Ownership Incentives and Management Fraud

Abstract: Agency Theory would suggest that increased firm ownership should mitigate a manager's propensity to fraudulently divert resources for unauthorized consumption. However, most of the frauds in recent times have been committed by senior managers and/or Chief Executives who may own a significant portion of the firm. Although such management fraud has been studied extensively in the economics of crime literature as white collar crime and has been the focus of many legislative initiatives such as the Sarbanes Oxley Act of 2002, the Securities Enforcement Remedies and Penny Stock Reform Act of 1995 and study teams such as the Treadway Commission (National Committee on Fraudulent Financial Reporting 1987), the assumptions behind many of these studies and legislative initiatives is that an increase in severity and certainty of ex-post penalty is an effective deterrent to financial fraud regardless of this ownership question. What separates financial fraud from other crime is that it is committed in the context of a market that is considered efficient in that it rationally anticipates and reacts to all information and uncertainty. Thus, the market is potentially able to protect itself to some extent by rationally pricing such possible behavior. Such ability to ‘self protect’ changes the nature of incentive and gain from fraud to a manager who, because of his part ownership, must face some consequences of his own fraud. In the ensuing game, though the penalty for fraud deterrence increases the cost of fraud, whether it can ensure complete honesty is a function of how efficient the legal system is and the extent of firm ownership by the manager. As the analysis of this paper shows, the question of fraudulent behavior can only be answered in conjunction with the question of the extent of ownership of the firm by the manager. The results show that increased ownership may not necessarily reduce the propensity to commit fraud. As the gain from fraud and the corresponding penalty increases, unless the gain from fraud is completely offset through the penalty, the results suggest that more and more managers may find it optimal to engage in a mixed strategy and behave fraudulently some of the time. What is more likely to be successful is the certainty of determination and application of the penalty rather than its size. These results have significant implications in countries such as those in Europe where the insider holdings vary significantly.