NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Who Blows the Whistle on Corporate Fraud?

" Fraud detection relies on a wide range of, often improbable, actors. No single type accounts for more than 20 percent of the cases detected...only just over 35 percent of the cases of fraud were revealed by the people appointed to search for it."

The large and numerous corporate frauds that emerged in the United States at the onset of the new millennium provoked an immediate legislative response in the Sarbanes Oxley Act (SOX). This law was predicated upon the idea that the existing institutions designed to uncover fraud (for example, the auditors) had failed, and that their incentives as well as their monitoring should be increased. Yet the political imperative to act quickly prevented any empirical analysis substantiating the law's premises.

In Who Blows the Whistle on Corporate Fraud? (NBER Working Paper No. 12882), authors Alexander Dyck, Adair Morse, and Luigi Zingales seek to address that question - which has implications for other countries beyond the United States -- by first gathering data on a comprehensive sample of alleged corporate frauds in the United States involving companies with more than $750 million in assets that took place between 1996 and 2004. After screening for frivolous suits, the authors end up with a sample of 230 cases of alleged corporate fraud, including all of the high profile cases such as Enron, HealthSouth, and WorldCom.

They review the history of each fraud, identify who was involved in its revelation, and ask what circumstances led to its detection. They also study the timing of the revelation in order to infer which mechanisms are most efficient in revealing fraud. To better understand why particular fraud detectors are active, the researchers study the sources of information and the incentives that detectors face in bringing the fraud to light. Finally, to identify the role of short sellers in all of this, the researchers look for unusual levels of short positions before a fraud emerges.

The clearest finding emerging from the data is that, in the United States, fraud detection relies on a wide range of, often improbable, actors. No single type accounts for more than 20 percent of the cases detected. This suggest that the failures of internal governance in other countries cannot be solved easily by introducing U.S. institutions, like class action suits or the SEC, which together account for only 8.4 percent of the revelation of frauds by external actors. Instead, an effective corporate governance system relies on a complex web of market actors who complement each other. Unfortunately, reproducing such a complex system abroad is much more difficult than copying a single legal institution.

The authors also find that the "mandated" approach to fraud detection did not work well at all, at least before SOX. Fewer than 6 percent of the fraud cases were identified by the authority charged with discovering them (that is, the SEC). Even when the authors enlarge the definition of "authority" to include external auditors (who have a duty to disclose fraud when they find it, but not to search for it) and industry regulators (who are not in charge of looking for financial frauds), they find that only just over 35 percent of the cases of fraud were revealed by the people appointed to search for it.

One interpretation of these results is that information about fraud is so diffuse that it is extremely costly (and thus ineffective) to appoint an official investigator: it is like looking for a needle in the proverbial haystack. Fraud tends to be revealed by people who find out about it in their normal course of business and who do not have any strong disincentive (or, even better, some positive incentive) to reveal it. For example, in sectors like healthcare where qui tam suits are possible (qui tam is a legal provision under U.S. law which allows a private individual, or whistleblower with knowledge of fraud committed against the federal government, to bring suit on its behalf), and thus whistleblowers are rewarded, employees play a much bigger role in revealing fraud. The authors show that in many real world situations (with auditors, analysts, and employees in other sectors) there are little or no monetary or career-related incentives to reveal fraud. The fact that only the most established newspapers and the most senior analysts are willing to come forward suggests, to the contrary, that the risks involved in blowing the whistle are substantial.

After the introduction of SOX, which significantly increased their duties and monitoring, the performance of mandated actors improved. Still, they account for only slightly more than half of the cases. According to the authors, only time will tell whether this recent surge in their relative performance is just a temporary blip, attributable to the enormous amount of public scrutiny that certain actors (like auditors) received after a few major corporate scandals, or to a permanent shift because of the changes in the incentives imposed by legislation. Either way, the authors' analysis suggests that an alternative, cheap way to address the problem is to extend the qui tam legislation to corporate fraud. As the evidence in the healthcare industry shows, such a system seems to work very effectively.

One objection to this approach is that it might lead to an excessive number of frivolous suits. But the evidence in the healthcare industry seems to mitigate this concern. Another objection is that an explicit reward to whistleblowers might foster distrust among employees, undermining their ability to work together for the benefit of the company. The authors are not aware of any sign of this problem in sectors subject to qui tam suits, but this is certainly an aspect that deserves further study before the qui tam idea is implemented.

-- Les Picker

The Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.
 
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