Financial reporting fraud and other forms of misconduct: a multidisciplinary review of the literature

Consequent to the objectives of this review, we do not purport to provide a comprehensive summary of all studies on financial statement misconduct, nor a review of all the papers in a select list of journals.

https://www.law.cornell.edu/uscode/text/15/77q

https://www.law.cornell.edu/uscode/text/15/78j

The framing for this nomenclature is in part motivated by the work of Jerry Martin, for which we are indebted.

425 F.2d 796 (2d Cir. 1969).

While the term “scienter” is casually used at times in the popular press and some literatures, we do not employ this term because the factors used to determine scienter vary across the 12 circuit courts of appeal. That is, scienter does not require that the defendant intended or desired to mislead anyone; it is sufficient that the misleading nature and consequences of words or actions are such that a reasonable person would be aware they are inaccurate. [See SEC v. Falstaff Brewing Co., 629 F.2d 62, 76 (D.C. Cir. 1980).] Recklessness is also a means to satisfy the courts’ requirement for scienter. The courts are divided on whether it is judged by an objective standard, akin to a gross negligence approach, in which the defendant has made an extreme departure from what would be reasonable under the circumstances (Buell 2011). However, most courts believe recklessness is judged subjectively, where not just an extreme departure from what the reasonable person would have done but taking that action or made statements that the defendant knew or must have known had a danger of misleading investors. [See Broad v. Rockwell Int’l Corp., 642 F.2d 929, 961–62 (5th Cir. 1981).] In addition to slight variations in how courts define recklessness, the appellate courts vary widely in their approaches to applying the heightened pleading requirement private litigants must meet when alleging scienter (Cox et al. 2009).

Dura Pharmaceuticals Inc. v. Broudo, 544 U.S. 336 (2005)

For earlier and more inclusive reviews of the empirical studies of securities fraud, see Choi (2004) and Cox and Thomas (2009).

The study’s findings are nearly identical to the authors’ earlier pilot study of 53 settlements. See Cox and Thomas (2002).

Securities Act Section 2(b), 15 U.S.C. §77(b).

Rule 10b5–1, Regulation Selective Disclosure and Insider Trading, prohibits company officers from trading in their company’s stock while in “knowing possession” of material, nonpublic information.

As further discussed in section 4.1, Karpoff et al. (2008a) find that 75% of these actions include allegation of fraud.

See Evans (2015) and SEC vs. World-Wide Coin Investments, 567 F. Supp. 724, 749–51 (N.D. Ga. 1983).

This literature has advanced as researchers have developed ways to measure culture that are tractable in large samples. Many measures of cultural influence or social norms focus on (1) managers’ personal backgrounds, behavior, and values (e.g., Cline et al. 2017), (2) religion (e.g., Stulz and Williamson 2003), (3) geographic commonalities (e.g., Parsons et al. 2017), (4) political affiliations (e.g., Hutton et al. 2015), (5) networks (e.g., Khanna et al. 2015), and (6) surveys and rankings (e.g., Bargeron et al. 2015). See also Section 3.2.

Akerlof’s (1970) market for lemons characterizes the potential breakdown in trust when counterparties have private information about their contractual performance. For additional theoretical models of reputation and trust that overcome the lemons problem, see the work of Kreps and Wilson (1982), Diamond (1989), and Tirole (1996).

For example, Section 77q(a) of Title 15, Chapter 2A, Subchapter 1 prohibits any person “… 1) to employ any device, scheme, or artifice to defraud, or 2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made ... not misleading” during the offer or sale of any security. Section 77q(b) prohibits a person from giving publicity to, or disseminating information about, a security without fully disclosing the presence and amount of any consideration received from an issuer, underwriter, or dealer (commonly known as an “anti-touting” statute), and Rule 230.463 requires new issuers to report on the uses of their issuance proceeds within the entity’s first annual report filed with the SEC. Specifically, see Sections 77.17(a), 77.17(b), and 15.77q and Rule 230.463.

See sections 78.15(c), 78.10A, 78.10(b), 78.10(a), and 15.78j(b) and Rules 240.15c1–2, 240.10b-9, 240.10b5–1, 240.10b-5, 240.10b-3, 240.10b-10, and 240.10b. http://​law.​justia.​com/​cfr/​title17/​17-3.​0.​1.​1.​1.​1.​58.​75.​html

Our proposed umbrella term, “financial misconduct,” differs from the term “financial market misconduct,” which Cumming et al. (2015) use to characterize a large class of illegal activities involving insider trading, market manipulation, and broker-agency problems.

Attempts to measure a firm’s reputation frequently are based on surveys (e.g., Pevzner et al. 2015), CSR-based rankings (Sadok et al. 2011), or firms’ written materials (e.g., Guiso et al. 2015), although many researchers define “reputation” as a general opinion about the firm, rather than as a capital asset, as the term is used in this paper. There also is overlap between measures of a firm’s reputation and measures of culture, as summarized in footnote 10.

Studies that find share value losses associated with earnings restatements include those by Anderson and Yohn (2002); Hribar and Jenkins (2004); Palmrose et al. 2004); Agrawal and Chadha (2005); Akhigbe et al. (2005); Burns and Kedia (2006); Desai et al. (2006); Hennes et al. (2008); Kravet and Shevlin (2010); and Chava et al. (2010). For share price reactions to securities-related lawsuits, see Kellogg (1984); Bohn and Choi (1996); Francis et al. (1994); Ferris and Pritchard (2001); Griffin et al. (2004); Romano (1991); Bhagat et al. (1998); and Gande and Lewis (2009). For share price reactions to regulatory enforcement actions for financial misconduct, see Feroz et al. (1991); Dechow et al. (1996); Beneish (1999b); Ozbas (2008); Karpoff et al. (2008a); and Karpoff and Lou (2010). Some papers use news stories or key word searches to identify samples of financial misconduct, e.g., Karpoff and Lott Jr. (1993); Davidson et al. (1994); Bernile and Jarrell (2009); and Tanimura and Okamoto (2013).

For a counterargument and evidence that public enforcement via agencies such as the SEC are important for financial market development, see Jackson and Roe (2009).

The legal perspective of this criticism, specifically whether penalties and class actions’ monetary outcomes serve their compensatory role, is discussed in section 2.2.2.

For an overview of the debate over the optimal mix of individual and firm-level penalties, see Arlen and Carney (1992), Polinsky and Shavell (1993), Arlen and Kraakman (1997), Arlen (2007), and Jackson and Roe (2009).

Griffin et al. (2017) document a seeming counterexample to these results, as they find that many bank managers who were associated with fraudulent residential mortgage-backed security offerings did not suffer large career consequences. It is possible, however, that the RMBS-related frauds examined in this study did not impose large reputational costs on the issuing banks. Cline et al. (2017) find that, in general, managerial indiscretions are associated with large consequences only when they disrupt the firm’s relationships with important counterparties.

Section 3.2, which partly overlaps with this section, points out another consideration in managers’ motives to engage in misconduct: overconfidence and personal attitudes toward social norms.

Beneish (1999b), however, does not find evidence that AAERs are associated with periods with external financing.

In the Povel et al. (2007) model, the combination of managers’ incentives to commit fraud and investors’ incentives to monitor yields nonmonotonic relations between fraud, investor beliefs, and monitoring costs. See also Hertzberg (2017), who develops a model in which positive investor beliefs generate greater managerial incentives to commit fraud.

For further detail on this debate, see generally Choi (2007) and Issacharoff and Miller (2013).

For a discussion of the “expectations gap” between what external stakeholders typically expect of auditors in a standard financial statement audit versus what is required of auditors by GAAS, see Albrecht and Hoopes (2014). As they discuss, given the scope of a financial statement audit as dictated by GAAS and, in contrast to a fraud audit, it is unclear whether auditors should be expected to detect misconduct in the course of a financial statement audit.