In our paper Corporate Fraud and Business Conditions: Evidence from IPOs, which is forthcoming in the Journal of Finance, we use a sample of firms that went public between 1995 and 2005 to test a set of theories modeling how a firm’s incentive to commit fraud when raising external capital varies with investor beliefs. Instead of a strictly increasing relationship between investor beliefs and fraud propensity as highlighted in Hertzberg (2005), we find evidence more consistent with the predictions of Povel, Singh, and Winton (2007): a firm is more likely to commit fraud when investors are more optimistic about the firm’s industry’s prospects, but in the presence of extreme investor optimism, the probability of fraud becomes lower as the firm is able to obtain funding without misrepresenting information to outside investors.
Further analysis suggests that both investor monitoring and executive pay structure play a role in the relationship between investor beliefs and fraud. Using venture capitalists as specialized investors with lower monitoring costs than other institutional investors, we find evidence supporting the prediction of Povel et al. Fraud is less likely for low investor beliefs but more likely for high investor beliefs for firms backed by venture capitalists than non-VC-backed firms, and for firms backed by venture capitalists of a higher level of industry expertise. Also, investor beliefs about business conditions have a positive impact on short-term compensation, which in turn has a positive impact on a firm’s fraud propensity, consistent with the predictions in Hertzberg. Nevertheless, the level of investor beliefs continues to have an independent, hump-shaped impact on the incidence of fraud even after controlling for executive compensation. This suggests that the mechanisms in both Hertzberg and Povel et al. are relevant for IPO fraud…(continue reading)