the SEC a Tough Enough Watchdog?
Evidence from Comment Letters
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?
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?
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.
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 www.sec.gov.
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.
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).
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.
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.
responded to the first issue by preparing a table that provided
all the required detailed information for each type of hedge relationship
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
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
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.
Areas Generate the Most 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.
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.
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.
sections that generated the highest number of issues are shown
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.
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
Companies Does the SEC Focus On?
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.
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.
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.
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
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’.
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.
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
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
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
Should the SEC Focus on?
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.”
areas should the SEC have been focusing on to protect investors
in national commercial banks?
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.
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
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.
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.
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.
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 firstname.lastname@example.org.