POLITICAL CONNECTIONS AND SEC ENFORCEMENT

ABSTRAKIn this study, I examine whether firms and executives with long-term political connections through contributions and lobbying incur lower costs from the enforcement actions by the Securities and Exchange Commission (SEC). I find that politically connected firms on average are less likely to be involved in SEC enforcement actions and face lower penalties if they are prosecuted by the SEC. Contributions to politicians in a strong position to put pressure on the SEC are more effective than others at reducing the probability of enforcement and penalties imposed by an enforcement action. Moreover, the amounts paid to lobbyists with prior employment links to the SEC, and the amounts spent on lobbying the SEC directly, are more effective than other lobbying expenditures at reducing enforcement costs faced by firms

IntroductionThe importance of the Securities and Exchange Commission (SEC) is widely recognized by the media, and its enforcement activities are under increased scrutiny following the recent wave of corporate scandals; such as Enron, Global Crossing, Halliburton, Harken, Arthur Andersen, Fannie Mae, Freddie Mac, Providian, and Bernard Madoff Investment Securities, to name just a few. However, the accounting literature has not dedicated much attention to SEC enforcement. In fact, while many studies rely on the SEC's Accounting and Auditing Enforcement Releases (AAERs) to examine the determinants of accounting fraud, they ignore the choice of enforcement targets by the SEC and the impact of political influence on this choice. One notable exception is Kedia and Rajgopal (2011), who find that, because the SEC is resource constrained, it is more likely to investigate firms located close to its offices and with higher visibility. However, while there are anecdotes consistent with firms using political contributions and lobbying to obtain favors from the SEC, there is no systematic evidence on this issue. To assess the likely extent of such behavior, I examine whether firms with political connections have lower SEC enforcement costs in the form of a lower probability of prosecution and lower penalties conditional on being prosecuted.

Theoretical support for the hypothesis that the SEC might be subject to political influence can be found in the regulation models developed by Stigler (1971), Pelzman (1976), and Grossman and Helpman (1994). These models emphasize an exchange relationship: groups of individuals compete for wealth transfers by offering political support in the form of money or votes to regulators. This exchange often takes place in the context of long-term relationships between firms and politicians (Snyder, 1990). The literature on political control of bureaucracies (Weingast, 1984; Weingast and Moran, 1983; McCubbins et al., 1999) further discusses how congressmen can use budget, oversight and the appointment of commissioners to reward (punish) these agencies for decisions that increase (decrease) their constituencies. Gordon and Hafer (2005) show that an association between political spending and reduced regulatory

enforcement may be observed in the absence of political interference if firms use political contributions to signal their willingness to fight agency decisions.

The main contribution of this paper is to study SEC enforcement and how it is affected by political influence. The paper also provides additional evidence on whether firms can influence the enforcement decisions of an independent agency through political expenditures.

To test whether political connections effectively reduce enforcement costs, I examine two different stages of the enforcement process: the decision to begin an enforcement action against a firm or its executives, and the regulatory penalties faced by respondents in the enforcement action. This study suggests that, consistent with earlier studies focusing on the Internal Revenue Service (IRS) (Hunter and Nelson, 1995; Young et al., 2001), the Federal Trade Commission (FTC) (Faith et al., 1982; Weingast and Moran, 1983), the Environmental Protection Agency (EPA) (Mixon Jr., 1995) and the Nuclear Regulatory Commission (NRC) (Gordon and Hafer, 2005), politically connected firms are on average less likely to be involved in an SEC enforcement action and face lower penalties if they are prosecuted by the SEC. In particular, long-term PAC contributions and lobbying expenses are associated with a lower likelihood of enforcement for restatement firms. PAC contributions are also associated with lower penalties conditional on an enforcement action being filed. There is no significant association between long-term lobbying expenditures and penalties imposed at the end of an enforcement action. This casts some doubt on the firms' ability to influence the outcomes of an enforcement action once it is filed. However, firms that directly lobby the SEC on average experience lower penalties if they are prosecuted.

These findings are consistent with firms using long-term political contributions in exchange for regulatory favors. However, one plausible alternative explanation for these findings is that the distraction caused by political consumption might lead to lower firm quality in general, and lower accounting quality in particular. On the one hand, a distracted manager might forgo positive net present value projects and intentionally misreport the firm's performance to conceal the resulting decrease in profitability.1 On the other hand, a distracted manager might devote less effort to financial reporting. In the first case, misreporting is intentional, and a finding of lower expected enforcement costs for politically connected firms is likely the result of political influence. In the second case, misreporting might be unintentional and consequently less penalized.

In an attempt to rule out this alternative explanation, I examine the cross-sectional variation in the association between political expenditures and: (a) the probability of enforcement; and (b) the penalties imposed at the end of an enforcement action. I find that continued contributions to high ranking politicians from the majority party are more strongly associated with a reduction in enforcement costs. Contributions to politicians sitting on committees involved in setting the SEC's

budget or overseeing the agency and, in particular, to their chairmen are also associated with a stronger reduction in the probability of enforcement and penalties. While this analysis produces results that are overall consistent with my hypothesis of political interference in the SEC's activities, it is possible that, because politicians who occupy positions of power are among the most popular in Congress, managers seek them out for personal reasons. To address this issue, I identify firms that either lobby the SEC directly, or use lobbyists with prior employment links to the SEC. I find that firms that employ linked lobbyists experience a larger reduction in the probability of enforcement and in penalties than those that do not. It is unlikely that the distraction theory explains these cross-sectional differences on the association between lobbying expenses and the probability of enforcement and the penalties imposed at the end of an enforcement action. However, these crosssectional differences may be explained by differences in “skill.” In particular, SEC-linked lobbyists may use their experience to advise clients in ways that lower the likelihood of regulatory enforcement and penalties. The empirical tests cannot rule out this alternative explanation for the findings.

The remainder of the paper is organized as follows: Section 2 reviews the literature, and Section 3 develops the hypotheses. In Section 4, I discuss the measurement of political connections and SEC enforcement. In Section 5, I discuss the empirical results, and Section 6 concludes.

2. Literature review The relevant literature can be divided into three strands. The first focuses on SEC enforcement, the second examines the political contributions to congressional and presidential candidates, and the third addresses the ability of Congress and/or the president to control regulatory agencies.

The studies in accounting and finance that use the data on SEC enforcement typically fall into two categories: those that examine the consequences of enforcement actions, and those that use enforcement actions to build a sample of misreporting firms and study the factors associated with this behavior (such as incentives and governance) or to test the power of earnings management proxies developed in the literature. The first set of studies documents the severe costs of an enforcement action for the firm and its managers (e.g., Karpoff et al., 2007, 2008a, 2008b; Feroz et al.,1991). Dechow et al. (1995, 1996, 2011) are examples of the second group of studies. These studies ignore the SEC's choice of an enforcement target. One important exception is Kedia and Rajgopal (2011), who document that, given its resource constraints, the SEC is more likely to target firms headquartered close to its offices.

2.2. Political connections The second strand of literature examines the value of political connections. In these studies, the degree of connectedness is evaluated by either identifying the explicit relationships between firms and politicians or measuring the political expenditures made by firms or individuals (PAC contributions, soft money contributions, individual executive contributions and lobbying

expenditures).Although evidence on specific issues is mixed, the findings of these studies suggest that these types of connections are valuable to firms.2 In particular, some studies document that politically connected firms have an overall higher performance (Cooper et al., 2010; Chen et al., 2010).3 This literature also documents a broad array of specific benefits from political connections. For example, Ramanna (2008) shows that politicians who opposed the Financial Accounting Standards Board's (FASB) proposal to eliminate pooling in accounting for business combinations received political contributions from firms that opposed that proposal. Farber et al. (2007) find that firms' PAC contributions surrounding the discussion of a bill concerning stock option expensing had an association with the bill's impact on their financial statements. Tahoun and van Lent (2013) find that financial institutions in the portfolios of key committee members received higher and quicker bailouts. Tahoun (2014) documents that firms exhibiting a strong politician ownership contribution association receive more government contracts.

Rather than examining the indirect effect of political contributions on agencies' regulations, some studies focus on the effects of direct lobbying. These studies examine how firms lobby the SEC through comment letters on proposed regulation or use the decision to send these letters as a measure of the firm's benefit or cost from the regulation (Lo, 2003).

In the models of regulation developed by Stigler (1971) and Pelzman (1976), interest groups compete for wealth transfers by offering political support to regulators in the form of money or votes. Watts and Zimmerman (1978) discuss how these economic theories apply to accounting and how lobbying by interest groups has affected accounting policies. Under this framework, managers might make accounting and political contribution decisions to minimize the probability and the size of the wealth transfers generated by regulatory enforcement.

Chaney et al. (2011) examine the association between earnings quality and political connections in a cross-country setting. They rely on Faccio's (2006) database of political connections and find lower accounting quality for politically connected firms. However, whether these results generalize to a country with high institutional quality like the United States is not clear. In addition, Chaney et al. say little about the mechanisms through which such an association is produced.

Two other studies link political expenditures and accounting decisions in the United States: Ramanna and Roychowdhury (2010) and Yu and Yu (2011). Ramanna and Roychowdhury (2010) find that firms that made large contributions to congressional candidates in the 2004 elections and that rely on outsourcing managed their earnings downwards in the period leading to the elections to protect themselves and the recipients of their contributions from public scrutiny.

Yu and Yu (2011) find that firms that lobby and are subject to security class action lawsuits have longer class action periods, consistent with the theory that lobbying delays the detection of fraud.

Furthermore, regulators are less likely to be the first actors to bring the fraud to light for these firms. These two findings, together with an increase in lobbying expenditures during fraud years, suggest the favorable treatment of lobbying firms.

The focus of my paper differs from that of Yu and Yu (2011) in that I examine the choice of enforcement targets by the SEC and the outcomes of SEC enforcement actions. The SEC has a broad arsenal of penalties at its disposal (monetary penalties, disgorgement of ill-gotten gains, temporary and permanent bars, injunctions and cease- and desist orders against future violations), many of which cannot be imposed in a class action lawsuit. As a result, irrespective of the mechanism that leads to the detection of fraud, the decision by the SEC to start an enforcement action can impose substantial costs on the firm and its managers (Karpoff et al., 2007, 2008a, 2008b). The combined evidence of Dyck et al. (2010) and Karpoff et al. (2007, 2008a, 2008b) suggests that while the SEC plays a modest role in fraud detection, it plays an important role in punishing detected fraud. For this reason, and also because the SEC enforcement actions are often used to form a sample of misreporting firms, it is important to understand the biases, if any, in enforcement decisions.

2.3. Political control over regulatory agenciesTo analyze whether political contributions influence SEC enforcement, it is important to understand whether the recipients of these contributions can pressure the agency or control its activities.

The Iron Triangles literature, starting with Freeman (1965), emphasizes the exchange of favors between agencies, special interest groups, and congressional committees with jurisdiction over a specific set of issues. The idea is that agencies are able to ensure higher levels of funding and increase their power by catering to certain interest groups. These groups can influence Congress and contribute to the re-election of politicians who favor specific legislation and who can in turn exert pressure on the regulatory agency to develop favorable policies. Stigler (1971) and Pelzman (1976) provide theoretical support for this literature by modeling the relation between two vertices: agencies and interest groups. In contrast, the Congressional Dominance Theory focuses on the relation between the two other vertices of the triangle, Congress and agencies. This theory describes the relation as a principal agent problem in which Congress delegates responsibilities to agencies and devises monitoring systems, such as the budget appropriation procedure and congressional oversight, to create incentives for the agencies to act in accordance with its goals, which are usually assumed to involve the maximization of political support (Weingast, 1984; Weingast and Moran, 1983; McCubbins et al., 1999). Shotts and Wiseman (2010) discuss how the threat of investigator turnover is also an important mechanism of political control in this setting in which enforceable performance-based compensation contracts are not possible. Empirical evidence on different agencies, such as the Internal Revenue Service (IRS), and the Federal Trade Commission (FTC), supports this view.4

A small number of studies examine the link between political expenditures and enforcement decisions by regulatory agencies. Gordon and Hafer (2005) document lower investigation rates by the NRC for firms that make PAC contributions. Similarly, Richer et al. (2009) show that lobbying firms experience lower tax rates, possibly as a result of more lenient interpretation and enforcement of tax laws by the IRS. Taken together, these findings are consistent with political expenditures related to Congress being associated with favorable treatment by regulatory agencies.

3. Hypotheses developmentThe SEC has limited resources. As a result, it cannot monitor all firms or investigate all leads. Both the SEC staff and the commissioners have discretion regarding enforcement outcomes (Khademian, 1992). The following figure, adapted from Karpoff et al. (2008a) shows the typical timeline of an enforcement action:

An enforcement action typically begins with a trigger event, such as a restatement, that the staff decides to investigate.

At the end of the investigation, the staff can make an enforcement recommendation to the commission that can in turn authorize the filing of a civil or administrative action. If an action is authorized, then a complaint or an order is filed that describes the misconduct and the sanction or remedial action sought. The staff has more discretion at the initial stages of the process on which leads to pursue, whether to start an investigation, and on the final enforcement recommendations made to the commission (SEC, 2013).5 In turn, the commissioners must decide whether to file a civil or administrative action, which penalties to demand, and whether to warn the Department of Justice (DoJ) (SEC, 2013). The commission also serves as a first appellate court in administrative proceedings and contributes to the definition of enforcement priorities, which constrain to some degree the staff's resource allocation choices in the initial stage.

I use the sample of restatements to identify a set of firm-years that were misreported and hence were potential SEC targets. Based on this sample, I examine the probability that an enforcement action will be filed. Because the disclosure of an investigation is at the discretion of the target firm, the filing of an enforcement action is usually the first enforcement event that is public information. The decision to file an enforcement action is the joint outcome of the staff's decision to investigate the restatement and the decision by the SEC to file an enforcement action following the investigation.

The literature often assumes that bureaucrats are driven by career concerns. In particular, bureaucrats are concerned about their probability of turnover and outside job opportunities (Shotts and Wiseman, 2010; Alesina and Tabellini, 2007). These opportunities are a function of

their perceived competence and popularity and their alignment with senior incumbent politicians (Alesina and Tabellini, 2007).

Based on this assumption, the literature on the political control of bureaucracies highlights three main mechanisms through which Congress and the president can control agency activities: budget setting (Weingast, 1984), the appointment of commissioners and the threat of turnover, and congressional oversight (Weingast, 1984; Weingast and Moran, 1983; McCubbins et al., 1999). In the Weingast (1984) model, the budget is a mechanism used by politicians to reward (or punish) agency decisions that increase (or decrease) their constituencies. Another key mechanism of control is the appointment of commissioners. The SEC has five commissioners appointed by the president with the advice and consent of the Senate. Commissioners often have political careers.6 While not politically appointed, staff members often work for lobbying firms or Congress, either before or after their employment with the SEC. Approximately 90 SEC staff members are identified by the Center for Responsive Politics (CRP) as having been through this revolving door. If commissioners and staff members seek to maximize current and future career rewards, they might have an incentive to act in accordance with congressional interests. The final key mechanism of control is congressional oversight. Congressional oversight can be extremely costly for the agency. Armstrong (1959) mentions a congressional investigation of the SEC in the late 1950s that took up 10,000 manhours of the SEC's top officials. For regulators with a short time frame, like SEC commissioners, an investigation like this can destroy the possibility of impacting policy (Weingast, 1984).7

The above discussion suggests that politicians can control the SEC's activities by using different mechanisms to punish or reward its decisions. I argue further that politicians could have an incentive to do so. In theoretical models of regulation, politicians are generally assumed to maximize their probability of re-election (Stigler,1971; Pelzman,1976). Political supportis assumed to be a function of the politicians' catering to their constituencies and the political contributions they receive (Poole and Romer (1985) and Strattman (1995) document an association between political contributions and the probability of re-election).

The traditional view of political expenditures emphasizes self-serving long-term relationships between firms and politicians in on which the firms can rely on as needed (Baron, 1989; Grossman and Helpman, 1994; Snyder, 1992). Snyder (1992) describes contributions as a long-term investment in politicians in the context of an implicit self-enforced contract. This contract consists of contributions through which firms facilitate the election and career progression of the politicianswho, in turn, return the favor if they win office and an opportunity to do so arises. In this setting, contributions might buy increased pressure on the SEC. If effective, this pressure can lead to an increase in the costs the SEC must incur in order to prosecute the firm.8

The commissioners and staff trade off the benefits and costs of prosecution in a way that is consistent with their budget constraint (this is the “constrained cop hypothesis” discussed by Kedia and Rajgopal, 2011). Therefore, if there are increased costs of prosecuting politically connected firms, then the political connections should be, together with other factors, an important determinant of the enforcement choice.

If the politician is aware of misreporting and a pending SEC investigation, he or she might have an incentive to prevent the filing of an enforcement action against one of his or her donors for two reasons: a public enforcement action against a donor might reduce the political support from the rest of his or her constituency, and a lack of support for the donor might break the relationship with that donor and reduce future contributions (this is particularly important in the context of longterm relationships in which the reputation of acting in accordance to the donor's interests is rewarded with continued contributions, as in Snyder (1992) and Krozner and Strattman (2005)). The possibility exists that, at different stages of the enforcement action, politicians will seek to distance themselves from the firm by returning political contributions. In an untabulated analysis, I examine all transactions between misreporting firms and politicians. I find no evidence of contributions being returned.

The politician does not necessarily have to be aware of the earnings misreporting or of an on-going investigation. The presence of an established, public relationship between the firm and key politicians could be sufficient because the SEC might be aware of the increased costs of initiating an investigation against such a firm.9

Hence, my main hypothesis is H.1. Firms with long-term political connections are less likely to be prosecuted by the SEC and, conditional on being prosecuted, on average pay lower penalties.

Although the hypothesized mechanism is political influence (or the fear of political influence) over the SEC, such an association could be observed as a result of managerial distraction through political consumption. Politically connected managers might devote substantial resources to rent-seeking activities and personal consumption, such as regularly attending fundraisers. A lower probability of enforcement could result directly from these distractions because unintentional misreporting is less likely to be penalized.

The mechanisms of political control described above can be used to form different cross-sectional predictions on the association between long-term political contributions and the probability of enforcement and penalties. In fact, several factors affect the ability and/or the willingness of the politician to help the firm by putting pressure on the SEC. The politicians who serve in Congress during the enforcement period have a greater ability to affect the SEC's activities than those who are not elected. Politicians who serve on committees that set the budget, appoint the SEC's commissioners, oversee the SEC, or have other types of frequent dealings with

the agency should also have a higher ability to affect the agency's activities (Weingast, 1984). The politicians' ability to affect the SEC should also increase with the relative power of their political party (Cooper et al., 2010) and with their seniority within committees because the chairman and the ranking minority member have the most power (Grier and Munger, 1991).

Additional factors affect the politician's willingness to influence the SEC's enforcement activities – namely, a repeated relationship with a politician should give the highest rewards to the firm because there are higher costs to the politician of breaking the relationship (e.g., Snyder, 1992; Krozner and Strattman, 1998).

H.1.a. Long-term political contributions are associated with a greater reduction in the probability of enforcement and in the penalties imposed at the end of an enforcement action when their recipients are the high-ranking members of the committees with the highest control over the SEC and have a long-term, repeated relationship with the firm.

The effectiveness of lobbying expenditures at reducing the probability of enforcement and the penalties is inherently a function of the employed lobbyists' ability. The lobbyists who have worked at the SEC have better knowledge of the inner workings of the commission and, possibly, stronger social ties with staff and commissioners. As a result, they may be able to convey the necessary information to the politicians or to the SEC, to ensure that the firm's objectives are met. Therefore, a given amount of lobbying expenditures made through connected lobbyists should result in a bigger decrease in enforcement costs. A firm with a history of lobbying the SEC directly should also experience lower enforcement costs.

H.1.b. Long-term lobbying expenditures are associated with a greater reduction in the probability of enforcement and the penalties imposed at the end of an enforcement action when lobbying is made through lobbying firms with connections to the SEC or when the firm lobbies the SEC directly.

It is also possible that a lobbyist connected to the SEC has a superior “skill” and can advise the firm in response to an investigation and enforcement action. This alternative mechanism, in the absence of a political connection, could result in a reduction in the probability of enforcement and penalties through the use of linked lobbyists. The empirical tests in the paper cannot rule out this alternative “skill” explanation.

4. Data and descriptive statistics This section discusses the measurement of the two constructs in the hypotheses: political connections and SEC enforcement.

4.1. Political connections

I measure political connections by the amount of PAC contributions and lobbying expenditures by the firm. A PAC is a political committee that is organized to raise money to elect or defeat candidates. It can be sponsored by a corporation that can cover the PAC's operating costs but cannot contribute directly to the PAC. Instead, PACs solicit contributions from executives, employees, and shareholders of the firm. The decision to distribute PAC contributions typically belongs to the top executives of the firm. Most of U.S. studies use PAC contributions as a proxy for political connections (see Milyo et al. (2000) for an overview of these studies).

The data on PAC contributions comes from the Federal Election Commission's (FEC) website (www.fec.gov). I match each Compustat firm to the connected organization field in the “Committee Master” files to determine whether the firm has a PAC in each election cycle. I then match these databases with both the “Contributions to Candidates from Committees” and the “Candidate Master” files to obtain information on the timing and the recipients of all of the contributions made by the firm between 1979 and 2006. Next, I match all of the recipient candidates by name to Charles Stewart III and Jonathan Woon's Congressional Committee Assignments, 1993–2007, and Garrison Nelson's Committees in the U.S. Congress, 1947– 1992, databases, which are available from the Charles Stewart III website at http://web.mit.edu/17.251/www/data_page. html. This matching allows me to track the committee assignments for each candidate over time. Panel A of Table 1 contains the descriptive statistics for the PAC contributions in the sample. Over the sample period (1980–2006), the contributing firms spent an average of $39,756 in PAC contributions to 32 candidates per year, with some spending more than $2 million and contributing to more than 500 candidates. The Republicans are the top recipients, although most firms contribute to both Republican and Democratic candidates. The incumbents receive larger contributions, consistent with the prior research (e.g., Snyder, 1990, 1992, 1993; Grier and Munger, 1991; Romer and Snyder, 1994; Krozner and Strattman, 1998, 2000).10 The large percentage of contributions made to incumbents is consistent with firms using PAC contributions to buy access or special favors, rather than for ideological reasons (Milyo et al., 2000). Over a five-year period, the contributing firms on average give $155,106 in PAC contributions.

Lobbying is the strategic transmission of politically relevant information. Firms spend large amounts of money to lobby Congress and federal agencies. Lobbying typically takes place behind the scenes and occurs at the highest levels of the organizations (usually by the CEO and other executives). Unlike PACs, lobbying expenditures are not capped.11

The CRP compiles the lobbying data from the quarterly lobbying disclosure reports filed with the Secretary of the Senate's Office of Public Records (SOPR). This data is available from 1998 onwards. Lobbying expenses cannot be traced to specific politicians. If a firm lobbies an individual congressman, the disclosure report indicates that the firm lobbied the “U.S. House of Representatives” or the “U.S. Senate.” If a firm lobbies bureaucratic agencies, these must be listed in the report. I use this information to identify firms that have a history of lobbying the

SEC. The determination of the amount of expenses that were allocated to lobbing each agency is not possible, as firms are not required to disclose this information.

Also, as part of their regularly filed lobbying reports, firms must indicate all of the lobbying firms that they employ as well as the total amount paid to each lobbyist if larger than $10,000. I classify a lobbying firm as having a link to the SEC if one of the following conditions is met: (1) the firm employs a lobbyist who has previously worked at the SEC, or (2) one of the current SEC commissioners or staff members previously worked for one of the lobbyists employed by the company. With this link, I attempt to measure both the lobbyist's knowledge of the inner workings of the SEC and the presence of social connections between the lobbyist and the SEC's staff and commissioners. I compute this link using the CRP's revolving door data. The CRP compiles this data from proprietary and publicly available sources, including a directory of lobbyists published by Columbia Books, Inc. and collected biographical information on federal government employees.

There are 2,623 firms that lobbied from 1998 to 2006 (and that I could match to Compustat manually by name) that spent an average of $772,444 per year (Table 1, Panel B). During the sample period, the firms lobbied an average of six agencies per year on five issues, and 1.67% of these issues were related to accounting. However, lobbying on other issues also related to the SEC, such as finance issues, is more frequent, occurring in 12% of the cases. Direct lobbying of the SEC and the DoJ occurs in 3.5% and 8.6% of the observations respectively.12 Each year, 16.87% of the lobbying firms employ at least one lobbyist linked to the SEC. They pay $125,031 on average to these linked lobbyists. Over a three-year period, the firms spend over $1 million on average for lobbying of which $265,137 is spent on lobbyists linked to the SEC. Over the same period, 9.75% of the firms on average lobby the SEC. I compute long-term lobbying expenditures over a three- rather than a five-year period for consistency with the remainder of the paper. For the enforcement and penalty analysis, calculating lobbying expenses over a five-year period substantially reduces the sample size given that lobbying data is only available from 1998.

Lobbying and PAC contributions exhibit a correlation of 0.405 (Panel C) and occur in 4.71% of the sample firm-years. In fact, PAC contributions can be used to obtain access to politicians in order to lobby them (Milyo et al., 2000). However, lobbying often occurs without PAC contributions and vice versa (in 8.47% and 2.4% of the sample years respectively).

There are two main issues with the measures described above. First, corporate political spending is very hard to track, and these expenditures are just a fraction of the total spending (cf. a recent report by the Center for Political Accountability, Freed and Carroll, 2006, emphasizes the flow of money through trade associations and 527 s). Second, most of the political influence might occur through social links without an exchange of money. For example, Agrawal and Knoeber (2001) and Hillman et al. (1999) examine the political experience of firms' directors. The

participation by politicians on boards in the United States is rare because of the legal restrictions. Therefore, political influence in the United States is unlikely to occur through this type of connection, as pointed out by Faccio (2006, 2007).

4.2. SEC enforcementI rely on an extensive database of enforcement actions by Karpoff, Lee, and Martin (hereafter KLM). This database contains detailed information on the SEC enforcement actions for financial misrepresentation starting in 1978. It is different from the AAER samples traditionally used in the accounting research. As KLM discuss, the AAER designation is a secondary designation that the SEC attaches to some, but not all, enforcement actions when an accountant or an auditor is involved. Fourteen percent of KLM's enforcement actions for financial misrepresentation have no related AAERs.13 Karpoff, Lee and Martin also collect data on the penalties imposed by the SEC and the DoJ for SEC enforcement actions on financial misreporting from three main sources: Lexis Nexis' FEDSEC:SECREL and FEDSEC:CASES libraries, the SEC enforcement division, DoJ websites, and the company's filings with the SEC available through EDGAR. Table 2 contains the descriptive statistics for the different penalties. There is disgorgement of ill-gotten gains in 36.29% of the cases and fines in approximately 48% of the cases. Most of these are imposed on individual respondents. The firm only had to disgorge in 5.76% of the cases and pay fines in 9.66% of the cases. These percentages occur in part because monetary penalties on the firm ultimately fall on shareholders, something that the SEC likes to avoid. In 35.98% of the cases, there is some type of accountant bar/censure; and in 32.24% of the cases, respondents are barred from serving as officers and directors either for a short period of time or indefinitely. There are prison sentences in 16.67% of the cases.

The penalty sample is especially interesting for two reasons: because enforcement actions are public, it is unclear whether it is possible for the firm to influence penalties; and the SEC must allege extreme recklessness or intentionality and usually only prosecutes if it has a high probability of winning the case. Therefore, the penalty sample is limited to a set of cases where intent is likely.

5. Empirical analysis5.1. Political expenses and the probability of an enforcement actionHypothesis H.1. states that politically connected firms are less likely to be prosecuted by the SEC. In order to test this hypothesis, I combine the Government Accountability Office (GAO) and Glass Lewis' restatement databases to identify a set of firms that have restated their financial statements and hence represent potential SEC enforcement targets. Panel A of Table 3 illustrates the construction of the restatement sample used in the analysis. There are 919 restatements in the GAO database, announced between 1996 and June 2002. 169 restatements which could not be matched to a GVKEY, or did not contain the necessary information to identify the restated period, and 11 restatements with restated period ending before 1996 were discarded from the sample. The resulting GAO sample contains 739 restatements, corresponding to 1,075

handcollected restatedfirm-years. There are 4,834 restatements, announced between June 2002 and December 2007, in the Glass Lewis database. I drop from the sample 1,531 of these restatements, for which GVKEY and restated period are unavailable, which leaves me with 3,303 restatements, and 6,277 restated firm-years. Finally, I combine the two data sources, to form a sample of 7,309 restated firm-years between 1996 and 2006. I run the following logit regression within the sample of restated firm-years:

The dependent variable equals one if there is a SEC enforcement action involving misreporting by firm i in year t. PAC contributions (lobbying expenses), ΣK k ¼ 1PCit k, are measured over a five(three)-year period ending in t1. The measurement of the political connections is in line with the long-term view of political expenditures emphasized in Snyder (1992) and Krozner and Strattman (2005). The advantage to this approach is that the political expenditures are measured over a period that precedes on average both the restated period and the enforcement decision of the SEC by several years.

I control for the level of discretionary accruals and several firm characteristics, such as size, book-to-market ratio, leverage, and age. Furthermore, following Kedia and Rajgopal (2011), I include proxies for the firm's visibility, such as whether the firm is a Fortune 500 company and the level of analysts' following, and a measure of the distance between the firm's headquarters and the closest SEC office. The final restatement sample includes 4,067 restated years with available financial data (Table 3, Panel A). Panel B of Table 3 presents descriptive statistics for political expenditures within the restatement sample. 12.84% of the sample firms make PAC contributions and contribute an average of 224,212 dollars in the five years leading to the restated period. The percentage of firms that lobby is higher (19.26% in the three years that precede the restated period). These firms on average spend 1.4 million in lobbying; 15.83% employ at least one lobbyist with links to the SEC, spending an average of 388,647 dollars on these lobbyists; 5% lobby the SEC directly.

I also build a sample of all Compustat firm-years with the required financial information to estimate Eq. (1). This sample, which covers the same time period as the restatement sample, contains 50,912 firm-year observations. Panel B of Table 3 presents descriptive statistics for political expenditures within this sample. The percentage of firms that make contributions PAC and lobby (11.62% and 17.57%, respectively) is lower in the full sample than in the restatement sample. These firms on average spend 202,090 in PAC contributions and 1.1 million in lobbying, of which an average of 136,129 dollars is paid to lobbyists linked to the SEC. Column (1) in Panel A of Table 4 reports the results from the estimation of Eq. (1) for the restatement sample. The probability of SEC enforcement is higher for firms with high discretionary accruals and a high book-to-market ratio, and for firms that are younger and larger. Long-term PAC contributions, PI PAC, are associated with a lower probability of enforcement.

In particular, a $1 million increase in PAC contributions made over the previous five years is estimated to reduce the probability of an enforcement action for the restatement sample from 8.58% to 3.43%.

By focusing on the sample of restated firm-years, I am able to identify cases of known misreporting. However, this approach has the disadvantage that the restatement set might not be inclusive enough, that is, instances of misreporting might exist without an accompanying restatement. As a robustness test, I reestimate the model for the full sample (column (4)). While broadening the sample introduces noise in the analysis, I find that, consistent with the findings for the restatement sample reported in column (1), long-term PAC contributions are associated with a lower probability of enforcement in the full sample. A $1 million increase in PAC contributions made over the previous five years reduces the probability of enforcement by one thirdin this sample.

One concern with this analysis is the endogeneity of the political contributions. In order to address this issue, I run two sets of probit regressions with instrumental variables. The first regression (columns (2) and (5)) uses the average level of political contributions made by the other firms in the same industry over the same period as an instrument. I follow the approach described by Larcker and Rusticus (2010) to test the validity of the instrument. I find that the average level of industry PAC contributions is strongly associated with the level of the political contributions of the firm. In the first-stage regression of PAC contributions on all of the exogenous variables, the partial F-statistic of the average amount of industry PAC contributions is 9.15 in the restatement subsample and 111.37 in the full sample. These values are above the thresholds recommended by Stock et al. (2002). The average amount of PAC contributions within the same industry is therefore highly correlated with those made by the firm. Furthermore, the average amount of long-term industry PAC contributions is unlikely to affect the SEC's enforcement decisions regarding individual firms. Instead, the industry PAC contributions are likely determined by factors that are exogenous to SEC enforcement. The IV probit model shows an even stronger association between PAC contributions and the probability of SEC enforcement, both in the restatement and full sample (columns (2) and (5)).

Because models (2) and (5) are exactly identified, statistically testing the exclusion restriction (i.e. the validity of the instrument) is unfeasible. Models (3) and (6) add two instruments to the first stage: the percentage of sales made to the government, and the number of years in the previous five years in which there was a close election involving two candidates in the firm's state. These variables are unlikely to be associated with the SEC's enforcement decisions especially because they are measured over the five years before the misreporting takes place, and hence several years before the enforcement decision. The coefficients on PAC contributions remain significantly negative and are close to the coefficients reported in the base IV models (columns (2) and (5)). The tests for the overidentifying restrictions, which are appropriate under

the assumption that at least one of the instruments is valid, are encouraging in the sense that they fail to reject the hypothesis that the instruments are exogenous (p-values are 0.4388 and 0.6308 for the restatement and full samples respectively).

These results suggest that long-term PAC contributions are effective at deterring SEC enforcement. However, the distracted management theory discussed earlier could be an alternative explanation for these findings. In an attempt to rule out this explanation, I examine the cross-sectional variation in the association between the different types of political expenditures and the probability of enforcement.

Hypothesis H.1.a. predicts that certain types of political contributions are more effective at reducing the probability of prosecution by the SEC. In order to test this hypothesis, I compute four different measures of long-term political contributions (PI STRENGTH and PI POWER follow Cooper et al., 2010). These measures assign a greater weight to contributions made to politicians with whom the firm has a long uninterrupted contributing relationship and who are in a stronger position to influence the SEC's enforcement activity. The first measure, PI STRENGTH, is defined as

where PAC jt 1;t 5 are the total PAC contributions made to candidate j in years t5 to t1, Ij;t is an indicator variable equal to one if candidate j is in office at time t and zero otherwise, NCVj;t is the number of votes that candidate j's party holds in office at time t, NOV j;t is the number of votes that candidate j's opposing party holds in office at time t, and rellengthj;t 5 is the number of months for which the firm has maintained an uninterrupted relationship with candidate j until time t. There is an uninterrupted relationship if the firm did not miss any past re-election cycles of the candidate. This measure captures all contributions made by the firm over the last five years to politicians with congressional seats in year t. The weight of each contribution is proportional to the votes of its recipient's party relative to the opposition party in the respective chamber (Senate or House of Representatives), with contributions to majority party congressmen receiving a weight greater than one. This is consistent with the premise that the ability of a candidate to help the firm is higher if the candidate's party holds a large majority of the votes because exerting pressure on the SEC is easier through the mechanisms described in Section 3 in this case (for example, it is easier to affect the content and timing of legislation affecting the SEC). The contributions to politicians that the firm has continuously contributed to over time receive higher weight, consistent with the idea that longterm contributing relationships should be more valuable than relationships more recently formed (Snyder, 1992; Krozner and Strattman, 1998, 2000, 2005). The second measure, PI POWER, is defined as

where m¼1,…, M are the different committees on which politician j serves, Committee Rankmt is the reciprocal of candidate j's rank on committee m, and Median Committee Rankmt is the median number of members on a given committee m of which candidate j is a member. The highest-ranking members should have a greater ability to set the agenda of the committee, greater expertise and collegial respect. Furthermore, career progression in Congress is a function of current ranking and seniority, and highly ranked, senior congressmen are more likely to have powerful committee assignments in future years. The third measure, PI RELATED, is defined as:

where RELATED jt ¼ 1 for politicians serving in the House or Senate Appropriations, Commerce and Banking Committees and zero otherwise. This measure captures the total contributions made by the firm over the last five years to members serving in the House or Senate Appropriations, Commerce and Banking Committees in year t. According to the Iron Triangles literature, members of these committees should be in a better position to influence the SEC through budget setting, appointment, or the threat of investigation. The fourth measure, PI CHAIR RELATED, is defined as

where CHAIR RELATED jt ¼ 1 if politician j is the chair of the House or Senate Appropriations, Commerce and Banking Committees and zero otherwise. This measure captures the total contributions made by the firm over the past five years to the chairs of the House or Senate Appropriations, Commerce and Banking Committees. Chairs schedule hearings and votes and can kill a bill if they choose. Therefore, they are in a better position to exert control over the SEC and perform political favors (Grier and Munger, 1991; Romer and Snyder, 1994). I reestimate model (1) with these measures. Panel B of Table 4 contains the results from the analysis. For the ease of interpretation, and following Cooper et al. (2010), I standardize all of the measures in Panel B to a mean of zero and a standard deviation of one. All of the control variables from Panel A are included in the regression, but are not reported in the table for simplicity. I find a robust and negative association between all of the PAC measures and the probability of SECenforcement.

These measures exhibit a strong correlation with the total amount of long-term PAC contributions (PI PAC). Therefore, in order to test whether the targeting is associated with a greater decrease in the probability of enforcement, I regress each measure on the PI PAC and retain the residuals. These residuals are uncorrelated with the PI PAC by construction. I then regress the probability of enforcement on the PI PAC and each residual: eðPI STRENGTHÞ, eðPI POWERÞ, eðPI RELATEDÞ, and eðPI CHAIR RELATEDÞ. I find that the coefficients on eð PI STRENGTHÞ, eðPI POWERÞ, and eðPI RELATEDÞ are negative and significant, which suggests that long-term relationships with high ranking politicians from the majority party and politicians serving in the Appropriations, Commerce and Banking Committees are more effective

at reducing the probability of enforcement. However, while negative, the coefficient on eðPI CHAIR RELATEDÞ is not significant.

Table 5 examines the association between lobbying expenditures and the probability of SEC enforcement. The table shows that there is a negative association both within the restatement subsample and the full sample (columns (1) and (4)).14 An increase of $4 million in long-term lobbying by a restatement firm is estimated to reduce the probability of enforcement from 8.12% to 4.01%. Columns (2) and (3) report the results from an IV probit estimation within the restatement subsample. In column (2), I use the average lobbying expenditures by the other industry firms over the previous three years as an instrument for the firm's lobbying expenditures during the same period. The industry's lobbying is strongly associated with the firm's lobbying, as evidenced by the partial F-statistic from the first stage. The coefficient on lobbying expenses remains negative and significant both in this specification and in column (3), in which two instruments are added to the first stage: the percentage of sales to the government and the number of close elections. Similar results are reported for the full sample in columns (5) and (6).

Panel B examines the association between different types of long-term lobbying expenses and the probability of a SEC action within the restatement sample. The three long-term lobbying variables, the amount spent on lobbyists linked to the SEC, a dummy for whether the firm employed a linked lobbyist, and a dummy for whether the firm lobbied the SEC directly are all significantly associated with a lower probability of SEC enforcement (models (1)–(3)). Because the targeted lobbying measures are correlated with total lobbying, I follow the same approach as in Panel B of Table 4 and regress each targeted measure on the total lobbying expenditures of the firm. I then add both the total amount of lobbying expenditures and these residuals, eðPI LOBBY LINKED TO SECÞ, eðPI LOBBYIST LINKED TO SECÞ and eðPI LOBBY SECÞ to the regression (models (4)–(6)). I find that, controlling for the level of long-term contributions, the residuals are significantly associated with a reduction in the probability of SEC enforcement (albeit only marginally in the case of the direct lobbying of the SEC). This analysis suggests that lobbying through lobbyists linked to the SEC and direct lobbying are more effective at reducing the probability of SEC enforcement. While the increased effectiveness of targeted lobbying could be consistent with political influence, it could also be result from superior “skill” of linked lobbyists. This alternative explanation cannot be ruled out by the empirical tests.

The above analysis examines the probability of an enforcement action as a function of political expenditures for a subsample of firm-years that were misreported. An alternative way to test the effect of political connections on SEC enforcement is to examine the probability that an enforcement action is started conditional on the firm being investigated by the SEC. The identification of the universe of all investigations is not possible because the SEC does not disclose investigations prior to the filing of an enforcement action. Therefore, the disclosure of an investigation is at the discretion of each firm and this type of analysis might be plagued by a selection bias. Nevertheless, I searched Factiva for disclosures of SEC investigations or inquires

related to financial reporting issues. I read through all of the articles produced by the searchand formed a sample of 344 SEC investigations (70% of which leading to an enforcement action). I reestimate Eq. (1) using this sample. Results (untabulated) are consistent with those in Tables 3 and 4. In particular, I find that PAC contributions and lobbying expenditures are negatively associated with the incidence of an enforcement action within the SEC investigation sample. Furthermore, there is cross-sectional variation in the effectiveness of these expenses in predicted ways (consistent with Panels B of Tables 3 and 4). Direct lobbying of the SEC is the only targeted measure that is not associated with an increased reduction in the probability of enforcement following an investigation.

5.2. Political expenditures and penalties Table 6 presents the results of the penalty analysis. I examine both the total amount of monetary penalties, including fines and disgorgement, imposed in each SEC enforcement action (columns (1) and (2)) and the probability that an enforcement action imposes officer and director bars on any of the respondents (columns (3) and (4)). An officer and director bar prohibits the respondent from acting as an officer or a director of a public firm for a limited or unlimited period of time. I follow Karpoff et al. (2007) to identify the set of control variables. These variables are proxies for the size of the harm caused by the violation, the complexity of the violation, and the ability of the defendants to pay (deep pockets variables). In addition, and also following Karpoff et al. (2007), I control for the legislation that came into place during the sample period.

According to the optimal penalty theory (e.g., Becker, 1968), the size of the penalty should increase with the size of the harm caused by the violation. I use three proxies for the size of the harm. Provable loss is the difference between the highest market capitalization during the violation period and the market capitalization on the first day of the enforcement period. Itis a measure of shareholder losses as a result of the misreporting. Because the potential harm caused by the violation to outside investors is likely higher if there was intent, following Karpoff et al. (2008a, 2008b), I also control for whether fraud and insider trading were involved in the violation. The second set of control variables are proxies for the complexity of the violation. These are included in the analysis for two reasons. First, complex violations can be damaging to investors'confidence. Second, complex violations are more likely to be intentional. I use the following measures for the complexity of the violation: the number of respondents in the action, the length of the violation period, and the length of the enforcement period. The optimal penalties also depend on the defendants' ability to pay. For this reason, I control for the firm's market capitalization before the beginning of the enforcement period and for whether the firm filed for bankruptcy between the beginning of the violation and the end of the enforcement action. I control for three major changes in regulation enacted during the sample period that could have an effect on penalty levels. The Sarbanes Oxley Act of 2002 (SOX) increased the penalties and added two new criminal laws for financial misreporting. The U.S. Sentencing Commission Guidelines (USCC), effective in 1991, also increased the monetary penalties for financial

misrepresentation. The Private Securities Litigation Reform act of 1995 (PSLRA), which affected the monetary awards paid by firms in private class action lawsuits, might have had an effect on SEC penalties as well. In addition to these variables, and also following Karpoff et al. (2008a, 2008b), I control for whether the firm cooperated by self-disclosing the violation, whether the financial reporting violation coincided with a securities offering or a merger, whether the firm is a recidivist (i.e., whether there have been other cases of financial misreporting affecting the firm), and for the fraction of shares held by individual respondents. I also control for whether the enforcement action is fully resolved and add fixed effects for the SEC chairman. As expected, the size of the provable loss, the number of respondents, and the length of the violation and enforcement periods are all positively associated with the amount of monetary penalties. Moreover, monetary penalties are higher after SOX and in firms where respondents hold a large percentage of the firm's shares.

PAC contributions are measured in the five years before the violation period. These contributions are associated with lower levels of monetary penalties. A $100,000 increase in PAC contributions over the last five years is associated with an 11% decrease in monetary penalties. I find no significant effect for lobbying expenditures.15

In columns (3) and (4), the dependent variable is equal to one if there is an officer or director (O&D) bar placed on one of the respondents. PAC contributions are associated with a lower likelihood of an officer or director bar. Over the long run, an additional $100,000 in PAC contributions reduces the probability of an O&D bar by 12.9%. However, there is no significant association between lobbying expenses and the probability of an O&D bar (the indicator variables for fraud and merger are excluded from the lobbying specification, column (4), because they perfectly predict an O&D bar). Insider trading and fraud are associated with a higher likelihood of an O&D bar, as is the length of the enforcement period.

Panel B presents the cross-sectional tests on the effectiveness of long-term PAC contributions at reducing the monetary penalties. As before, all of the political measures, PI PAC, PI STRENGTH, PI POWER, PI RELATED and PI CHAIR RELATED, are standardized to a mean of zero and a standard deviation of one. These political indices are calculated based on the contributions made in the five years prior to the first year of the violation period and to politicians serving in Congress during the first year of the enforcement period. The coefficients on all of the political indices are negative and significant at the conventional levels. Columns (6)–(9) include both the total long-term PAC contributions and the residual of a regression of each index on the total contributions. All of the residuals are significantly negative, which suggests that the targeted PAC contributions are associated with a lower probability of enforcement after controlling for the total level of PAC contributions.

As discussed earlier, Panel A shows no significant association between lobbying expenditures and monetary penalties. Panel C examines whether targeted lobby is associated with lower

penalties. While I find no association between the total amount of lobbying expenditures made through lobbyists linked to the SEC and the amount of monetary penalties, I find that the indicators for whether the firm used a lobbyist linked to the SEC and for whether the firm lobbied the SEC directly are associated on average with lower penalties.

While the observed cross-sectional variation in the effectiveness of some of the PAC-based indices could still be consistent with the distraction theory, it is unlikely that the variation in the effectiveness of lobbying expenditures can be explained by management distraction. However, the lack of significance of the coefficient on the total amount of lobbying expenses casts some doubt on firms' ability to influence the outcome of an enforcement action once the enforcement action is started.

6. ConclusionIn this paper, I examine whether firms with political connections incur lower costs from SEC enforcement actions, in the form of a lower probability of enforcement and lower penalties conditional on being prosecuted. The lower enforcement costs could be explained in the context of a long-term relationship between firms and politicians which firms rely upon as needed (Snyder, 1992). This long-term relationship could result in increased pressure from politicians on the SEC. Firms could also be using political contributions to signal their willingness to fight the SEC's enforcement decision (e.g., Gordon and Hafer, 2005).

I show that long-term PAC contributions and lobbying expenditures are associated with a lower likelihood of an enforcement action for restatement firms. While PAC contributions are also associated with lower penalties, lobbying expenditures are not, which casts some doubt on the ability of firms to use lobbying to influence the penalties imposed at the end of an enforcement action. I find that the effectiveness of long-term political contributions in reducing the probability of enforcement and penalties is associated in a predictable fashion with the factors that influence the politician's ability or willingness to pressure the SEC. Lobbyists with prior connections to the SEC and direct lobbying of the SEC are both effective mechanisms to reduce enforcement costs.

The findings of this study suggest that the SEC is influenced by considerations other than the merits of the case and raise questions regarding the effectiveness with which the agency plays its deterrence and compensation roles.

Whether similar results could be obtained for other types of non-monetary political connections, which are potentially less visible, is an open research question. Examining the social interactions between firm executives and politicians in order to develop network-based measures of connections could be an important avenue for future research.