Corporate fraud and investment distortions in efficient capital markets

Abstract

Inefficient investment allocation induced by corporate fraud, where informed insiders strategically manipulate outside investors' beliefs, has been endemic historically and has recently attracted much attention. We reconcile corporate fraud and investment distortions with efficient capital markets, building on shareholder-manager agency conflicts and investment renegotiation in active takeover markets. Because investments that are ex post inefficient are not renegotiation proof, the optimal renegotiation-proof contract induces overstatements by managers, accompanied by overinvestment in low return states and underinvestment in high return states by rational investors. Our framework also helps explain why easy access to external capital appears to facilitate corporate fraud. Copyright (c) 2009, RAND.

Voluntary Disclosures, Corporate Control, and Investment

“…To address these issues, we consider a model in which a partially informed manager has private information about his/her firm's prospects 3 We discuss the related literature subsequently. 4 Although we do not explicitly model the market for corporate control, our analysis and results also qualitatively apply to a setting in which such a market ensures the ex post efficiency of investment decisions (Kumar and Langberg [2009]). 5 In particular, managers might at times have a preference for larger investment levels (i.e., empire building as in Stulz [1990]), investment levels that resemble those of their industry peers (i.e., herding behavior as in Scharfstein and Stein [1990]), or lower investment levels that preserve the status quo (i.e., enjoying the quiet life as in Bertrand and Mullainathan [2003]).…”

Securities Fraud and Corporate Finance: Recent Developments

“…Kumar and Langberg () formally model corporate fraud and investment distortions. In their model, fraud and overinvestment and underinvestments can arise in equilibrium with rational expectations and perfect capital markets.…”

Financial Report Manipulation and the Efficiency of Capital-Raising and Investment Decisions

“…Dye (1988) and Bolton, Sheinkman and Xiong (2006), on the other hand, argue that shareholders may actually prefer contracts that induce report inflation if they plan to sell their shares in the short-run. Kumar and Langberg (2009) find that a contract of this type may be the optimal renegotiation-proof contract, even if shareholders do not benefit directly from report inflation. A sample of empirical work relating conflicts between managers and shareholders to fraudulent reporting includes papers by Beneish and Vargus (2002), Li (2005) 3 See also Roychowdhury (2003 the more realistic case in which managers possess separate private information about assets in place and the firm's investment opportunities.…”