Courtesy of Braiden Coleman, Ken Merkley, Brian P. Miller, and Joseph Pacelli
The Securities and Exchange Commission (SEC) has a long-standing policy to keep formal investigations confidential. In our recent article, we examine the extent to which compliance with the Freedom of Information Act (FOIA) provides investors with information about ongoing SEC investigations. We exploit a unique empirical setting whereby the SEC denies FOIA requests due to ongoing enforcement proceedings (hereafter, exemption denials). We find that exemption denials predict a substantial number of ongoing and future SEC investigations. Exemption denials are also associated with significant negative future abnormal returns, which is consistent with exemption denials providing a noisy public signal that allows certain sophisticated investors to earn future abnormal returns. Overall, our findings suggest that information transparency laws, such as FOIA, have the potential to limit the SEC’s ability to maintain effective and confidential investigations.
Introduction
An important strategic objective of the Securities and Exchange Commission (SEC) is to “prosecute violations of federal securities laws and hold violators accountable through appropriate sanctions and remedies.” Accordingly, the SEC places a strong emphasis on conductinghigh-quality investigations to ensure investors are protected. A critical part of the SEC’s formal investigation policy is to maintain confidentiality throughout the entire process. This policy is intended to ensure that material information is not prematurely released to a subset of market participants and to protect the reputations of companies and individuals. As a result, the SEC maintains a strict policy of neither confirming nor denying the existence of an investigation unless and until it becomes a matter of public record.
We examine one potential impediment to the SEC’s ability to maintain effective and confidential investigations stemming from freedom of information laws. While these laws were designed to give the public greater oversight of government activity, the requirement to comply with FOIA requests may reveal information about ongoing, confidential investigations that is more accessible to sophisticated investors. This information can thus constitute a noisy public signal that may allow certain investors to earn significant abnormal returns. We assess (i) the degree to which the FOIA denial responses are predictive of ongoing and future formal SEC investigations, and (ii) whether such responses are associated with negative future stock returns.
Given the negative market consequences associated with the SEC investigations, investors have strong incentives to identify firms that are under current investigation by the agency. Although the SEC will not directly confirm nor deny the existence of an investigation, the agency will often deny FOIA requests based on the reasoning that fulfilling such a request would interfere with ongoing enforcement proceedings. The SEC refers to these denials as 7(A) exemptions, hereafter ‘exemption denials.’ It is important to note that such exemption denials were unobservable to the general public throughout our sample period, as the SEC has just recently begun posting the monthly FOIA denial logs. This suggests that any investor seeking information regarding an ongoing SEC investigation during our sample period would have to submit a FOIA request, which represents a potential costly barrier to accessing information. We thus contend that exemption denials can provide an opportunity for certain investors to identify potential investigations that the SEC usually is unwilling to disclose. If these denials are informative, we predict that exemption denials will be associated with (i) ongoing investigations and (ii) future negative abnormal returns.
Background Information & Data Collection
The FOIA allows for nine exemptions that permit government agencies to deny requests. Our study focuses on one exemption to the statute, Exemption 7, which pertains to information compiled for law enforcement purposes. In particular, Exemption 7(A) allows federal agencies to deny the disclosure of information that “could reasonably be expected to interfere with enforcement proceedings.”To obtain the SEC’s exemption denial FOIA responses, we submit a FOIA request to the agency requesting these records. From the SEC, we received a detailedpanel of all exemption denials issued by the agency during the years 2006-2016, including the name of the FOIA requester, the requester organization, the name of the firm that is the subject of the request, and dates for when the request was submitted and closed due to the 7(A) exemption (i.e., ‘exemption denial’). We next obtain raw data on all closed SEC investigations between January 1, 2000, and August 2, 2017, from Blackburne et al. (2019). We then match our FOIA exemption data with this investigation data along with firm fundamentals data from Compustat, market return data from CRSP, and restatement data from Audit Analytics. Our final sample contains 42,249 firm observations by year across our sample period that have the requisite data for our tests.
Results
Our results indicate that exemption denials are positively associated with ongoing and future SEC investigations. The predictive ability of this association is economically significant: in univariate analysis, we find that the conditional probability of having a concurrent SEC investigation based on the occurrence of an exemption denial is 40.1%, which is over four times greater than the unconditional probability of having an SEC investigation (9.0%). Further, the predictive ability of FOIA denials persists after controlling for other well-known predictors of SEC enforcement actions, including a firm’s probability of misstatement, distance to an SEC office, firm-characteristics (e.g., profitability, and prior restatements) and industry (or firm), and year,fixed effects. This evidence is consistent with the confidential information about investigations being revealed through FOIA requests.
Next, we examine whether exemption denials constitute an information signal that predicts future negative abnormal returns. Our results indicate that exemption denials predict negative and significant future abnormal returns, with a mean characteristic-adjusted (size, book-to-market, and momentum- adjusted) annual return beginning on the FOIA denial date of -3.3%. Additional analysis shows that the mean characteristic-adjusted returns range from -0.9% at three months to -5.9% over a two-year window. Moreover, we find similar inferences if a calendar-time portfolio approach is implemented based on potential trades on exemption denial information each month.
We further employ a multivariate regression framework to assess whether the negative returns predicted by the FOIA denials are explained merely by the presence of a FOIA request. Using a sample of all firm-specific FOIA requests, we regress one-year characteristic-adjusted abnormal returns on an indicator for whether the FOIA request received an exemption denial while controlling for firm characteristics that might relate to a firm receiving a FOIA request. We find that FOIA requests are associated with significantly larger negative abnormal returns when the request receives an exemption denial. In addition, we find that FOIA denials that are associated with SEC investigations that are concluded in the same year as the FOIA request, and FOIA denials that are associated with Accounting and Auditing Enforcement Releases (AAERs), predict significantly more negative returns.[1] This is consistent with the future negative returns relating to negative information released after the SEC has finished its assessment. Collectively, this evidence strengthens our case that FOIA denials exhibit negative returns, in part, because they anticipate negative information from investigations (e.g., AAERs).
Overall, these findings suggest that exemption denials constitute an information signal that can tip investors about taking short positions in specific stocks, knowing which stocks to sell to avoid future losses, or knowing which stocks to avoid purchasing.
Conclusion
Our collective evidence suggests that information transparency laws, such as the FOIA, have the potential to limit the SEC’s ability to maintain effective and confidential investigations. In particular, the FOIA requirements create a potential impediment to the SEC’s objective of maintaining fair and orderly markets for investors. As such, our results point to a potential unintended consequence associated with the SEC’s adherence to the FOIA. Regulators should consider this evidence when assessing the net benefits or costs associated with the decision to exempt the SEC from certain FOIA requirements.
[1] Accounting and Auditing Enforcement Releases (AAERs) are released by the SEC when there is sufficient evidence to determine that a company committed a violation. These violations can include infractions such as insider trading or intentional falsification of financial statements and often result in penalties to firms that committed the infractions.
