Recent Supreme Court rulings could backfire on markets and investors

Editor’s note: This article, distributed by The Associated Press, was originally published on The Conversation. The Conversation is an independent, nonprofit source of news, analysis, and commentary from academic experts.

---

In two important rulings last month, the U.S. Supreme Court has curbed the power of federal agencies to develop and enforce policies that affect the nation’s financial health. One important agency, the Securities and Exchange Commission, has been hit particularly hard.

As someone who has investigated financial intrigue for almost 50 years, I fear that these rulings will have a negative impact on markets and investors.

Taken together, they could lead to weaker regulation, weaker enforcement, and less oversight of the country’s financial markets and public companies. Ultimately, I fear, they could be a significant factor in a future market crash.

In one case, Securities and Exchange Commission v. JarkesyThe court issued a sharp reprimand to the SEC — the agency that protects investors from fraud — for using internal procedures to punish companies and others for violating securities laws. The SEC will now have to prosecute accused securities fraudsters in federal court, which could be more complicated and expensive.

And in the second case, Loper Bright Enterprises v. RaimondoThe court sharply curtailed a long-standing doctrine — the Chevron rule — that gave agencies significant latitude in creating rules and regulations, especially when the law they were based on could be ambiguous. As a result, federal agencies, including the SEC, have less authority to act, handing that authority over to longer and more expensive lawsuits.

More layers of hidden risk for investors

Both decisions could affect the country’s financial well-being. Investors who rely on the SEC’s disclosure rules and enforcement mechanisms for protection — now subject to legal challenges — will be burdened with an additional layer of hidden risk not seen in decades — most notably more questionable accounting practices in their regulatory filings.

Recall that in 1933 and 1934, Congress created the SEC in the wake of the Great Depression. The years that followed saw the formation of less risky and more informed markets.

Investors could also rely on market prices to effectively and impartially reflect all public information, rather than having to delve into complex financial statements. This led to the US markets becoming the most attractive place in the world for funds investing in risky business projects.

The SEC later strengthened financial markets with measures under the Dodd-Frank Act of 2010 to correct other abuses — such as overly generous credit ratings — that likely contributed to the Great Recession of 2007–08. Today, thanks to extensive disclosure requirements and relatively effective enforcement mechanisms, the United States has arguably the healthiest and most robust financial markets in history.

A New Challenge for Law Enforcement

However, healthy and stable financial markets do not rely on altruism.

Monitoring and enforcement mechanisms are key. While the SEC relies in part on the private sector to detect and punish rogue managers for securities law violations—for example, through federal and state securities class action lawsuits—the bulk of its efforts rely on the SEC’s enforcement division.

Specifically, the SEC uses “Accounting and Auditing Enforcement Issues,” or AAERs, to ensure that companies keep clean books. Since 1995, the SEC has issued 3,266 AAERs, mostly to correct accounting and auditing deficiencies in companies’ financial statements. Numerous studies confirm that AAERs are evidence of financial fraud.

AAERs are also a highly effective form of enforcement — and much less expensive than a securities class action lawsuit. Companies typically agree to settle allegations of wrongdoing without admitting liability, taking timely steps to improve accounting and auditing, and paying fines and penalties.

The payments were substantial. For example, for 760 enforcement actions in 2022, companies paid the SEC a whopping $6.4 billion. The announcement of AAER actions is also costly to a company’s shareholders, with stock prices falling 50% in the six months following an AAER announcement, according to researchers.

But Jarkesy ruling could change everything. I don’t see why any public company would agree to an AAER settlement with fines and penalties when it can now challenge the SEC’s arguments in court.

The danger of law enforcement by the courts

What might be the consequences of removing or restricting the Securities and Exchange Commission’s primary enforcement tool?

The risk likely returns to an environment like 1928 or 2007. That’s because the ruling will effectively lower the costs of accounting or auditing violations for potential or actual violators. It shifts the authority to decide penalties and fines to the courts rather than internal SEC investigations, increasing enforcement costs for the SEC.

In short, companies will worry less about a future AAER investigation.

Moreover, despite auditors’ efforts to ensure that publicly traded financial and investment firms maintain a clean set of accounts based on generally accepted accounting principles, or GAAP, there are still many choices, including the broader use of non-GAAP accounting principles. With less enforcement, Jarkesy This ruling will encourage more creative accounting, not restrict it.

This creativity is already skewing toward bullish earnings reports. The vast majority of earnings releases are now beating analysts’ forecasts—77% for the S&P 500 in the first quarter of 2024. What’s more, my own research suggests that not only are earnings reports beating analysts’ forecasts, but also that the dollar size of positive corporate earnings surprises has been steadily increasing over the past decade, another hidden risk.

Less control, more long-term risk

Some securities lawyers argue that Jarkesy The decision will not change the SEC’s behavior as the agency increasingly moves proceedings to regular courts.

While this is true for some actions, I think the biggest impact will be one that the SEC has yet to take. Companies and the SEC will operate differently in the future because Jarkesy makes SEC enforcement more expensive and uncertain.

You might expect companies to put more effort into presenting their financial results in the best possible terms, knowing that the costs of SEC enforcement have just increased, while the likelihood of detection and the expected costs to a company for violating generally accepted accounting principles or generally accepted auditing standards have just decreased.

While not all scholars agree, there are two major periods in U.S. financial history that saw financial collapse that was likely caused in part by poor accounting and reporting—the Great Depression of 1929 and the Great Recession of 2007–09.

In the coming years or decades, if the country faces another major financial crisis that leads to recession, it will be harder to blame accountants and investment bankers. Instead, attention may turn to two court decisions from mid-2024 and the judges who wrote them.

Paul Griffin is professor emeritus of management at the University of California, Davis.