Study: SEC reorganization, scrutiny may reduce corporate risk-taking

By Mike Koon

Sometimes the best of intentions leads to some less desired, unintended consequences. That’s the argument Gies College of Business professor Kangkang Zhang makes in examining the Securities and Exchange Commission’s 2007 decision to reorganize its regional enforcement structure.

The SEC’s mission is to “protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation”. One of the SEC’s key enforcement areas involves financial reporting and disclosure compliance.

Before 2007, the SEC had five regional offices and six district offices. Those district offices support the regional offices. To increase enforcement efficiency and further protect investors, the SEC decided to elevate the six district offices to regional offices, bringing the total to 11. These regional offices have the authority to investigate and enforce violations of federal securities laws, such as insider trading, market manipulation, and fraud.

While the reorganization expanded the SEC’s local enforcement capacity and gave the SEC more resources to oversee illegal practices, Zhang discovered that the move ultimately led many firms to reduce risk-taking, such as investment in research and development, a key driver of long-term growth. Zhang and co-authors David Weber and Nina Xu (both from the University of Connecticut) released their findings in “SEC scrutiny and corporate risk-taking”, which was published in the Journal of Accounting and Economics.

Specifically, Zhang and her coauthors found that this increased SEC scrutiny led to as much as a 4.5 percent decrease in stock return volatility, reduced risky investment via a 6 percent lower R&D spending, lower innovation output in the form of fewer forward patent citations, and less earnings management.

Zhang said that to keep travel expenses low, the SEC prioritizes cases that are closer to their offices. The authors provide evidence consistent with higher local enforcement intensity at the newly elevated offices, including increases in office resources and a greater likelihood of investigation following major restatements.

“The added regional offices meant more companies were in the immediate purview of the SEC,” said Zhang, an assistant professor of accountancy at Gies Business. “What we are hypothesizing is that when the SEC is closer, you are less likely to do some accounting tricks.”

Zhang notes that it’s common for some companies to manipulate earnings through those accounting “tricks” following failures in R&D or other risky endeavors.

“Especially for younger CEOs, it is likely that those failures will go public and be scrutinized by shareholders,” Zhang said.

Why regulatory proximity affects risk-taking decisions

Risky bets can pay off big — but when they don’t, the downside shows up fast. And when a company has a major reporting problem (for example, a serious restatement), that’s the kind of trigger that can put it on the SEC’s radar. The SEC’s decision to elevate its district offices made it more likely that these accounting practices, which often occur after a failure, would be discovered, taking the option of smoothing or managing reported losses off the table. Because of that, many companies instead chose to invest less in risky projects, limiting their exposure to failure when heightened scrutiny makes poor outcomes harder to manage after the fact.

“More SEC oversight meant less accounting manipulation and less room for discretionary accruals,” Zhang said. “As a result, companies became more cautious about pursuing riskier projects because of this accounting restriction.”

On the surface, the reduction of accounting manipulation is a good thing for investors. After all, SEC scrutiny promotes market transparency with companies forced to report true numbers that reflect their fundamentals, Zhang said.

“Better disclosure leads to better information. The less information asymmetry, the better the market transparency,” she explained.

But the paper flags a real tradeoff: tighter oversight can also make managers more risk‑averse, which may reduce willingness to pursue higher‑uncertainty initiatives. The study does not claim what the “optimal” level of SEC scrutiny should be — it highlights that stronger enforcement can come with unintended behavioral side effects.