Investment, Shareholder Monitoring and The Economics of Corporate Securities Fraud

In this study, I investigate the economic determinants of firms’ propensity to commit securities fraud and the determinants of fraud detection. The analysis is based on a new handcompiled fraud sample of private securities class action litigation suits filed between 1996 and 2003 involving allegations of accounting irregularities. I use econometric methods to account for the unobservability of undetected frauds, and disentangle the effects of cross-sectional variables into their effect on the probability of committing fraud and the effect on the probability of detecting fraud. I find the different types of investment have differential effects on firms’ fraud incentives. Investment that introduces valuation imprecision negatively affects the probability of detection and positively affects the probability of fraud, but straightforward investment does not show this pattern. I further show that larger block ownership holdings and institutional holdings are associated with higher likelihood of detection and lower ex-ante propensity to commit fraud, which implies the important role of shareholder monitoring in combatting fraud. Finally, high growth potential, large external financing needs, and negative performance shocks seem to be important motivational factors for fraud. The paper also demonstrates the importance of disentangling the probability of committing fraud and the probability of detecting fraud, because cross-sectional variables can have opposing effects on these two probabilities, and therefore can be masked in their overall effect on the incidence of detected fraud.