhances value. The relation between enforcement and firm value is not necessarily monotonic, and increasing enforcement beyond an optimal level could result in compliance costs that outweigh the benefits of investor protection (leading to negative effects on value). Also, the results may not generalize to all settings, because research proposes that foreign firms may be unique in their intention to signal their credibility by bonding to more stringent legal regimes.
Roger Silvers is an Associate Professor at the Accounting Department of the University of Utah.