Corporate Scandals and Regulation

AuthorAHMED TAHOUN,CLARE WANG,LUZI HAIL
DOIhttp://doi.org/10.1111/1475-679X.12201
Date01 May 2018
Published date01 May 2018
DOI: 10.1111/1475-679X.12201
Journal of Accounting Research
Vol. 56 No. 2 May 2018
Printed in U.S.A.
Corporate Scandals and Regulation
LUZI HAIL,
AHMED TAHOUN,
AND CLARE WANG
Received 1 November 2015; accepted 5 December 2017
ABSTRACT
Are regulatory interventions delayed reactions to market failures or can reg-
ulators proactively pre-empt corporate misbehavior? From a public interest
view, we would expect “effective” regulation to ex ante mitigate agency con-
flicts between corporate insiders and outsiders, and prevent corporate mis-
behavior from occurring or quickly rectify transgressions. However, regula-
tors are also self-interested and may be captured, uninformed, or ideological,
and become less effective as a result. In this registered report, we develop a
historical time series of corporate (accounting) scandals and (accounting)
regulations for a panel of 26 countries from 1800 to 2015. An analysis of the
The Wharton School, University of Pennsylvania; London Business School; Tippie Col-
lege of Business, University of Iowa.
Accepted by Haresh Sapra. This paper is the final Registered Report resulting from the
Registration-based Editorial Process (REP) implemented by JAR for its 2017 conference.
Details of the REP are available here: https://research.chicagobooth.edu/arc/journal-
of-accounting-research/2017-registered-reports. The accepted proposal and an On-
line Appendix for this report are available here: https://research.chicagobooth.edu/
arc/journal-of-accounting-research/online-supplements. We appreciate the helpful com-
ments of two anonymous referees, the many country experts, Sudipta Basu, Christian Leuz,
and workshop participants at the 2017 JAR conference, Northwestern University, and Uni-
versity of Zurich. We thank Linda Aikala, P´
eter Aleksziev, Inˆ
es Bastos, Wilbur Chen, Joris
de Kok, Manuel Engelmann, Rita Estˆ
ev˜
ao, Christos Grambovas, Seung Youb Han, Selina
Hartmann, Jonathan Hori, Elisabetta Ipino, Keita Kana, Florian Klassmann, Benjamin Miller,
Siladitya Mohanti, Andreea Moraru Arfire, Victor Musuku, Stefan Romeijn, Varun Sharma,
Ido Spector, Josep Maria Vil`
a Calopa, Gabriel Voelcker, Halina Waniak, and Melody Xu for
their excellent research assistance. We gratefully acknowledge financial support by Wharton’s
Global Initiatives Research Program (Luzi Hail), the Institute for New Economic Thinking
(Ahmed Tahoun), and the Lawrence Revsine Research Fellowship of the Kellogg School of
Management at Northwestern University (Clare Wang).
617
Copyright C, University of Chicago on behalf of the Accounting Research Center,2018
618 L.HAIL,A.TAHOUN,AND C.WANG
lead-lag relations at both the global and individual country level yields the fol-
lowing insights: (1) Corporate scandals are an antecedent to regulation over
long stretches of time, suggesting that regulators are typically less flexible and
informed than firms. (2) Regulation is positively related to the incidence of
future scandals, suggesting that regulators are not fully effective, that explicit
rules are required to identify scandalous corporate actions, or that new regu-
lations have unintended consequences. (3) There exist systematic differences
in these lead-lag relations across countries and over time, suggesting that the
effectiveness of regulation is shaped by fundamental country characteristics
like market development and legal tradition.
JEL codes: F30; G18; G38; K22; L51; M48; N20
Keywords: accounting fraud; corporate scandals; capital market regulation;
economics of regulation; law and finance; international accounting
Government regulators—you can count on it—are always late to presumed
“problems” that are invariably fixed by market competition. Once again,
if regulators could predict markets, they surely wouldn’t be working as
regulators. Tamny [2015, p. 126]
1. Introduction
Can regulators proactively pre-empt corporate wrongdoing before it
occurs? And do they detect and rectify actual misbehavior in a timely
and persistent manner? To shed light on the issue of “regulatory effec-
tiveness,” we examine in this registered report the lead-lag relations be-
tween corporate (accounting) scandals and (accounting) regulation for
a global sample of 26 countries over a period of more than 200 years.1
This large historical panel lets us test whether corporate scandals are re-
lated to future regulatory actions, or whether the relation goes the other
way, and past regulations systematically precede future corporate scan-
dals. Such an analysis of temporal patterns allows us to draw partial infer-
ences about the effectiveness of regulation, and how regulation has his-
torically been shaped by corporate scandals (e.g., Nobes [1991], Waymire
and Basu [2007, 2011]). Given the high economic and social costs asso-
ciated with corporate scandals, the importance of such considerations is
clear. In monetary terms, the estimated annual cost of fraud among large
U.S. corporations is US$ 380 billion or about 3% of the enterprise value
of each firm (Dyck, Morse, and Zingales [2014], see also Karpoff, Lee, and
1We focus on accounting regulation and accounting scandals involving private corpora-
tions, but do so in a broad sense. Thus, we also consider regulations and voluntary conven-
tions regarding corporate governance and investor protection and, on the scandal side, inci-
dents of financial frauds, embezzlements, investments schemes, tax evasion, etc. We do not
include cases of political scandals and corruption or general financial crises. See subsection
2.1 for details. Henceforth, we interchangeably use the terms scandal, corporate scandal, and
accounting scandal.
CORPORATE SCANDALS AND REGULATION 619
Martin [2008]). When the impact of lost public trust in financial markets
is taken into consideration, the cost is even higher (Giannetti and Wang
[2016]).
The political economy literature puts forward three main perspectives to
help interpret the observed temporal patterns between corporate scandals
and regulation. First, the public interest view argues that regulators are per-
sons of character who seek public office to change policy and monitor mar-
ket mechanisms in the best interest of the public (e.g., Pigou [1938], Wit-
man [1977], Alesina [1988], Previts and Merino [1998], Diermeier, Keane,
and Merlo [2005], Callander [2008]). From this point of view, we would ex-
pect “effective” regulation to ex ante mitigate agency conflicts between cor-
porate insiders and outsiders, and prevent corporate misbehavior from oc-
curring. Where corporate misbehavior is ongoing or has already occurred,
effective regulators would detect and rectify transgressions in a timely man-
ner, and prevent such incidents from recurring. According to this view,
newly introduced regulation should reduce the incidence of future cor-
porate scandals and, from an ex post perspective, current corporate scan-
dals should increase the enactment of future regulations. At the same time,
there might exist positive serial correlation between today’s regulations and
future scandals in the short run, if it requires new rules for the regulator
to become active and identify ongoing corporate actions as unlawful or in
violation of public trust.
Under the second view, legislators and regulators respond to economic
incentives in their best self-interest (see, e.g., Stigler [1971], Krueger
[1974], Peltzman [1976], Kalt and Zupan [1984], Frye and Shleifer [1997],
Mahoney [2003], Mian, Sufi, and Trebbi [2010], Tahoun and van Lent
[2013]). They react to pressure from constituents, succumb to lobbying
and other rent-seeking behaviors, and act, in general, to increase their per-
sonal utility. If for these reasons regulators are captured by the regulated,2
their regulatory actions are unlikely to be effective in serving the public’s
interest (e.g., Stigler [1971], Partnoy [1999], Mahoney [2001], O’Connor
[2004]). It follows that new regulatory activity is unrelated or even posi-
tively related to the incidence of future corporate scandals, if those scan-
dals benefit the special interests of the regulated firms (and, therefore,
indirectly the self-interest of the regulators), or if managers are quick to
adapt and shift their corporate wrongdoing to areas beyond the scope
of the new regulation. Similarly, corporate scandals would not necessarily
lead to an increase in the enactment of future regulations, and regulatory
2Regulatory capture can occur through materialistic or nonmaterialistic means. The for-
mer is known as financial capture and indicates that the regulator receives bribes or political
donations from the regulated party that wants to maintain its government funding. The non-
materialistic, cognitive capture occurs when the regulator’s mindset is in sync with the regu-
lated party due to intense lobbying (see e.g., Engstrom [2013], Carpenter and Moss [2014]).
Often, a lobbying coalition of “Baptists” (moral message) and “Bootleggers” (moneyed inter-
ests) forms and adopts both strategies to achieve their common goals (e.g., Yandle [1983]).

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