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On a recent visit to Salt Lake City, Alexander Dyck ordered Chinese takeout and received a branded fortune cookie to wish him wealth and promote FTX, presumably packaged before the epic collapse of the crypto empire. “I should have made it,” he said ruefully.
Mr Dyck is a professor of finance at the University of Toronto who has just published a provocative new study on the ubiquity of corporate fraud. The study has been making the rounds in academia in recent weeks and has become a fascination for general counsels, business leaders and investors.
It suggests that only about a third of fraud in public companies actually comes to light, and that fraud is disturbingly common. Mr. Dyck and his co-authors estimate that about 40 percent of companies commit accounting violations and 10 percent engage in what is considered securities fraud, destroying 1.6 percent of its equity value each year – about $830 billion by 2021.
“What people don’t understand is how widespread the problem of corporate fraud is,” Dyck said of his research, which was published this month in the Review of Accounting Studies.
Tip of the iceberg
Last year, Trevor Milton, the founder of electric vehicle maker Nikola, and Elizabeth Holmes, founder of the blood testing company Theranos, were both found guilty of fraud in high-profile trials. Holmes’ conviction coincided with the rapid fall of FTX, founded by Sam Bankman-Fried, giving 2022 a distinctly fraudulent flavor.
But the amount of fraud committed at any given time remains fairly stable, Mr Dyck said.
Mr. Dyck and his colleagues wanted to take a closer look at misconduct in publicly traded companies to find out how much of it normally goes undiscovered. To do this, they first examined a period of unique research in accounting history, the demise of the accounting firm Arthur Andersen in 2001 following the collapse of Enron.
At the time, the company’s former clients were in the spotlight, and new accountants were much more motivated to uncover wrongdoing given the suspicions looming among companies that had worked with Arthur Andersen. That should make the fraud rate they found more accurate than other measures. But the probes revealed no more wrongdoing among Arthur Andersen’s clients than at other firms that depended on other accountants. The same fraud rate showed up in a series of comparisons with other research, which showed it to be consistent. They used this fraud rate to conclude that about a third of corporate fraud goes unnoticed.
Given how common fraud is in controlled public companies, Mr Dyck said, misconduct is likely to be even more pervasive in private companies, particularly in crypto, which is only loosely regulated.
In the trenches
Even people who have spent their entire careers tracking corporate misconduct struggle to estimate how much fraud occurs in large corporations and how little is detected.
Allison Herren Lee, former commissioner and interim chairman of the Securities and Exchange Commission, has worked as an enforcement attorney and within a mismanaged company. She said she is well aware of how people in business try to push the boundaries, but was surprised by the study’s estimate that a third of misconduct goes undetected.
In the early 2000s, Ms. Lee was a partner in a Denver law firm, where she spent a stint with the telecommunications provider Qwest Communications International, on loan as an advisor to the company then headed by Joseph Nacchio. She often found herself advising clients against the risky moves the company was rushing to take with minimal legal scrutiny, she said. In 2007, Nacchio was convicted of securities fraud and sentenced to prison.
Still, it is very difficult to prove wrongdoing and address anyone involved in wrongdoing, Ms. Lee said. Affected people often feel they are just testing boundaries rather than breaking the law, and such schemes can be widespread in large companies. “To prosecute fraud, you have to show intent,” she said. “It’s difficult in large public companies, because it takes a village to commit fraud.”
One way to address this is to remove the need to show criminal intent and make it easier to punish executives for allowing misconduct in their care, a proposal from Democratic Senator Elizabeth Warren of Massachusetts in 2019. The bill gained little traction.
Psychology of a fraudster
Corporate crime fighters agree that fraud is a major problem. But some are critical of the new study’s comprehensive take on the term. The research drew on studies with different definitions, applying to a range of misconduct, including settled cases arising from allegations of accounting violations that were ultimately never proven by the prosecution.
“The use of the term ‘fraud’ in the title of this article is highly problematic. The authors themselves admit that they use the word ‘fraud’ ‘loosely’ and for ‘simplicity,’” said Joseph Grundfest, a Stanford Law School professor, former SEC commissioner and creator of a database that tracks cases of federal securities fraud. “But events they call fraudulent include alleged fraud that wasn’t fraud, genuine errors, and disagreements over accounting treatment. Calling all these events “cheating” is like “loosely” calling a mouse an elephant for the sake of “simplicity” and then rationalizing the overly broad classification on the grounds that both are mammals. Just as mice are not elephants, alleged frauds are not frauds, and disagreements are not frauds either.”
The mentality of a typical fraudster is at the heart of the definitional issues, said Georgetown University Law Center’s Donald Langevoort, a former SEC special counsel who has written extensively on corporate crime and is familiar with the studies underlying the investigation by The Mr. Dyck and his colleagues.
Legally, prosecutors must prove they have intent to commit fraud, but that’s not easy because perpetrators are often adept at lying to themselves and defiant about the rules, he said. “People in Enron were convinced that the accounting was bad and they are good,” he said. “Drivers who think that way will cross the line.”
The SEC recently passed a rule to change that mindset. When it comes into effect later this month, registered businesses must develop a chargeback policy. Such rules allow companies to reclaim incentive-based compensation from current or former executives if it was based on misreported financials and the company was forced to make an accounting restatement.
Knowing that their own bonuses are at stake will encourage even challenging executives to be more vigilant, said Mr. Langevoort. But the new rule and other efforts to tackle corporate fraud leave some companies untouched.
Take FTX’s Bankman-Fried, now under house arrest at his parents’ California home, awaiting trial on a series of criminal fraud charges. He is accused of siphoning billions of dollars out of his companies, made possible by the lack of financial data. On social media, in interviews and in his new Substack newsletter, the fallen driver has maintained that he didn’t steal money and could have saved FTX if lawyers hadn’t forced him to relinquish his place as CEO and file for bankruptcy in November.
“Self-deception is ubiquitous in crypto, but it’s not like in traditional finance where people say ‘the bureaucrats are holding us back’,” said Mr. Langevoort. “It’s more like ‘there’s a brave new world to invent and you need to break some eggs to make an omelette’.”
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