Fraud: investor priorities and attitudes

Luigi Zingales has been involved in some interesting work on fraud. In this paper he and co-authors look at who detects and exposes fraud, and they find some perhaps surprising results. Employees are the whistle-blowers most often (and, as such, the suggestion is made that further incentives are provided to encourage more of it) followed by regulators and the media. But auditors, analysts and short-sellers are further behind, external shareholders barely get a look in. There is nuance to the picture, if you read the paper they do find that short-sellers are quicker at exposing fraud (9 months versus 21 months for employees), but they expose less of them.

Zingales has also done research into the prevalence of fraud. He and his co-authors estimate that, in any one year, there is a 14.5% probability of a company engaging in fraud. In his book on crony capitalism, Zingales says that 5% to 10% of public companies are affected by fraud every year, though some of this may not be significant in scale. He also argues that one of the reasons it may be so prevalent is because it's not really anyone's job to find it. And notably he goes on to draw a link between the failure to root out unethical behaviour like fraud and the nature of board appointments (i.e. directors are selected by existing board members).

Corporate corruption and fraud occur when controls are weak, and controls are weak when the people in charge have no incentive to challenge the CEO. Yes, there are many serious board members who do their jobs well – but they do so despite the incentives… [C]orporate board members care less about their reputation with shareholders than their reputation with CEOs

So what do we make of all that? A few things suggest themselves. First, investors should probably assume that there is fraud happening somewhere in their portfolio. It may not be a significant risk (though Zingales et al say: average corporate fraud costs investors 22 percent of enterprise value in fraud-committing firms and 3 percent of enterprise value across all firms) but it's probably there.

Second, they should support moves that increase the incentives to expose fraud and decrease/remove the incentives to hide/ignore it. Taking the latter first, this surely means trying to make the auditor as independent as possible, for example by banning or strictly limiting non-audit work. It also seems to strengthen the case for making board members more accountable to others than simply those that appointed them. And it suggests that investors might want to find ways of encouraging employees to speak out.

Finally, in my own corner of the world, I would argue that these findings also mean that corp gov people in particular ought to adopt a sceptical/suspicious approach. Financial (and other) wrongdoing may be much more prevalent than we tend to think, and the incentives for companies to tell investors the truth are... ahem... not straightforward. I can think of a couple of companies I've engaged with that were subject to controversy of one form or another where what we were told initially proved to be wildly inaccurate - and that's if I'm being charitable and assuming they believed what they were saying. It was only because we stuck with it, and probed a bit, that the stories unravelled. And as we saw with News Corp / News International, even major corporations will issue public statements that bear little relation to the truth.

It can be difficult, embarrassing, career-limiting and so on to challenge senior people like board directors when you aren't confident in what they are telling you. But, if you accept Zingales' point that no-one really has the job of exposing wrongdoing, then I think we have a duty (and not just a fiduciary one) to ask the awkward questions.