March 14, 2002
Regulations not best prevention against fraud
The financial value of a law-abiding reputation — not tighter government regulations — is the best way to prevent future scandals like those enveloping energy giant Enron and its auditor Arthur Andersen, a UW researcher says. And Jonathan Karpoff believes this will hold true despite the call by many financial and political leaders for Congress to pass tighter accounting regulations and reforms. Karpoff, a finance professor in the Business School, bases his views on the dramatic results of a study he conducted on the reputational effect that white-collar crime — including financial reporting fraud — has on company stock values. Karpoff and John Lott, of the Wharton School at the University of Pennsylvania, discovered that the “enforcement effect” of reputation encourages firms not to commit fraud and penalizes firms when they do. Fraud allegations have been at the root of the Enron scandal. “We found that arbitrary, large increases in criminal penalties for fraud can do more harm than good, because they squeeze out reputation as a policer of fraud and increase consumer costs,” Karpoff says. “The Enron scandal is more likely leading to companies willing to pay more for quality audits, and that will drive the accounting market — not government imposed regulations.” Karpoff contends that the two companies’ executives underestimated the value of reputation and that naivete contributed to their downfall. “Even after restating its profits, Enron still made $880 million in 2000. Even if half of that is bogus, Enron had a core of profitable operations,” he says. “The reason for the firm’s complete meltdown is that much of its credible business activity depended on a good reputation. Buyers and sellers of electricity, for example, lost confidence that Enron would uphold its side of any deals. So even this legitimate part of the firm’s business sunk with the firm’s lost reputation.” Likewise, Arthur Andersen is in the business of providing assurances of quality. As an auditor, its whole business is based on its credibility, Karpoff says. The firm is now scrambling to re-establish its reputation — for example, hiring Paul Volker to help clean up its act. “But,” Karpoff says, “it has dug a huge hole for itself.” The researchers studied data on 132 cases of alleged and actual corporate fraud, including stakeholder, government, financial reporting (misleading accounting practices) and regulatory violations (currency transaction reporting), from 1978 through 1987. They compared stock values following initial press reports of allegations or investigations of corporate fraud against private parties with those after the penalties that resulted. They found an average decrease of $60.8 million in the values of the affected companies’ stock. Criminal fines, restitution, civil penalties and other legal costs accounted for only 5.5 percent of the drop. The rest was due to lost future sales or higher costs. This finding is especially relevant to Enron today, Karpoff says, because it explains Enron’s meltdown and the downward spiral of fewer customers for Arthur Andersen. “These results indicate that firms committing fraud face market penalties that far outweigh any prospective legal penalties,” Karpoff says. The research, published in the Journal of Law and Economics in 1993, has been supported by follow-up papers using current data. While neither laws nor reputation will ever completely prevent fraud, Karpoff argues his research shows reputational costs will provide even more of a deterrent now because of the recent scandal. “The theory is that when something bad happens we need more regulations. But the fact is millions of business transactions occur daily without any direct government oversight. What keeps people honest as they engage in business transactions? Our research indicates that it is largely the discipline provided by the market,” Karpoff says. The latest scandal, however, will influence other company executive behavior. “What will happen is that some accounting firms will develop stronger reputations for providing honest results to their clients,” Karpoff says. “Their reputations will cost more to clients, but some firms will find it worthwhile to pay more because they want to convince investors that their books are not cooked.” Most importantly, Karpoff hopes his research may slow a rush to judgment that could lead to counterproductive statutes. “Everybody’s knee-jerk reaction in a case like this is that we need more government regulation,” Karpoff says. “I would argue that we don’t because the costs of such regulations are substantial and the benefits are small. The perceived benefit — that the incidence of fraud will decrease dramatically — is vastly overstated. As it is, businesses have to keep their noses clean in order to make a profit.”
