The U.S. Securities and Exchange Commission (SEC) is facing an increasing risk of shutdowns as its budget requires Congressional approval amid a divisive political climate. SEC chair Gary Gensler has highlighted that discontinuities in capital market regulation due to SEC shutdowns can impact corporate governance if the SEC cannot fulfil its oversight mandate, even temporarily. In our recent article titled “Do Corporate Insiders Respond to Variation in SEC Scrutiny?”, we investigate significant governance effects for listed companies resulting from SEC shutdowns, emphasizing the importance of stable SEC funding. The findings of this study can thus inform the debate on SEC self-funding, offering insights into the broader implications of regulatory gaps caused by funding issues.

The U.S. government shutdown from late 2018 to early 2019 provides a natural experiment to examine how corporate insiders behave when the SEC’s oversight is weakened. This shutdown, the longest in American history, saw the SEC operating at a mere fraction of its normal capacity, significantly reducing its regulatory activities. We examine whether corporate insiders exploit this lack of SEC enforcement by analyzing the profits insiders make from trading shares in their companies during the shutdown.

The primary economic outcomes focused on in this study are excess returns earned by insider trading, monitored by the SEC’s Division of Enforcement, and comment letters issued by the SEC’s Division of Corporate Finance. The results reveal that corporate insider trading profits are significantly higher during the SEC shutdown compared to the same periods in the two years prior and the two years following the shutdown, especially for insider sales, indicating a response to the temporary lapse in regulatory oversight.

Additionally, we compare the trading profits of insiders from U.S. firms to a sample outside the U.S., where the regulators should not be affected as funding continued in the other countries. Difference-in-difference analyses show that U.S. insiders earned significantly higher profits during the shutdown compared to insiders in the global sample. This result is consistent when the non-U.S. sample is restricted to Canadian firms, where regulatory features are assumed to be similar to the U.S. In addition, insiders are more likely to sell shares during the SEC shutdown ahead of very bad news (indicated by highly negative future abnormal stock returns). Collectively, these results support the notion that insiders opportunistically exploited the SEC shutdown, capitalizing on their access to non-public information during a time when regulatory scrutiny was diminished.

These findings suggest that insiders behave as if SEC enforcement is weaker during and following the SEC shutdown. To further support this claim, we conduct two ex post analyses showing that the regulatory shortfall exists and is not compensated for after the shutdown ends. First, data on actual SEC insider trading enforcement releases indicate fewer enforcement actions related to transactions executed during the shutdown compared to pre-shutdown periods. This reduction in enforcement activity provides direct evidence of a gap in regulatory oversight. Second, the number of comment letters issued by the Division of Corporate Finance drops to zero during the shutdown, evidencing a real effect on this form of SEC oversight. Importantly, there is no abnormal increase in comment letters after the shutdown. 10-Ks filed post-shutdown are less likely to receive comment letters, even for more severe accounting issues like revenue recognition. This persistent decrease in regulatory activity post-shutdown underscores the long-term impact of temporary funding lapses on the SEC’s ability to oversee corporate governance effectively.

Overall, the results in this study suggest that there are real costs to government shutdowns in terms of lower levels of capital market oversight by the SEC related to both increased opportunistic insider trading and less intense reviews of corporate periodic filings. These findings contribute to the debate on SEC funding sources by illustrating the consequences of funding disruption. We do not make a normative claim on whether the SEC should be self-funded but raise important questions for policymakers to consider. Whether the costs of SEC shutdowns are so great that they justify a more autonomous funding model is for the legislative and executive branches to decide.

The full paper can be downloaded here.