Who Blows the Whistle on Corporate Fraud?

by R. Christopher Small, for The Harvard Law School Forum at Harvard Law School, Febraury 15, 2010.

In our paper, Who Blows the Whistle on Corporate Fraud?, which is forthcoming in the Journal of Finance, we study all reported fraud cases in large U.S. companies between 1996 and 2004 to identify the most effective mechanisms for detecting corporate fraud.

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 had failed, and their incentives as well as their monitoring should be increased. The political imperative to act quickly prevented any empirical analysis to substantiate the law’s premises. Which actors bring corporate fraud to light? What motivates them? Did reforms target the right actors and change the situation? Can detection be improved in a more cost effective way?

To answer these questions, we gather data on a comprehensive sample of alleged corporate frauds that took place in U.S. companies with more than 750 million dollars in assets between 1996 and 2004. After screening for frivolous suits, we end up with a sample of 216 cases of alleged corporate frauds, which include all of the high profile cases such as Enron, HealthSouth, and WorldCom. Through an extensive reading of each fraud’s history, we identify who is involved in the revelation of the fraud. To understand better why these fraud detectors are active, we study the sources of information detectors use and the incentives they face in bringing the fraud to light. To identify the role played by short sellers, we look for unusual levels of short positions before a fraud emerges…(continue reading)

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