Who Blows the Whistle on Corporate Fraud?

It takes a village.

Alexander Dyck, Adair Morse, and Luigi Zingales found that fraud detection does not rely on standard corporate governance actors. Instead they found that employees, short sellers and analysts are the top sources in uncovering corporate fraud.

The three researchers studied reported fraud cases between 1996 and 2004 for U.S. companies with more than $750 million in assets. They ended up with a sample of 216 cases, including the high profile cases like Enron, HealthSouth and Worldcom.

They conclude that those in the best position to spot fraud are those who gather a lot of relevant information as a by-product of their normal work.  Employees, industry regulators, and analysts are at the top of the list.

Financial Reward

A monetary award, like the bounty under the Federal Civil False Claims Act, seems to be a good incentive for employees.

Short sellers are another group with a financial incentive.  The researchers looked at short selling activity prior to revelation of fraud. When that activity three standard deviations above the prior three month average they took that as indication that the short sellers had identified a fraud. If you use that benchmark, the short-sellers detected 22 of the fraud cases.

Reputation Reward

The other incentive is the reputation reward that they largely attribute to journalists. A journalist who uncovers a big fraud gets national attention and future career opportunities. It is interesting that when they weight the frauds based on size, journalists move farther up the list as the fraud detector. That seems a clear indication that reporters are more interested in the big, splashy fraud cases. That also means that we cannot expect the media to act as an effective monitor for smaller companies or for technical violations.

Auditors

I’m sure Francine McKenna, of re: The Auditors, would be interested to see their findings regarding auditors.

“We find very weak evidence of auditor’s incentives to blow the whistle. Auditing a fraudulent company is bad for reputation, but conditional on doing so, bringing this information to light has no benefit for an auditor: it is likely to cost him the account and it does not make him gain new ones.”

Compliance

On a positive note from the compliance perspective, of the 216 cases, 74 or 34.3%, were detected by internal governance. But we shouldn’t pat ourselves on the back too much. These cases are pre-2005 and therefore date before the compliance era.

Raw Data

Of the the 142 cases detected by external governance here is the breakdown:

Fraud Detector Cases Percentage
Employee 26 18.3%
Analyst 24 16.9%
Media 22 15.5%
Industry Regulator or SRO 20 14.1%
Auditor 16 11.3%
SEC 10 7.0%
Client or Competitor 9 6.3%
Equity Holder 5 3.5%
Short seller 5 3.5%
Law Firm 5 3.5%

It would be great to move the SEC higher on the list. But it seems that you want to keep as many groups interested in detecting and reporting fraud. There are lots of groups interested in detecting fraud for lots of reasons. We should make sure that all of them stay engaged and have incentives to report the fraud.

Sources:

Image is Qiqi Green Whistle by Steven Depolo under Creative Commons

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3 Responses to Who Blows the Whistle on Corporate Fraud?

  1. Francine McKenna April 29, 2010 at 8:41 am #

    Very disappointing with regard to auditors but not surprising.

    • Doug Cornelius April 29, 2010 at 11:18 am #

      On the bright side, auditors are way ahead of the lawyers.

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