How common is corporate fraud?

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On a recent visit to Salt Lake City, Alexander Dyck ordered Chinese takeout and received a branded fortune cookie wishing him wealth and promoting FTX, believed to have been packaged before the crypto empire’s epic collapse. “I should have skipped it,” he said regretfully.

Mr. Dyck is a professor of finance at the University of Toronto who has just published a provocative new study on the prevalence of corporate fraud. The study has been circulating around academia in recent weeks, and has become a source of fascination for general counsel, corporate leaders and investors.

It suggests that only about a third of public company scams actually come to light and that fraud is alarmingly common. Mr. Dyck and his co-authors estimate that about 40 percent of companies commit accounting violations and that 10 percent commit what qualifies as securities fraud, destroying 1.6 percent of equity value each year — about $830 billion in 2021 .

“What people don’t understand is how pervasive the problem of corporate fraud is,” Dyck said of his study, published this month in the Review of Accounting Studies.

tip of the iceberg

Last year, Trevor Milton, founder of Nikola, the electric vehicle maker, and Elizabeth Holmes, founder of blood testing company Theranos, were both found guilty of fraud in high-profile lawsuits. Holmes’ conviction coincided with the rapid fall of FTX, founded by Sam Bankman-Fried, leaving 2022 with a distinctly fraudulent flavor.

But the amount of fraud committed at any given time remains fairly constant, Mr Dyck said.

Mr. Dyck and his colleagues wanted to scratch the surface of public company wrongdoing to see how much of it typically goes undetected. To do this, they first examined a period of unique scrutiny in accounting history, the demise of accounting firm Arthur Andersen in 2001 following the collapse of Enron.

Back then, the firm’s former clients were in the spotlight, and new accountants were far more motivated to uncover wrongdoing given the suspicions that were rising about companies that had worked with Arthur Andersen. That should make the fraud rate they found more accurate than other measures. But the investigations uncovered no more wrongdoing at Arthur Andersen’s clients than at other companies that depended on other auditors. The same cheating ratio showed up in a number of comparisons to other research, leading them to conclude it’s consistent. They used this fraud rate to conclude that about a third of corporate fraud goes unnoticed.

Given how common fraud is at audited public companies, Mr. Dyck said misconduct is likely to be even more prevalent in private companies, particularly in crypto, which is loosely regulated.

In the ditches

Even people who have spent their careers studying corporate wrongdoing have trouble judging how much fraud is going on in large corporations and how little is being uncovered.

Allison Herren Lee, a former commissioner and interim chair of the Securities and Exchange Commission, has worked as a law enforcement attorney and at a poorly run corporation. She said she’s very familiar with how businesspeople try to push the boundaries, but was surprised by the study’s estimate that a third of misconduct goes unnoticed.

In the early 2000’s, Ms. Lee was a partner in a Denver law firm where she served as a consultant to telecommunications provider Qwest Communications International on loan for the firm, then led by Joseph Nacchio. She often found herself advising clients against the risky actions the company proposed hastily and with minimal legal scrutiny, she said. In 2007, Nacchio was sentenced to prison for securities fraud.

Still, it is very difficult to prove wrongdoing and target everyone involved in wrongdoing, Ms. Lee said. Stakeholders often feel they are just testing boundaries rather than breaking the law, and such schemes can permeate large organizations. “To prosecute fraud, you have to show intent,” she said. “It’s difficult in big public companies because it takes a whole village to commit fraud.”

One way to address this would be to remove the need for proof of criminal intent and make it easier to penalize executives for allowing misconduct under their supervision, a move proposed in 2019 by Democratic Senator Elizabeth Warren of Massachusetts . The bill met with little approval.

Psychology of a scammer

The fight against corporate crime agrees that fraud is a big problem. However, some criticize the expansive interpretation of the term in the new study. The investigation drew on studies with differing definitions relating to a range of types of wrongdoing, including closed cases that arose from allegations of accounting violations that were never conclusively proven by prosecutors.

“The use of the term ‘fraud’ in the title of this article is highly problematic. The authors themselves acknowledge that they use the word “scam” “loosely” and for “simplicity,” said Joseph Grundfest, a Stanford Law School professor, former SEC commissioner and creator of a database that tracks federal securities fraud cases tracked. “But events they call fraudulent include alleged frauds that were not frauds, honest mistakes and accounting disagreements. Calling all of these events “cheating” is like calling a mouse an elephant “for convenience” and then rationalizing the over-categorization on the grounds that both are mammals. Just as mice are not elephants, alleged cheating is not cheating, and disagreements are not cheating.”

The mindset of a typical fraudster is at the heart of the definition problems, said Donald Langevoort of the Georgetown University Law Center, a former SEC special counsel who has written extensively on corporate crime and is familiar with the studies underlying the research by Mr. Dyck and his colleagues.

Legally, prosecutors have to prove fraudulent intent, but that’s not easy because perpetrators are often experts at lying to themselves and flout the rules, he said. “People at Enron were convinced that accounting was bad and that they were good,” he said. “Leaders who think like this will cross the line.”

The SEC recently passed a rule aimed at changing that mentality. When it goes into effect later this month, registered businesses will need to develop clawback policies. Such rules allow companies to reclaim incentive-based compensation from current or former executives when it was based on misreported financial data and the company is forced to perform an accounting restatement.

Knowing their own bonuses are at stake will encourage even defiant executives to be more vigilant, Mr Langevoort said. But the new rule and other efforts to crack down on corporate fraud are leaving some businesses untouched.

Take FTX’s Bankman-Fried, who is now under house arrest at his parents’ home in California awaiting trial on a range of criminal fraud charges. He is accused of skimming billions of dollars from his dealings, made easier by the fact that financial records were scarce. On social media, in interviews and in his new Substack newsletter, the ousted executive has insisted he didn’t steal any funds and could have saved FTX if lawyers hadn’t forced him to step down as CEO and file for bankruptcy in November.

“Self-deception has been rampant 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 have to break some eggs to make an omelette.'”

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