Who Blows the Whistle on Corporate Fraud?

This post comes to us from Alexander Dyck, Professor of Finance at the University of Toronto, Adair Morse, Assistant Professor of Finance at the University of Chicago, and Luigi Zingales, Professor of Entrepreneurship and Finance at the University of Chicago.

In our paper, Who Blows the Whistle on Corporate Fraud?, which is forthcoming in the Journal of Finance, we study all reported fraud cases in large U.S. companies between 1996 and 2004 to identify the most effective mechanisms for detecting corporate fraud.

The large and numerous corporate frauds that emerged in the United States at the onset of the new millennium provoked an immediate legislative response in the Sarbanes Oxley Act (SOX). This law was predicated upon the idea that the existing institutions designed to uncover fraud had failed, and their incentives as well as their monitoring should be increased. The political imperative to act quickly prevented any empirical analysis to substantiate the law’s premises. Which actors bring corporate fraud to light? What motivates them? Did reforms target the right actors and change the situation? Can detection be improved in a more cost effective way?

To answer these questions, we gather data on a comprehensive sample of alleged corporate frauds that took place in U.S. companies with more than 750 million dollars in assets between 1996 and 2004. After screening for frivolous suits, we end up with a sample of 216 cases of alleged corporate frauds, which include all of the high profile cases such as Enron, HealthSouth, and WorldCom. Through an extensive reading of each fraud’s history, we identify who is involved in the revelation of the fraud. To understand better why these fraud detectors are active, we study the sources of information detectors use and the incentives they face in bringing the fraud to light. To identify the role played by short sellers, we look for unusual levels of short positions before a fraud emerges.

The main result emerging from our analysis is that in the United States fraud detection relies on a wide range of, often improbable, actors. No single one of them accounts for more than 20 percent of the cases detected. These findings suggest that to improve corporate governance abroad one needs to adopt a broader view than implied by the legal or private litigation approaches to corporate governance. It is insufficient to replicate U.S. institutions of private enforcement such as class action suits or of public enforcement such as the SEC (together they account for only 10 percent of the revelation of frauds by external actors). Rather, the US relies on a complex web of market actors that complement each other. Unfortunately, reproducing such a complex system abroad is much more difficult than copying a single legal institution.

The second main result is that the incentives for the existing network of whistleblowers are weak. Auditors, analysts, and employees do not seem to gain much and, in the cases of employees, seem to lose outright from whistleblowing. The two notable exceptions regarding who benefits from whistleblowing are journalists involved in large cases and employees who have access to a qui tam suit.

A natural implication of our findings is that the role of monetary incentives should be expanded. We find that the use of monetary rewards provides positive incentives for whistleblowing. As the evidence in the healthcare industry shows, such a system appears to be able to be fashioned in a way that does not lead to an excessive amount of frivolous suits. The idea of extending the qui tam statue to corporate frauds (i.e. providing a financial award to those who bring forward information about a corporate fraud) is very much in the Hayekian spirit of sharpening the incentives of those who are endowed with information. This proposal is consistent with a recent IRS move, which instituted a form of qui tam statue for whistleblowers in tax evasion cases.

The full paper is available for download here.

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