The Cost of Securities Fraud

Article excerpt

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. …