accounting fraud, earning manipulation, corporate liability
The empirical evidence suggests that firms overpay for fraud liability and overspend on internal compliance mechanisms (which are not very effective at preventing fraud). Yet, insiders who commit fraud are rarely sanctioned for their wrongdoing, which produces moral hazard and individual underdeterrence.
Two factors explain the failure to sanction managers who commit fraud. First, managers control the information revealing who was involved in account fraud and, thus, can impede external investigations and sanctions. Second, managers also influence whether the firm will investigate and sanction accounting fraud internally. Managers’ control over settlement and the availability of directors’ and officers’ insurance further reduce the likelihood that dishonest mangers will be sanctioned.
Most proposals have focused on reducing the costs of fraud liability to firms by raising pleading standards or eliminating corporate liability for accounting fraud altogether, but have neglected the question of individual deterrence. Although these proposals might reduce the costs to firms, accounting fraud cannot be deterred effectively without shifting liability to those responsible. High levels of fraud are inevitable, so long as social costs of fraud exceed private costs.
To sanction dishonest insiders, private and public enforcers need to know their identities and their actions, which is often prohibitively costly to obtain their firm cooperation. This Article proposes using leverage against the firm to encourage disclosing private information, thereby lowering overall enforcement costs and increasing the probability that dishonest insiders will be sanctioned. At the same time, the proposal also reduces the risk that firms will overpay, because ex post cooperation will reduce firms’ liability.
The Article develops the conditions for superiority of leveraged sanctions and proposes that their use be expanded to civil and regulatory actions, eliminating many of the concerns that leverage raises in criminal investigations. Improved deterrence is significant because it will reduce accounting fraud, producing more efficient capital markets.
44 U.C. Davis Law Review 1281 (2011).