Proximity to the SEC and Stock Price Crash Risk

• Author: G. Brandon Lockhart,Thomas R. Kubick
• Date: 01 May 2016
• DOI: http://doi.org/10.1111/fima.12122
• Published date: 01 May 2016

Proximity to the SEC and Stock Price

Crash Risk

Thomas R. Kubick and G. Brandon Lockhart∗

We explore the possibility that Securities Exchange Commission (SEC) oversight influences dis-

closure practices in a manner that reducesthe likelihood of individual stock price crashes. Firms

located farther from the SEC have greaterstock price crash risk and this result is more pronounced

for firms with financial statements that are less readable(those with larger 10-K filings) and more

pronounced when SEC budgets are relatively smaller. Similar results are obtained in response

to SEC regional office location changes that are more likely to be exogenous. Our results sug-

gest that SEC oversight induces disclosure practices that reduce the likelihood of large negative

disclosures.

Recent theoretical and empirical research has focused on the underlying causes of firm-specif ic

stock crashes. Theoretical explanations of stock price crash risk emphasize managerial disclosure

policies regarding cash flows and investmentoppor tunities. Common to these explanations is the

prediction that managers act on incentives to conceal negative firm-specific information, which

can result in large negativestock price corrections upon the revelation of accumulated information.

In support of this theoretical explanation, research utilizing executive surveys reveals that some

managers conceal, or delay the release of, material negative information for additional “analysis

and interpretation” (Graham, Harvey, and Rajgopal, 2005). Although managerial disclosure

practices at US firms are legislated by Congress, monitored by investors, and regulated and

enforced by the US Securities and Exchange Commission (SEC), managers possess significant

discretion over their own disclosure policies and practices. We assume that SEC enforcement

activities influence managerial disclosure choices, and explore the effect of the organization of

SEC enforcement activities on firm-specific stock price crash risk.

As explored by Kedia and Rajgopal (2011) in their study of corporate financial misconduct,

proximity to SEC officials can influence managerial disclosure practices in at least two ways.

First, proximity to SEC officials can provide managers with information regarding enforcement

activities and preferences, referred to as the “differentially informed criminal hypothesis.” Re-

search on crime in the economics literature (Becker, 1968) emphasizes that a potential criminal

internalizes the perceived benefits and costs of committing a crime and, typically, it is assumed

that the expected costs of committing a crime are less certain than the expected benefits. This

asymmetry is largely due to the lack of knowledge of the true probability of being caught, prose-

cuted, and the resulting punishment conditional on prosecution. Further, potential criminals have

subjective estimates of the probability of the enforcement of laws. Subsequent research considers

We thank Marc Lipson (Editor) and an anonymous referee for their especially helpful comments. All errorsremain the

sole responsibility of the authors.

∗Thomas R. Kubick is an Assistant Professor of Accounting and Information Systems at the University of Kansas in

Lawrence, KS. G. BrandonLockhart is an Assistant Professor of Finance at Clemson University in Clemson, SC.

Financial Management •Summer 2016 •pages 341 – 367

342 Financial Management rSummer 2016

the importance of social interactions for the formation of these subjective estimates (Sah, 1991;

Glaeser, Sarcedote, and Scheinkmen, 1996).1

In addition, proximity to SEC officials may decrease the cost of investigating potential vi-

olators, referred to as the “constrained cop hypothesis.” A recent Government Accountability

Office (GAO) report suggests that SEC enforcement activities are negatively affected by SEC

resource constraints (GAO,2007). Kedia and Rajgopal (2011) f ind evidence that the SEC is more

likely to investigate geographically proximate firms among the set of f irms that issue financial

restatements.

We explore the idea that information regarding SEC enforcement activities and SEC resource

constraints influence managerial disclosure practices that can result in stock price crashes by

analyzing the cross-sectional association between stock price crashes and the distance between

firm headquarters and the nearest SEC regional or headquarters off ice. The distance from firm

headquarters to the nearest SEC office proxies for the possible importance of soft information

regarding both firm activities and SEC enforcement preferences, and for the likely importance of

SEC enforcement budget constraints for managerial disclosure practices. Weuse three commonly

used measures of firm-specif ic stock crashes: 1) a large negative weekly abnormal return that is

several standard deviations lower than the mean weekly abnormal stock return during the fiscal

year, 2) negative conditional skewness of the weekly abnormal stock return distribution, and 3)

the asymmetric volatility of negative weekly returns relative to positive weekly returns, and find

consistent evidence that firms located further from SEC officials have greater stock price crash

risk.

In our primary results, we determine that distance from the nearest SEC regional or headquarters

office is positively related to crash risk. Specifically, wef ind both the log of the distance from the

firm’s headquarters to the nearest SEC office and an indicator variable that is equal to one if the

firm is located more than 100 miles from the nearest SEC office are both positively related to crash

risk. Our results are robust to controlling for other known firm-specific and managerial-specif ic

determinants of crash risk, including managerial equity incentives (delta and vega), de-trended

stock trading volume, lowermoments of the stock return distribution, and other impor tant controls

including firm characteristics and industry and time effects.

We perform a number of tests to confirm the robustness of the results. First, we split the

regression sample into two subsamples based on the size of the firm’sannual repor t filed with the

SEC. Loughran and McDonald (2014) find that larger 10-K file sizes are associated with g reater

subsequent return volatility,g reater analystforecast er ror,and g reater analystforecast dispersion.

The authors conclude that larger 10-K filings are more difficult to process and to incorporate into

firm valuations. We find that the association between crash risk and the distance to SEC officials

is stronger for firms with larger 10-K file sizes. This non-parametric evidence supports the idea

that corporate disclosure practices are important for the association between crash risk and SEC

proximity,and is consistent with managerial influence over 10-K content and/or presentation with

the intent to obfuscate when there is negative information and greater distance between managers

and the SEC.

Next, we explore whether time-invariant unobserved firm characteristics, such as f irm culture

or technology,are responsible for the positive association between crash risk and distance to SEC

1The importance of social interactions and proximity for processing soft information has received recent attention in

other areas of financial economics, including portfolio investment decisions (Coval and Moskowitz, 2001), mutual fund

performance (Fu and Gupta-Mukherjee, 2014), analystforecasts (Malloy, 2005; Giannini, Irvine, and Shu, 2014), corporate

misconduct (Kedia and Rajgopal, 2011), corporate investmentdecisions (Uysal, Kedia, and Panchapagesan, 2008), capital

structure (Gao, Ng, and Wang, 2011), equity issuance (Loughran, 2008), and knowledge spillovers (Audretsch and

Feldman, 1996).