The Cost of Securities Fraud
Velikonja, Urska, William and Mary Law Review
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 …
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Publication information: Article title: The Cost of Securities Fraud. Contributors: Velikonja, Urska - Author. Journal title: William and Mary Law Review. Volume: 54. Issue: 6 Publication date: May 2013. Page number: 1923+. © 1999 College of William and Mary, Marshall Wythe School of Law. COPYRIGHT 2013 Gale Group.
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