Fraud and firm performance: keeping the good times (apparently) rolling

The purpose of this paper is to examine the hypothesis that a period of sustained supernormal firm performance (for up to five years before fraud commission) creates financial pressure on actors/agents so they have a propensity to behave fraudulently to keep the good times (apparently) rolling.

Applying the Fama and French (1993) three-factor model using a range of calendar time portfolio methodologies, the authors measure abnormal drifts in stock performance in periods up to five years before alleged fraud commission dates. The authors examine a sample of 561 US firms subject to enforcement actions initiated by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) over 1968-2009.

The authors find that sustained firm-specific positive stock price performance for up to five years followed by the almost inevitable adverse shock, which eventually brings the good times to an end, generally precedes corporate fraud. Fraud occurs when firm managers engage in misconduct in a misguided attempt to keep the good times (apparently) rolling despite the negative shock.

The sample is restricted to firms with trading histories on the stock market prior to the misconduct, and to firms contained in the Federal Securities Regulation database of US firms subject to enforcement actions initiated by the SEC and the DOJ over 1968-2009.

The desire to keep the good times rolling appears to be a very important driver of fraudulent behavior, even after controlling for the executive compensation incentive effects and business cycle effects emphasized in prior studies. The robust findings of positive abnormal returns for up to five years preceding initial fraud commission suggest that regulators and investors would be well-advised to scrutinize the behavior of firms that exhibit surprisingly persistent superior performance over an extended period. If the financial results appear too good to be true, a closer examination might just reveal that they indeed are.

While most investors generally like to see the “good times keep rolling” this pressure can create ethical dilemmas for managers.

Unlike most other papers in this area of the literature, which concentrate on the pre-fraud disclosure, the authors investigate the firm’s performance in the pre-fraud commission period. The authors find that the commission of the alleged fraud is preceded by a sustained period of surprisingly good performance of up to five years in length. The authors believe that the paper provides empirical evidence that supports the hypothesis that a period of sustained supernormal firm performance (for up to five years before fraud commission) creates financial pressure on actors/agents so they have a propensity to behave fraudulently to keep the good times (apparently) rolling.