Is the SEC a Tough Enough Watchdog?
Evidence from Comment Letters

By Victor Valdivia

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DECEMBER 2007 - In the aftermath of an unprecedented real estate boom, the financial services industry and its regulators are being subject to close scrutiny. Questions being raised include: What are the losses due to loan defaults and foreclosures? What is the fallout from the widespread use of nontraditional lending products such as adjustable rate mortgages (ARM)? What is the impact of the deterioration of lending standards, which allowed loans with no documentation or down payments? Did regulators and rating agencies perform their roles properly? How sound are the major financial institutions?

Repercussions are being felt throughout the economy, and those impacted include consumers, financial institutions, and investors. Several regulators are also important players in this drama. This article focuses on one of the most important watchdogs, the SEC, and how it has been doing in its oversight of national commercial banks. Has the SEC focused primarily on the disclosure of information critical to investors in the banks financing the recent real estate expansion? Or has the SEC been focused on enforcing strict adherence to existing accounting standards? Has the SEC focused on underlying economic substance, or on accounting form?

To address these questions, the content of SEC comment letters on
commercial banks was examined. These comment letters are written by the SEC after a company files a financial report. Comment letters contain questions on the report filed, as well as requests for additional information, and require the filer to send a response to the SEC. The author studied the content of this correspondence to reveal the areas on which the SEC focuses its attention.

Comment Letter Process

The SEC began the wide dissemination of comment letters, as well as the filers’ responses to these SEC letters, for all filings submitted after August 1, 2004. Before this, the correspondence was available only to those requesting access under the Freedom of Information Act. This caused an uneven and selective availability of this information. Comment and response letters are now released within 45 days of the completion of the SEC’s filing review and are freely available at

Exhibit 1 shows this correspondence process. After a company files an annual or quarterly report with the SEC, the SEC’s Division of Corporation Finance selects some filings for review. For those cases selected, the SEC staff writes a letter to the company on the specific filing. The content of these letters consists primarily of specific questions on the report and requests for additional information. The company usually has 10 business days to reply to the SEC.

The SEC staff can send follow-up letters that prompt filers to write additional response letters. Several such rounds of correspondence are possible. This correspondence cycle concludes when the SEC staff is satisfied with the responses from the filer.

Although the SEC uses these letters to opine on any type of filing subject to requirements of the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Indenture Act of 1939, or the Investment Company Act of 1940, this article focuses only on comment letters related to annual (10-K) and quarterly (10-Q) reports. The SEC reviews these filings selectively, but must review the 10-K reports of every registrant at least every three years, according to the requirements of section 408 of the Sarbanes-Oxley Act (SOX).

The wide dissemination of SEC comment letters and their responses from filers illuminates the communication between the SEC and filers, and increases the transparency of the reporting and regulatory process. Public companies can use the letters to improve on their own reporting practices. In addition, the content of the letters can reveal the key areas on which the SEC’s review concentrates.

Sample Comment and Response Letters

As an example of the correspondence between the SEC and a registrant, consider the case of the SEC’s review of Amcore Financial’s Form 10-K for its fiscal year ended on December 31, 2005 (Exhibit 2). This shows that the SEC’s initial comment letter raised two issues related to the 10-K’s notes to the financial statements, “Note 1—Summary of Significant Accounting Policies— Derivative Financial Instruments and Hedging Activities.” The first issue requests additional information on hedge relationships. The second issue focuses on the use and applicability of the shortcut method of accounting for derivatives.

The company responded to the first issue by preparing a table that provided all the required detailed information for each type of hedge relationship used. (Exhibit 2 shows only the initial SEC comment letter and not the follow-up correspondence.) Regarding the second issue, the company acknowledged that it did use the shortcut method of derivative accounting and described how it determined that some of its hedges qualified for this treatment.

The SEC issued a follow-up comment letter with two additional requests. First, the SEC requested an “example demonstrating the hedge strategy of a fixed-rate forward loan commitment and the subsequent loan.” As in its initial letter, several specific items were requested, such as the terms of the hedged and hedging items, and the risk being hedged. Second, the SEC requested that the filer provide an analysis for the use of paragraph 65 of SFAS 133. The company responded by providing a detailed response, after which the SEC sent a final letter indicating that the review of the company’s filing was complete.

In this particular example, there are a total of five letters: two comment letters, two response letters, and a final letter concluding the review process. All of these letters concerned just the two issues noted above.

Companies Examined

The authors focused exclusively on the national commercial bank sector, with the Standard Industrial Classification (SIC) code of 6021. This sector includes well-known large banks, such as Bank of America, Citigroup, and Wells Fargo, as well as smaller ones, such as Dekalb Bankshares from South Carolina. State commercial banks, savings institutions, and broker/dealers all are classified under different sectors.

A random sample of 101 national commercial banks was selected for this study. Some of the banks were selected for review by the SEC, and others were not. The sample was restricted to corporations that filed 10-K or 10-Q reports between August 1, 2004 (which could have given rise to comment letters that are widely available to the public), and December 31, 2006.

The SEC selected 35% of all filers in the sample for review. On average, there were four letters per reviewed filing. The maximum number of letters for a single filing was 11, reflecting five rounds of correspondence plus the final letter from the SEC indicating that the review process was complete.

Which Areas Generate the Most Issues?

All issues covered in the SEC comment letters and the companies’ response letters are organized according to the appropriate section of the annual or quarterly report. As shown in the sample comment letter in Exhibit 2, the SEC identifies the section in the comment letters. The outline of a representative 10-K or 10-Q report filed with the SEC is presented in Exhibit 3 (Part I), Exhibit 3 (Part II). This sample report outline has three parts. Part I contains general, high-level information on the company. Part II covers the Management’s Discussion and Analysis (MD&A), the financial statements, and detailed notes to these statements, as well as a section on internal controls. Part III contains additional information on control persons, related-party transactions, and executive compensation, as well as officers’ certifications and other exhibits.

The topics of each section and subsection in Exhibit 3, as well as their ordering and organization, mirror actual financial reports filed with the SEC. The sections that generated the largest number of issues are highlighted in red, including the four sections on: 1) significant accounting policies for hedging and derivatives; 2) merger, acquisition, and subsidiary sale; 3) debt and equity securities; and 4) derivatives. These sections each accounted for 5.5% to 6.7% of all issues and together accounted for 25% of all issues. The sections highlighted in red, orange, and yellow together account for half of all issues.

Ninety percent of all issues are directly linked to specific sections of annual reports. The remaining 10% are not directly related to specific sections of a filed report. Instead, these issues are related to current (or 8-K) reports, or to the comment letter process itself, as when a filer requests additional time to respond to the SEC’s comment letter.

The report sections that generated the highest number of issues are shown in Exhibit 4. The sections on “Accounting Policy on Derivatives and Hedging” and “Merger, Acquisition, or Subsidiary Sale” generated the highest number of issues, with each of these sections responsible for 6.7% of the total number of issues in the sample. The 10 report sections shown in Exhibit 4 were together responsible for 43% of all issues.

Note that the first and fourth sections in Exhibit 4 are related to the accounting for derivatives. The first one is related to the accounting policies used in derivative accounting, whereas the fourth one is concerned with the accounting of derivatives. Together, these two sections are responsible for 12% of all issues. By this metric, the SEC’s single most important area of focus is compliance with SFAS 133, Accounting for Derivative Instruments and Hedging Activities.

Which Companies Does the SEC Focus On?

The behavior ascribed to the SEC here is meant to describe the results of the SEC process. The author does not mean to imply that the SEC is using an explicit selection process from, say, a written procedure manual or a policy. Rather, the results presented here indicate that the SEC is behaving in such a way that it effectively shows the selection biases explained below.

What companies does the SEC select for review? Exhibit 5 shows the differences between companies that were selected by the SEC for review and those that were not selected. There are three main differences between these sets of companies. First, firms that undergo an SEC review are, on average, larger, as measured by total assets: The median assets of firms selected for review is $980 million, compared to only $533 million for companies not selected for review. A second difference is that companies selected for review differ from those not selected, according to where their shares trade. For example, 23% of reviewed companies were listed on the New York Stock Exchange (NYSE), whereas only 5% of those that do not get reviewed appear on the NYSE. In contrast, 56% of companies that are not reviewed trade on Nasdaq, but only 43% of companies that get reviewed are on Nasdaq. The third difference lies with the auditor. Companies audited by a Big Four firm are more likely to be reviewed: 51% of reviewed companies were audited by a Big Four auditor, whereas only 29% of firms that were not reviewed use a Big Four auditor, although there are differences among each of the Big Four.

The data presented in Exhibit 5 are informative, but not conclusive, because these attributes (company size, exchange, and auditor) are interrelated. For example, larger firms tend to have shares that trade on the NYSE and also are more likely to be audited by a Big Four firm. Exhibit 6 shows the correlations between several firm attributes and firm size, as measured by total assets. A correlation of 1 means that two variables are perfectly correlated (if one variable increases by 10%, the second variable also increases by 10%). A correlation of –1 means that two variables are perfectly negatively correlated (if one variable increases by 10%, the other decreases by 10%). A correlation of zero means that there is no correlation (if one variable increases by 10%, the other variable does not change).

Several important observations can be made. First, larger companies are more likely to have their shares trade on the NYSE, whereas smaller companies trade on Nasdaq or pink sheets if they are publicly listed. Second, larger companies are more likely to use Big Four auditors than smaller firms. There are differences among Big Four auditors, however. Only PricewaterhouseCoopers and KPMG banking clients are, on average, large companies, whereas those of Deloitte
& Touche and Ernst & Young are not. It is particularly noteworthy that PricewaterhouseCoopers’ clients are comparatively larger than other auditing firms’.

Because of the interrelations between company attributes, the differences in Exhibit 5 between companies selected for review and those that are not, are only suggestive and not conclusive. To identify meaningful relationships, one needs to sort out the interrelations between the different attributes in order to find the separate effects that size, stock exchange, and auditor have on the SEC’s selection of companies for review. A Probit regression model was used for this purpose. The results are presented in Exhibit 7, and they show what companies get selected for review. After controlling for firm size, registrants that trade on Nasdaq or pink sheets are less likely to be selected for review, whereas companies audited by PricewaterhouseCoopers are more likely to be selected for review.

What companies are reviewed due to derivative issues? This is an important question because the single biggest focus area for the SEC is that of derivatives, representing 12% of all issues. It is interesting to see what kinds of companies have such derivative issues. The results of a Probit analysis indicate that, after controlling for size, companies that trade on Nasdaq are less likely to be selected for the review of a derivative issue.

What companies generate the most issues? It is also important to find out what kinds of companies generate the highest number of issues. The results of a regression model indicate that there are three main factors that increase the number of issues in a review (Exhibit 8). First, company size matters; larger companies generate a larger number of issues. Second, companies with shares listed on the NYSE also generate a larger number of issues, even after controlling for size. This implies that a large company with shares traded on the NYSE is more likely to generate more issues than one of the same size with shares trading on Nasdaq. Third, companies audited by PricewaterhouseCoopers also show a larger number of issues.

What Should the SEC Focus on?

The stated goal of the SEC is to “protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation.” The SEC seeks to achieve this goal by requiring “public companies to disclose meaningful financial and other information to the public. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security. Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions.”

What disclosure areas should the SEC have been focusing on to protect investors in national commercial banks?

During the last several years, these banks have been active intermediaries in financing an unprecedented real estate boom. An important characteristic of this expansion has been the increased use of innovative financing products, such as ARMs, interest-only initial periods, and low initial teaser interest rates. The risk of these new products is that monthly mortgage payments due can increase over time, raising default rates, charge-offs, and losses. Another characteristic of the recent period has been the deterioration of lending standards, which allowed lending without borrowers making a down payment or submitting documentation.

Given this backdrop, if the SEC were to achieve its stated goal of protecting investors through the disclosure of meaningful economic information, it should have been working to enhance disclosure on the increased risks taken by banks during the real estate boom. Improved disclosure on the allowance of loan losses, estimates on charge-offs, anticipated foreclosure rates, lending quality, ARM lending, as well as any expected increases in the impairment of investments, would be welcome.

Admittedly, according to the findings of this study, the number of issues that the SEC reviewed related to these topics is one of the areas that received the most attention. Exhibit 4 shows that the 10-K
sections of allowance for loan losses, nonperforming assets, delinquencies, foreclosures, and impairments generated 4% of all issues. In comparison, however, derivative accounting sections generated three times as many issues.

Underlying Challenges

The SEC needs to refocus its attention and overcome two key challenges. First, the SEC currently uses its valuable resources to ensure that accounting standards are followed. This effort does not seem to leave sufficient resources to enhance disclosures in areas that are critical to investors. The second challenge is that accounting standards have, until recently, centered on historical information. If the SEC is going to achieve its mission of protecting investors by providing valuable information, it also needs to emphasize the quality of disclosures related to forward-looking information. This will require a shift in emphasis in accounting standards away from historical costs and toward present value.

According to the evidence presented here, the SEC’s focus has been on enforcing accounting standards, rather than ensuring that relevant investment information is made widely available to investors. As such, our watchdog is falling short of investors’ expectations, more focused on accounting form than on economic substance.

Victor Valdivia, CPA, PhD, is the CEO of Hudson River Analytics, Inc., based in New York City, and a professor of accounting at Towson University, Towson, Md. He can be reached at




















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