The cost of securities fraud.

• Author: Velikonja, Urska
• Position: III. Financial Misrepresentations and Intrafirm Cost A. Intrafirm Cost: Theory 3. Do Nonshareholders Care About Financial Disclosures? through Conclusion, with footnotes, p. 1923-1957

3. Do Nonshareholders Care About Financial Disclosures?

   One might argue that employees, for example, do not read and rely on financial disclosures. Even if they did, a public firm's disclosures are directed at the shareholders, not employees, so employee reliance is irrelevant. This Article offers four related responses.

   First, the business community and some academic commentators seem to believe that public disclosures "are increasingly useless as sources of information." (166) There is no empirical evidence that this is in fact true. Public disclosures, and in particular audited financial statements, are generally perceived as cheap to find, comprehensive, and reliable because they are audited and certified, and carry a nontrivial risk of liability if found to be false. (167)

   But even if audited financial statements were indeed irrelevant to investors, that fact would say little about whether they are relevant to a firm's employees, for example. Many employees have access to private information about their employers, but the information is often incomplete and unverified. The larger, more complex, and more diversified the firm, the less useful is employees' private information about their employer. It is rational for employees to rely on publicly disclosed information unless they believe their private information is more accurate--for example, when they are involved in or aware of the fraudulent scheme. (168) Most public firms are sufficiently large that the vast majority of their employees really do not have access to the sort of internal information that would flag fraud. (169)

   Second, fraud begets more fraud. When a firm releases a false financial statement, its voluntary disclosures and its observable actions must be consistent with the false statement, or else fraud will be discovered. (170) Mass layoffs at a time that a firm is reporting exponentially growing revenues are suspicious, at the least.

   Firms' managers recognize that employees read publicly disclosed information about the firm. For example, the auditor of Groupon, an online daily deal vendor, recently identified material weaknesses in the firm's internal controls, which usually signal more serious problems. (171) Shortly after the disclosure, Groupon's CEO Andrew Mason addressed the firm's 11,000 employees in a town hall meeting to reassure them that the firm was taking steps to fix the problem. (172) Surely, the rank-and-file employees were not only concerned about the value of their Groupon stock but also about their jobs.

   Third, it is true that investors, creditors, and employees care about different information about the firm. Any information that moves the stock price is arguably relevant to investors. Banks and institutional creditors care about the risk of default and the liquidation value of their claims, but are largely indifferent to firm performance above a certain threshold. (173) Institutional creditors, for example, are very sensitive to a firm's systemic weaknesses in internal controls that affect the firm's overall control environment and financial reporting process, because they signal uncertainty about the firm's creditworthiness and liquidation value. (174) Creditors are substantially less concerned about improper accounting of individual transactions. (175)

   On the other hand, most employees, suppliers, and vendors have open-term contracts with the firm. As a result, they are sensitive to specific information that makes contract termination more likely, such as declining sales or revenues of particular divisions and mounting debt burden, but they also care about general risk that the firm will lay off people on a large scale and shrink production. (176) As a result, at-will employees are quite sensitive to information about the performance of the firm and its divisions, as well as the firm's debt burden.

   And finally, one might contend that firms disclose their financial information to investors, and thus other market participants have no right to rely on it: their reliance is not justifiable in a legal sense. (177) That may be, but that is only an argument against private causes of action by employees, not against taking the total cost of financial statement fraud into account in public regulation and enforcement. Once relevant information is publicly disclosed, market participants will use it and rely on it. Moreover, it enhances social welfare when market participants rely on accurate disclosures and make better-informed investment decisions. (178) Conversely, their reliance on fraudulent financial disclosures reduces social welfare. (179) Even if the disclosing firm's employees have no legal right to sue for financial misrepresentations, the harms they suffer ought to be included in the calculation of the total harm that the false disclosure causes.

   2. Intrafirm Cost: Evidence

   No doubt, financial misrepresentations harm the firm's shareholders. Dozens of studies report average stock price declines ranging from 9 percent (180) to a high of 38 percent. (181) But as the theoretical discussion above suggests, financial manipulation harms the firm's nonshareholder constituents also. Not surprisingly, the value of the firm's debt usually declines when fraud is revealed. (182) Thus far underappreciated has been the harm to employees.

   First, a couple of caveats are in order. Many of the studies reported in this Article focus on the effects of restatements issued between 1997 and 2002. It is possible that the period is not representative because the frequency of earnings manipulation was relatively high. Between 1988 and 2008, on average twenty-one firms per year faced an SEC enforcement action for securities fraud. (183) Between 1997 and 2002, the average was 53 percent higher, or thirty-two firms per year. (184) As a result, the findings reported below might not be representative of accounting fraud generally.

   In addition, a few of the studies discussed report effects of all restatements, not just restatements accompanied by an enforcement action or a lawsuit. An enforcement action is a strong signal of fraud, but a restatement without an enforcement action does not necessarily signal the absence of fraud. The SEC has historically used its limited budget to target smaller frauds and "the more obvious and spectacular cases of earnings manipulation." (185)

   This warrants two further observations. First, social welfare losses accompany even entirely innocent misstatements, but fraudulent misrepresentations ought to produce greater losses. (186) If a misrepresentation is truly innocent, managers have no incentive to engage in costly masking strategies to avoid detection. An error might induce them to pursue an ill-informed business strategy but will not lead to investments specifically chosen to disguise fraud. In addition, if managers do not try to conceal errors, it is plausible that the errors will be detected and corrected sooner than fraudulent disclosures. Moreover, it is likely that honest managers will notice a discrepancy that is significant, suggesting that erroneous misstatements should be smaller than those that are fraudulent. Finally, if innocent errors are distributed normally, they should cancel each other out across firms--at least to some extent--with some overstating earnings and others understating earnings. As a result, measuring the effects of accounting fraud by looking at all restatements understates social welfare losses that each incident of fraud causes, assuming that at least some restatements are entirely innocent. (187)

1. The Cost of Fraud to Employees

   Few studies have attempted to study whether and how harmful accounting fraud is to the firm's employees and labor markets generally. Professors Kedia and Philippon estimated the real economic costs of financial misrepresentations to labor markets by examining a large sample of restating firms between January 1997 and June 2002, when about 10 percent of all listed firms restated their earnings at least once. (188) They found that restating firms hired and invested more than comparable firms during periods of suspicious accounting, reduced labor and borrowing, and sold capital assets after the restatement. (189) To maintain consistency between reported numbers and their business operations, restating firms mimicked firms that were growing as fast as the numbers would suggest. (190) The authors showed that overinvestment would not have been possible but for the financial misrepresentation. (191)

   The implications of the Kedia and Philippon study are significant. Restating firms overhired and overinvested during the period of the misrepresentation and reduced both labor and investment thereafter. The subsequent decline was not offset by the earlier growth--it exceeded it and substantially exceeded the trends in the economy. While all nonfarm payrolls increased by 6.7 percent between 1997 and 1999 and then declined by 1.5 percent from 2000 to 2002, employment in restating firms increased by 500,000--25 percent--and then fell by 600,000. (192)

   More troubling is that industries marred by restatements lost jobs permanently, even where rivals were able to reclaim the restating firms' market shares--an expected boon for the shareholders. Instead of expanding their employment and investment to compensate for the losses of restating firms, rivals also reported negative employment and investment growth, coupled with strong labor productivity growth, compared with nonrestating firms in more honest industries. (193) However, increased labor productivity was not offset by higher wages. (194)

   4. FINANCIAL MISREPRESENTATIONS AND EXTERNAL COST

   1. The Cost of Fraud to Rivals: Theory

1. Economic Learning

   Securities laws require firms to disclose specific information about lines of business, the cost of sales, and market share, which is useful to that firm's present and potential rivals. Unlike a stylized financial model where risk and expected returns of...