Securities Fraud: An Economic Analysis

Abstract

This thesis develops an economic analysis of securities fraud. The thesis consists of a theory essay and an empirical essay. In the theory essay, I analyze a firm's propensity to commit securities fraud and the real consequences of fraud. I show that fraud can lead to investment distortions. I characterize the nature of the distortions, and show that it results from fraud-induced market mispricing and management's ability to influence the firm's litigation risk through investment. The theory also characterizes the equilibrium supply of fraud. I demonstrate the linkages between a firm's fraud propensity and the structure of its assets in place and growth options, and analyze the effect of corporate governance on fraud. The theory provides testable implications on cross-sectional determinants of firms' fraud propensities and the relation between fraud and investment. In the empirical essay, I test my main model predictions, using a new hand-compiled fraud data set. 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 that the level, type, and financing of investment all matter in determining the probability of fraud and the likelihood of detection. I also examine the monitoring roles of large shareholders, institutional owners, independent auditors, and corporate boards. I find that large block or institutional holdings tend to discourage fraud by increasing the detection likelihood. The roles of independent auditors and corporate board are weaker. Finally, insider equity incentives, growth potential, external financing needs and profitability all influence a firm's propensity to commit fraud. The paper also demonstrates the importance of separating fraud commitment and fraud detection, because cross-sectional variables can have opposing effects on these two components, and therefore can be masked in their overall effect on the incidence of detected fraud.