Examining publicly available information taken from SEC filings, my colleagues and I found that the amount paid in dividends to shareholders and salaries to senior management during years of honest reporting and during years immediately preceding fraudulent reporting differ in significant ways. In the fraud years, senior management receive less compensation—you read that right,
The logic behind the model we designed pinpointed these as trends to look for. We didn’t know whether we would actually find these patterns in SEC filings, but we did know that they were the key to predicting fraud if our model was right.
Why these patterns? CEOs always have incentives to take actions that protect their jobs. If they see that their company is not performing up to market expectation, they are at risk and will take action to salvage their situation. Now, they can argue that the firm is the victim of unforeseeable shocks for which they should not be held accountable (this was the argument made by the CEOs of GM and Chrysler in seeking a government bailout—they pointed to the economic downturn, not management’s decisions, as the cause of the auto industry’s woes), but such arguments are risky to say the least, and may not be adequate to protect a CEO’s job.
If blaming the economy or some outside force doesn’t salvage senior management’s situation, then the top executives might misrepresent the corporation’s true performance. If they can sell the belief that the company is performing just fine, then they won’t be at risk of being fired. It is difficult for outsiders to know the corporation’s true volume of sales, revenue, costs, and profits. Market capitalization reflects these factors, and indeed these are the factors that when falsely reported and subsequently detected result in accusations of accounting fraud.
If revenues are exaggerated or costs are understated, then senior executives can temporarily lead the marketplace to misjudge the true worth of a company, making the company appear (falsely) to have met or exceeded expectations. This, the model suggests, is the essential motivation behind corporate fraud.
This wedge between lower-than-expected stock dividends and compensation for executives and seemingly normal or good growth in market capitalization is therefore an early-warning indicator of an elevated risk of fraud. Neither the SEC nor many corporations, however, seem to realize the importance of this information in detecting early signs of trouble. Sarbanes-Oxley certainly does not draw attention to analyzing the size of this benefits wedge.
The game’s logic and the evidence culled from more than a decade of corporate filings across hundreds of firms also raise questions about journalistic accounts and popular perceptions. A pretty standard journalistic view of fraud is that greedy executives act to enrich themselves at the expense of shareholders and employees, that they are little more than looters, and that the problem boils down to outrageous character flaws. This kind of thinking gets us nowhere.
Too often we look at what happened most recently and assume that earlier actions were motivated by those ends. It is easy to believe that greedy executives cook the books to enrich themselves, with self-interest tied merely to short-term gain (of course I would never argue that self-interest isn’t the key motivation, but we must examine exactly what the nature of that self-interest is). But in doing so we forget, for example, that Enron’s fraud started around 1997 and yet the senior managers did not sell off their shares until around 2000 and 2001. Why would they have waited so long, risking discovery for years, before cashing out? True, stock prices were going up, but equally true, the risk of being uncovered grew greater and greater with each passing month and year. Did they really only seek the gains to be made in the period from 1997 to 2001, or were they hoping for much greater gains five, ten, or fifteen years on?
We won’t analyze the problem properly if we look for the causes of fraud in its end result. Remember, correlation is not causation—the beginning, not the end, is where the explanation lies.
In the Enron case, it seems clear that by 2000 or 2001 the most senior leadership in the company realized that they could not fix its problems. Having reached the end of the corporate game, they cashed out. It is despicable that they did so while covering up the true state of affairs, thereby leaving their pensioners on the hook. But it seems equally evident that Enron’s senior management did not hang on for four years before cashing out just to enrich themselves and walk away. All that time, according to the game’s logic, they were trying to save the company because their longer-term interests would be rewarded if they were successful in doing so. If the numbers had to be fudged while they corrected the company’s course, so be it. In their view, the end justified the means. None of that was going to happen if the shareholders, and especially if key board members, found out what trouble Enron was in.
Give executives the wrong incentives and you can count on their taking actions with bad social consequences. Give them the right incentives and they will do what is right, not because they are filled with civic virtue but because it will serve their own interests. Remember Leopold? He had pretty good incentives in Belgium and he did good things there. He had horrible incentives in the Congo and he did horrible things there.
What, then, are the right and wrong incentives? Why do some companies commit fraud while others—the vast majority of firms—even in dire circumstances do not? In answering these questions we can gain insight into how to alter incentives appropriately and how to anticipate who has the wrong incentives and is at serious risk of committing fraud.
One clear implication of the fraud model my colleagues and I developed is that the broader the group of people CEOs rely on to keep their jobs, the more likely it is that the shareholders who put them in power will throw them out. That’s what happens to leaders of democracies, and that is what is more likely to befall underperforming CEOs in relatively democratic companies. To save themselves, they are perversely incentivized to misrepresent the corporation’s true performance so that they don’t have to explain underperformance in the first place.
This is not to say that more “autocratic” companies (fewer people to please in the power structure) are incapable of fraud. It’s just that things have to be considerably worse for those companies before management sees sufficient risk to their jobs that they are tempted to engage in fraud. Our sliding scale extends across the public/private company divide as we consider partnerships (think of them as oligarchies) and family companies (monarchies).
Government regulators and boards of directors could do a better job of protecting shareholders and employees from the risk of fraud. To do so, the focus needs to be more squarely placed on the incentives executives have to monitor themselves and their colleagues in the face of declining business performance. Knowing how to adjust governance structures to induce the right incentives is the way to regulate firms successfully. Balancing incentives in good times and bad is a major challenge for running a business in a way that attracts and retains top-quality executives and satisfies shareholder expectations. Optimal corporate governance design needs to be done on a case-by-case basis, taking the nature of the firm’s market into account. A sweeping regulation cannot facilitate the fine-tuning that is needed to get incentives right. Confidence in business requires that we move in these directions rather than putting our energies into finding greedy individuals to blame or one-size-fits-all fixes for what are
