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Academic

: Conglomerate

The Revolving Door Run Around

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

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I said in an earlier post that the revolving door story, in which government regulators lay down on the job in the hopes of getting future employment from those they regulate, sounds nice in theory, but doesn't work in practice. I'm standing by this claim, particularly with regard to white collar prosecutors, who get big future private sector paydays by being active, rather than compliant.

Why doesn't the revolving door work in practice? There are many possibilities:

bringing big cases and winning them signals to private practice that you are a good lawyer
a reputation for toughness might help you make the case to future prosecutors that your internal investigation (which uncovered no wrongdoing that can't be remedied by firing a couple of people, but certainly doesn't require criminal penalties, etc, etc) was plausible
having a strong reputation will make it more likely that other former white collar prosecutors who go into private practice will refer cases to you, which means you're more likely to be able to build a book of business

And so on. I'm willing to admit that the revolving door for, say, Pentagon procurement officers may be replete with different incentives.

What about securities enforcement? They look a lot like prosecutors, right? Right, but Stavros Gadinis has investigated whom the SEC enforces against (often small firms located outside of securities centers), and has found some evidence of a revolving door problem:

This study suggests that the SEC favors defendants associated with big (listed) firms compared to defendants associated with smaller firms through two channels. First, the SEC is more likely to choose administrative rather than court proceedings for big-firm defendants, controlling for types of violation and levels of harm to investors. Second, within administrative proceedings, big-firm employees are likely to receive lower sanctions, notably temporary or permanent bars from the industry. To explain this gap, the paper first investigates whether big-firm violations are qualitatively different from small firms? violations, but finds no support for this. This paper instead finds tentative support for the hypothesis that SEC officials favor prospective employers, as big firms headquartered in desirable locations receive lower sanctions.

The evidence?

Depending on headquarters? location, firms are divided using three criteria: firms located in the greater New York area (?NY-NJ?) versus other firms, firms located in the greater New York area and Massachusetts (?Desirable Location?) versus other firms, and firms located in cities where there is a stock exchange (?Exchange Location?: New York, Chicago, Boston, and Los Angeles) versus other firms. Since the type of industry ban is an ordinal variable, Wilcoxon-Mann-Whitney tests are performed to compare mean sanctions for each group. In all three groups, listed firms located in the target area receive lower industry bans compared to listed firms located outside that area. Results are statistically significant at the 5% level in all three groups. Thus, the geographical divide in enforcement bias is generally supportive of the employer favoritism hypothesis and rather inconsistent with the socialization hypothesis, whose impact should be uniform across the country.

This is a really nice paper, and the problem, as Gadinis recognizes, is that it is difficult to be sure that big and little, New York and non, aren't proxies for quality, as well as proxies for future employment (or, for that matter, that future employment isn't a proxy for quality; SEC enforcers may not wish to go work for bucket shops). Well worth your time. After the jump, some scene setting from the paper:

Gadinis writes:

[T]his paper uses a new dataset of all SEC actions against broker-dealers in 1998, 2005, 2006, and the first four months of 2007 to investigate whether the SEC treats large and well-known investment houses more favorably than small broker-dealers. Because the SEC may choose to pursue a broker-dealer by either filing a civil lawsuit or by initiating administrative proceedings before an administrative law judge, the paper first explores the factors that determine the agency?s choice of venue. Courts are a worse forum for finance professionals, since, conditional on a finding of violation, a court is more likely than an administrative law judge to ban defendants from the securities industry. The paper finds that, for the same violation and comparable levels of harm to investors, big firms and their employees are more likely to avoid courts and face administrative proceedings instead.The paper then turns to administrative cases, which the SEC controls more directly than court cases. Again, the paper finds that, for the same violation and comparable levels of harm to investors, big firms and their employees are less likely to receive a ban from the securities industry, compared to small firms and their employees. Some theories could justify the differential treatment of large and small firms, on the basis of systemic risk considerations or concerns about unduly penalizing entire firms because of limited violations. However, no public policy justification exists for the preferential treatment of individual employees in large firms.

Full post as published by Conglomerate on February 09, 2009 (boomark / email).