The cost of securities fraud.

• Author: Velikonja, Urska
• Position: Introduction through III. Financial Misrepresentations and Intrafirm Cost A. Intrafirm Cost: Theory 2. Employees, p. 1887-1923

ABSTRACT

Under the dominant account, fraudulent financial reporting by public firms harms the firms' shareholders and, more generally, capital markets. This Article contends that the account is incomplete. In addition to undermining investor confidence, misreporting distorts economic decision making by all firms, both those committing fraud and those not. False information impairs risk assessment by those who provide human or financial capital to fraudulent firms, the firms' suppliers and customers, and thus misdirects capital and labor to subpar projects. Efforts to hide fraud and avoid detection further distort fraudulent firms' business decisions, as well as decisions by their rivals, who mimic or respond to what appears to be a profitable business strategy.

If fraud is caught, managers externalize part of the cost of litigation and enforcement to employees, creditors, suppliers, and the government as the insurer of last resort. Mounting empirical evidence suggests that harm to nonshareholders dwarfs that suffered by defrauded shareholders. Moreover, unlike investors, who can limit their exposure to securities fraud by diversifying their holdings and demanding a fraud discount, other market participants cannot easily self-insure. The Article supplies both theoretical and empirical support for the assertion that defrauded investors are not the only victims of accounting fraud. In conclusion, the Article outlines and assesses some alternative fraud deterrence and compensation mechanisms.

TABLE OF CONTENTS INTRODUCTION I. THE REGULATION OF SECURITIES FRAUD A.A Summary of Regulation B. Existing Thought on the Harm from Securities Fraud II. OVERVIEW OF FINANCIAL MISREPRESENTATIONS A. The Anatomy of a Misrepresentation B. If and After the Truth Is Revealed III. FINANCIAL MISREPRESENTATIONS AND INTRAFIRM COST A. Intrafirm Cost: Theory 1. Creditors 2. Employees 3. Do Nonshareholders Care About Financial Disclosures ? B. Intrafirm Cost: Evidence 1. The Cost of Fraud to Employees IV. FINANCIAL MISREPRESENTATIONS AND EXTERNAL COST A. The Cost of Fraud to Rivals: Theory 1. Economic Learning 2. Distorted Competition 3. Contagion B. The Cost of Fraud to Rivals: Evidence 1. Equity Market Externalities 2. Debt Market Externalities C. The Cost of Fraud to the Government and Communities V. DETERMINANTS OF THE COST'S MAGNITUDE A. The Likelihood of Fraud B. The Size of the Distortion from Fraud 1. Fraud Characteristics 2. Fraudulent Firm Characteristics 3. Market Characteristics 4. Summary VI. IMPLICATIONS AND SOLUTIONS A. Implications B. Solutions 1. Making Disclosure Less Public 2. Improving Disclosure by Improving Compliance 3. Victim Compensation a. Victim Lawsuits b. Victim Compensation Fund c. Eliminating Securities Fraud Class Actions CONCLUSION INTRODUCTION

Just over ten years ago, on June 25, 2002, WorldCom announced that its financial disclosures were fiction. (1) Accounting fraud at WorldCom ultimately destroyed tens of billions of dollars in investors' equity and pushed the firm into bankruptcy. (2) When it emerged two years later as MCI, Inc., it had shed 33,000 employees, (3) more than a third of its workforce. (4) Its general unsecured creditors ultimately received only thirty-six cents on the dollar. (5) While WorldCom was fabricating its financials, its rivals, Sprint and AT&T, made business decisions believing that WorldCom's success was real. Under pressure from its own shareholders, AT&T cut $7.5 billion in costs and laid off 20,000 employees. (6) Still unable to compete with WorldCom's imaginary figures, AT&T split itself into three units, which were sold individually--a decision then, and now, widely viewed as value destroying. (7) In fact, during the fraud, WorldCom's true costs were higher than AT&T's. (8) Telecommunications equipment manufacturers, including Lucent Technologies and Nortel Networks, initially benefitted from WorldCom's apparent success but suffered when the industry retrenched after the fraud was revealed. Both suppliers fired workers and saw their equity shrink. (9) In the aftermath of the WorldCom fraud, the telecommunications industry as a whole lost a quarter of its jobs: 300,000. (10) WorldCom's share price, the usual yardstick for measuring harm from securities fraud, captured none of these losses.

WorldCom might be an outlier, but it is hardly unique. (11) By misreporting their firm's financial results and prospects, managers credibly communicate to markets (12) that the firm is more profitable and, importantly, less risky than it in fact is. Managers sell the lie by increasing hiring and investment, and cutting prices. Relying on false information, lenders underprice credit, employees make career and retirement decisions based on a false picture of their firm's prosperity, and rivals make business decisions on a distorted playing field. (13) Honest firms face the obverse side of fraud and cannot fund and employ workers for valuable projects, producing additional deadweight losses borne by all workers, primary-market investors, and beyond.

If fraud is caught, fraudulent firms spend substantial resources on investigation, litigation, damages, and fines. Many file for bankruptcy that could have been avoided in the absence of fraud, or make costly adjustments that they often shift to employees, creditors, suppliers, customers, and the government as the insurer of last resort. (14) Rivals face doubts about their own financial reporting, which increases their cost of capital and further depresses hiring in the industry. The ripple effects are felt throughout the economy and, once aggregated, exceed the harms to defrauded shareholders by a substantial margin. (15)

Not only are investors not the sole victims of securities fraud, but this Article contends that they are also in a better position than other market participants to reduce their exposure to fraud. (16) They can eliminate firm-specific risk through diversification. Diversification cannot eliminate undiversifiable or market risk of fraud, but investors demand a fraud discount when purchasing securities as ex ante compensation. Although investors as a group benefit if the prevalence of fraud decreases, they are indifferent to accounting fraud if its impact remains stable. Those supplying labor, on the other hand, cannot diversify their human capital at all and are exposed to the risk that securities fraud by their employer will eliminate their jobs and impair their earning potential. (17)

Surprisingly, the recognition that investors do not bear the full cost of securities fraud is largely missing from our securities laws--from statutes to rule making, (18) enforcement decisions to judicial opinions, (19) and policy debates (20) to academic analysis. (21) Corporate governance reforms adopted in the Sarbanes-Oxley Act after the rash of accounting scandals in 2001 and 2002 were widely criticized because of their purportedly high cost for firms and their shareholders. (22) Based on a similarly cramped understanding of the economic cost of fraud, the recently adopted JOBS Act relaxed reporting and audit requirements for new public firms. (23)

Securities commentators frequently warn that "onerous disclosure obligations and their accompanying liability are like the rain--they fall on the good and the bad alike." (24) But securities fraud, too, harms both honest and dishonest firms, as well as their employees, creditors, and other constituents. With all costs included and tallied, the following conclusions are inescapable: (1) false disclosures affect financial markets as well as markets for inputs, labor and credit, and product markets; (2) framing financial statement fraud as fraud against investors understates the harm it causes; and (3) regulation and enforcement predicated on the assumption that securities fraud does not impose substantial negative externalities on nonshareholders leads to underregulation and underdeterrence of fraud and offers remedies that do not redress the injury. (25)

In Part I, this Article provides a brief overview of securities laws that require disclosure and sanction fraud. It also describes the existing consensus that securities fraud harms primarily investors by reducing capital market liquidity, depressing investor returns by misallocating capital, and impairing shareholder monitoring.

Parts II, III, and IV constitute the major contributions that this Article makes to the literature. In Part II, the Article explains analytically how false securities disclosures distort and harm nonfinancial markets. First, public firms' financial disclosures are made publicly, not only to present and future shareholders. Disclosed information is useful to a variety of market participants. If false, disclosures lead suppliers of financial as well as human capital to underprice their inputs. Second, to avoid detection, managers change the firms' observable actions--they overinvest and overhire --to match false disclosures. Thus, securities fraud interferes with economic learning, distorts real economic decisions by rivals, and impairs product markets. Third, if unmasked, accounting fraud is very costly for the firm, and the managers often pass that cost on to nonshareholders. In Parts III and IV, the Article details how false financial disclosures specifically harm employees and rivals. In each Part, the Article supplements the theoretical analysis with empirical evidence.

In Part V, the Article discusses the determinants of the cost of financial statement fraud. Not surprisingly, fraud by a larger firm and larger fraud relative to the size of the firm tend to produce a greater market distortion and cost. (26) Less well known, competition has a profound effect on the prevalence and the cost of securities fraud. First, fraud is generally more likely in concentrated than in competitive markets. But, during investment booms, when competitive pressure weakens, previously competitive markets succumb to fraud...