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Until 2004, the U.S. Securities and Exchange Commission (SEC) “comment letters”—queries sent to companies regarding accounting disclosures—were withheld from the general public. As a result, a cottage industry sprang up around selling material obtained in response to Freedom of Information Act requests. To stem the flood of paperwork and ensure more equal access to information, the SEC announced comment letters would be uploaded to a database, called EDGAR, accessible to the public on the SEC’s website.
However, the SEC allowed a 45-day pre-release window (later shortened to 20 days) after the close of each review, so that managers’ confidential treatment requests and SEC internal documentation would not be inadvertently released. This exclusivity window created a brief interval of information asymmetry, in which information intended for—and potentially of great interest to—investors is available only to corporate insiders.
Bret Johnson, assistant professor of accounting at George Mason University, recently co-authored a paper in Management Science finding that SEC comment letters are leaking out among investors close to the company concerned, who then use it to their advantage. Technically, such information-sharing violates Regulation Fair Disclosure (FD), which prohibits companies from sharing secrets with network partners such as institutional investors and analysts.
“I think one of the hardest regulations to enforce is Regulation FD, because it’s so hard to tie down whether information was privileged when they received it,” Johnson says. “There is so much we can’t observe as researchers, let alone the SEC.”
Nonetheless, Johnson and his co-authors[1] found evidence of abnormal trading activity in the time between issuance and public release of comment letters. “Mutual funds in our study, on average, net sold $724,000 [worth of] equity securities per firm in the six days following the receipt of each SEC comment letter,” the paper states. Additionally, the amount of abnormal selling per letter increased as the exchanges with the SEC grew to two or more letters—supplying yet more evidence of a causal relationship, since deeper and thornier issues, i.e. those most meaningful to investors, presumably require more rounds of correspondence. The selling activity was also higher for comment letters that addressed more critical issues.
The researchers’ intuition that insiders were sharing the contents of comment letters with close associates seemed to be confirmed by a higher intensity of selling activity around firms whose directors were more well-connected, and those with an above-median percentage of dedicated institutional ownership.
Going further, the researchers determined that these sell-offs generated significantly beneficial financial outcomes for the mutual funds in the 45 days after a private comment letter was sent. The more abnormal selling mutual funds engaged in during the private period, the greater the monetary rewards.
To be sure, a comment letter from the SEC isn’t necessarily a red flag that would draw investor attention. It is estimated that only about half of 10,000 reviews result in a comment letter being issued, and many types of comments are quite routine. Letters could be triggered by anything from a simple filing error to shifting SEC priorities that go beyond any one company. However, they can also be leading indicators of impending trouble.
Johnson says that comment letters in general contain “signals [that] could be very subtle or small pieces of information. It might not be a big impairment or write-down. It may just be that the investors are learning a little bit more about management, how transparent they’re willing to be with the SEC staff reviewers…They’re learning these more qualitative aspects, as well as what the numbers are saying.”
Johnson is intimately familiar with how the SEC operates, having worked for six years as a staff accountant in the agency’s Division of Corporation Finance, which handles the filing review process and the issuance of comment letters. In addition, he held a one-year academic fellowship at the SEC ending in July 2021, where he served as a “liaison between SEC staff and the academic community, keeping them abreast of developments related to their policies.”
As with the information leakage paper, Johnson’s research often zeros in on issues that have policy implications for the SEC, and it has been warmly received by his former colleagues: “They are hungry to receive academic research that could help improve their policies and practices,” Johnson says.
He hopes that his research will prompt a debate within the agency about the optimal length of time that should transpire before comment letters are added to EDGAR. Further shortening of the 20-day window, or even releasing letters in real time, could be considered, but these options would possibly undermine the agency’s goal of fostering frank and open dialogue with companies. Johnson recalls SEC staff accountants saying to him, in effect, “When we issue a comment to a company, we want them to really defend or articulate their accounting positions. We encourage them to push back.” It’s unclear how curtailing the window of confidentiality would affect managers’ willingness to engage.
Johnson says his findings should also inspire managers to get their interactions with the SEC right the first time, thus avoiding drawn-out exchanges that are likely to be overheard by insider-adjacent investors. “An audit partner I was recently talking to about this process said, ‘You don’t want to get into a pen-pal relationship with the SEC.’”
[1] Marshall A. Geiger and Abdullah Kumas of University of Richmond, and Keith L. Jones of University of Kansas.