As the new millennium dawned, so did a spate of U.S. corporate scandals. The names Enron, WorldCom, and numerous others are tainted by cases of corporate fraud and malfeasance. These frauds and the accompanying outrage spurred the passage of the Sarbanes-Oxley Act (SOX). The underlying premise of SOX was that institutions charged with uncovering fraud had failed in their duties, and their incentives and monitoring needed to be enhanced.
In the haste to pass SOX into law, however, little attention was paid to the premise of the new regulation. Few stopped to ask: Who plays a role in detecting and deterring corporate fraud, and what is their motivation? Did reforms target the right people and fix the problem? Furthermore, can fraud detection be improved in cost-effective ways?
These questions are addressed in the new study “Who Blows the Whistle on Corporate Fraud?” by University of Chicago Graduate School of Business professors Adair Morse and Luigi Zingales, and Alexander Dyck of the University of Toronto’s Rotman School of Management.
Morse, Zingales, and Dyck found fraud detection relies not on a single person or institution, but on the actions of a wide range of sometimes unlikely heroes. In particular, they find that when there exists a monetary reward for fraud revelation— as is the case for fraud against the U.S. government— employees become much more active in revealing fraud. Since the authors do not find that monetary rewards increase frivolous lawsuits (suits dismissed or settled for less than $3 million), they conclude that it could be beneficial to extend the same regime to publicly traded companies.
Multiple Sources
Morse, Zingales, and Dyck began their research by gathering
a comprehensive sample of corporate fraud perpetrated in
companies with more than $750 million in assets in the United
States between 1996 and 2004.
After screening for frivolous lawsuits, their final dataset contained 230 cases of corporate fraud, including the highprofile Enron, HealthSouth, and WorldCom cases. For each case, the authors identified who revealed the fraud, the circumstances leading to detection, the timing of the revelation, the sources of information, and the incentives that led detectors to bring the fraud to light. To help identify the role of short sellers (traders who sell borrowed stock in the hope of a decline in price) the authors searched for unusual levels of short positions (i.e., sales of borrowed stock) before the emergence of a fraud.
Their results demonstrate that fraud revelation comes from many sources. For example, the Securities and Exchange Commission (SEC) accounts for only 6 percent of detected frauds; short sellers and equity holders account for 9 percent; and financial analysts and auditors account for 14 percent.
As intriguing as who detects corporate fraud is who does not. Almost completely absent from the roster of detectors are stock exchange regulators, commercial banks, and underwriters. The authors also identified several unlikely detectors: the media uncovered 14 percent of the fraud, non-financial market regulators found 16 percent, and employees detected 19 percent.
One might expect private security litigation to play a large role in fraud detection, but in fact less than two percent of fraud cases are brought to light in this manner.
Private litigation is not necessarily ineffective. It can be a mechanism to force those committing fraud to pay for their misdeeds. But far from operating on its own, private security litigation requires the assistance of an assortment of institutions to uncover the presence of fraud.
“The most surprising result was the relatively small role of the SEC,” says Zingales. “I had assumed that the SEC and class action suits were very important in bringing frauds to light, but they don’t seem important overall. It takes a village to detect fraud because not only are there many different players involved, but the process by which this fraud emerges rests on interaction between these players.”
Quick to Respond
The average speed with which fraud is detected is another
yardstick of the comparative effectiveness of these detectors.
Financial analysts and short sellers are the quickest to uncover fraud, with each needing 9.1 months on average. Frauds that slip by these individuals are unmasked by external stockholders (15.9 months); suppliers, clients, competitors, and nonfinancial market regulators (13.3 months); auditors (14.7 months); and employee whistle blowers (20.9 months). Those with relatively minimal access to the company manage to catch frauds later in the process. These include the media (21 months), the SEC (21.2 months), and plaintiff lawyers (31.4 months).
Turning next to the risk/benefit equation, the authors looked at motives to ferret out fraud. For instance, financial analysts are viewed as agents of professional investors, giving them strong motives to uncover fraud. However, this incentive may be diluted by the potential conflict of interest between their advising and their firms’ investment banking services. Similarly, journalists face tradeoffs between boosting their careers and jeopardizing advertising income from the firms they write about.
The authors found that analysts, journalists, auditing firms, and employees who uncover fraud do not appear to benefit from either a career or financial standpoint. Auditing firms are more likely to lose the client when they reveal fraud than when they do not. In 82 percent of cases in which named employees blow the whistle, these employees end up being fired, quitting under pressure, or shifting duties.
The prospect of monetary or career gain also does not spur younger go-getters to look for fraud, despite the lingering legacy in the government arena of a youthful Woodward and Bernstein blowing the lid off the Watergate scandal.
Sixty percent of the corporate fraud revelations by analysts are uncovered by senior analysts at top-10 investment banks. Among the media players detecting fraud, the majority of cases are uncovered by experienced reporters from the most highly regarded newspapers.
The paradox is that those with little or no incentives to reveal fraud, such as employees, tend to be the most active, while those with greater motivations, such as short sellers, are far less involved. The key is access to important information.
“Some people become aware of fraud in the course of their normal business dealings,” says Zingales. “Not only do they not have a positive incentive to reveal the fraud, they have an extremely large disincentive to reveal.”
Zingales adds: “These employees are usually fired or completely ostracized by their officemates. The culture of loyalty is important, but it can lead to fraud being concealed.”
Mandatory versus Market
In the course of their research, the authors examined the relative
merits of two different approaches to detecting fraud. The
first, or “mandatory” approach, generally relies on auditors,
the SEC, and nonfinancial market regulators to detect fraud.
An alternative, or “market” approach, rewards individuals
such as short sellers and financial analysts with monetary or
career rewards when they uncover corporate fraud.
The authors found that 73 percent of corporate frauds were revealed via the market approach prior to July 2002, but that number plunged to 46 percent thereafter. That decline likely resulted from new regulations (including SOX) that boosted incentives and penalties for those participants in the mandatory approach to detection.
The authors then examined an alternative to the mandated approach of SOX—that of providing monetary rewards to detectors. In particular, they studied the effect of the Federal Civil False Claims Act, which promise people who bring to light frauds against the government between 15 to 30 percent of the money recovered.
In the health care industry, where the government comprises a substantial percentage of revenues, 46.7 percent of frauds are ferreted out by employees—a much larger figure than the 16.3 percent detected by employees in all other industries.
The obvious conclusion is that monetary rewards do spur people with information about fraud to come forward with their findings.
“The greatest benefit of this approach is that you can create competition,” says Zingales. “Once there’s a reward, there is an incentive to speak up and to be the first to do so. It’s very difficult for a large company to stop that. You can bribe one or two guys, but not an entire company.”
One criticism of adopting such a policy is that it may result in frivolous lawsuits. However, the authors find this argument without merit. There is a lower, not higher, percentage of frivolous suits in the health care industry than other industries.
Another concern is that rewarding whistle blowers may foster distrust among employees and subvert working relationships that benefit employers. While failing to find evidence of such a problem in sectors that reward the reporting of fraud, the authors acknowledge this is an area that merits further study.
“Since the qui tam approach has worked very well in combating fraud against the federal government, there’s no reason why we shouldn’t try to extend this approach to corporate fraud as well,” says Zingales.
“Who Blows the Whistle on Corporate Fraud?” Alexander Dyck, Adair Morse and Luigi Zingales.