Are Lessons Well Learned? Evidence from SEC Enforcement Releases

Abstract

SEC Accounting and Auditing Enforcement Releases (AAERs) sometimes demonstrate wealth pursuing through compensation schemes as a motive for misreporting (henceforth, compensation-mentioned releases or CMRs). Do firms revise their CEO compensation after CMRs to prevent future misreporting? Conventional Bayesian learning suggests that firms update the misreporting probability as more information becomes available. However, the availability heuristic suggests that firms assess the misreporting probability subjectively based on how easily they recall these releases. I examine the equity-based compensation of non-accused firms and find firms that proactively benchmark their CEO compensation against fraudulent firms named in CMRs significantly reduce their CEOs’ risk-taking incentives, manifested in replacing option grants with restricted stock grants. Changes are greater when firms are closer (both in geography and social identity) to CMRs, which is consistent with the availability heuristic hypothesis. The findings suggest that narratives on misreporting motives in AAERs can affect corporate policies, which provide implications for resource-constrained regulators and corporate policy-makers.

Keywords: SEC enforcement actions; compensation design; limited attention; peer effects

JEL Classification: J33, M41, M52, G38