It’s been a hot few years for corporate fraud. A plea deal earlier this week for Binance founder Changpeng Zhao on money laundering charges comes on the heels of the conviction of FTX founder Sam Bankman-Fried in what prosecutors called “one of the largest financial frauds in U.S. history.” Said. And earlier this year, former Theranos executives Elizabeth Holmes and Sunny Balwani began serving multi-year sentences after a jury determined that their aggressive overselling of unproven blood-testing technology amounted to fraud.
But what if there is so much fraud that we don’t even know about? That’s what a recent paper by three finance professors tries to make – and their findings point to SBF, Holmes, et al. Well, you know, these are just the tip of the iceberg.
“It is very difficult to know the prevalence of crime, because the only thing you look at is the crimes caught,” said Luigi Zingales at the University of Chicago and author of “How Widespread Is Corporate Fraud?” Said one of the authors. published in Review of Accounting Studies,
To find out how common fraud is, the authors (Zingales, along with Alexander Dyck at the University of Toronto and Adair Morse at the University of California, Berkeley) looked at corporate clients of the accounting firm Arthur Andersen, which was founded in 2002 to help Enron. Collapsed later. The biggest accounting scam in history continues.
Following the demise of Arthur Andersen, clients were forced to find new accounting firms – and new auditors would have additional incentive to catch any wrongdoing. Looking at fraud rates across all businesses before and after the firm’s collapse, the authors came up with a conservative estimate: About one in 10 large companies engages in fraud each year, according to their calculations, and it hurts shareholders. incurs losses of hundreds of billions of dollars.
They estimate that only one in three cases of fraud is detected. They write, “Fraud is really like an iceberg with significant unknown fraud occurring just beneath the surface.”
Is this fraud, or just a mistake?
Certainly, the authors take a broader definition of alleged fraud than some legal observers.
“What we colloquially call fraud are major incidents of maladministration that cause a company to lose large amounts of money,” Zingales said. He called it an important case because most cases of corporate wrongdoing in the United States are settled and fraud cases go unpunished.
“From a legal perspective, fraud requires intent, and intent only has to be documented in court,” he explained, but the general principle is that misrepresentations cost shareholders money.
Zingales and co-authors looked at multiple datasets, including filed shareholder class-action lawsuits, accounting and auditing enforcement actions from the Securities and Exchange Commission, and SEC securities fraud cases.
This helped him understand what Zingales called “the universe of financial mistakes,” or “basically every form of violation of the law, whether it’s a misrepresentation, or an antitrust action, or that ‘I didn’t follow EPA rules. “And it hurt the share price,” he said.
This broad definition has caused some objection from enforcement professionals. Former SEC Commissioner Joseph Grundfest, who now teaches at Stanford, told new York Times That the paper incorrectly included “honest mistakes and differences about accounting treatment” in the definition of fraud.
But intentional or not, these mistakes cost company shareholders hundreds of billions of dollars annually. The cost of fraud comes to between 1.2% and 2.2% of the market value of public companies, meaning that, in 2021, it cost shareholders $830 billion. This is a problem not only for the investor class but for the entire American public, who invest in these large public companies through retirement accounts and pension funds.
Who is to blame for this epidemic of fraud? Corporate managers, certainly—but also the audit industry, Zingales said. He argued that, since the collapse of Enron, auditors overall decided that their responsibility was only to make sure the corporation’s numbers went up, not to find out whether their clients were doing wrong. But recently, auditors have also had to struggle with the numbers: Nearly 40% of audits last year had errors, according to a government watchdog report this summer that declared the state of the industry “completely unacceptable.”
Zingales, who praised the report, also supports requiring auditors to flag accounting problems to regulatory authorities. Currently, they have to do so only in limited circumstances. “This is probably the biggest change that needs to be made,” he said.
Until such time, he believes the low fraud detection rate – two-thirds of cases are not caught – will ensure it continues.
“That’s why fraud continues, because it actually benefits,” he said.
He added, “Even when they are caught, very few of these people go to jail.” “If two-thirds of the time you get away with murder, and one-third of the time you get a slap on the wrist, are you surprised there is so much fraud?”
Subscribe to the CFO Daily newsletter to stay connected to the trends, issues and executives shaping corporate finance. Sign up for free.