Securities Fraud, Financial Misrepresentation, WorldCom, Enron, Sarbanes-Oxley Act
Policy makers, regulators, and academics have traditionally looked for the harm from securities fraud in the easy-to-study financial markets. However, by doing so, they have missed the significantly larger social welfare losses caused by securities fraud that fall outside financial markets. False financial disclosures, which are the most common variant of securities fraud, distort real economic decisions that firms, their rivals, suppliers, vendors, lenders, and workers make, thus distorting markets for inputs and outputs. When the fraud is revealed, every party affected makes costly adjustments. Many fraud-committing firms file for bankruptcy. Their rivals face doubts, called contagion. All firms must adjust their business operations to the new (accurate) information, and they often pass on the cost to their employees, suppliers, and customers. Significantly, the cost to non-shareholders dwarfs that suffered by shareholders.
As a result, securities regulation and enforcement predicated on the assumption that financial misrepresentations harm only investors will result in worse disclosures and more fraud than is socially optimal. Because the cost of fraudulent disclosures is dispersed and may be difficult to quantify with sufficient precision, private remedies against fraud are inevitably ineffective. Instead, honest disclosures have the characteristics of a public good. And so, public regulation directed at prevention and early detection, coupled with public enforcement actions against individual wrongdoers, is the welfare enhancing.
Law and Economics
Digital Commons Citation
Velikonja, Urska, "The Social Cost of Financial Misrepresentations" (2012). Faculty Scholarship. 1172.