The Relationship Between Corporate Fraud and Investor Optimism

If there’s a phrase that captures the essence of the mid- to late-1990s business world, it’s “irrational exuberance.” Those words, uttered by former Fed Chairman Alan Greenspan in a 1996 speech, sum up the period, which was initially marked by record-setting IPOs, stock option payouts, and rampant investor speculation. The inevitable post-bubble hangover saw federal regulators uncover numerous cases of large-scale corporate fraud.

That era serves as the backdrop for research by Tracy Yue Wang and Andrew Winton with Indiana University’s Xiaoyun Yu on the relationship between investor beliefs about industry business conditions and the prevalence of corporate financial fraud. They used a sample of U.S. firms that filed IPOs between 1995 and 2005 to explore the issue.

Did they find that fraud was an inevitable byproduct of excessive investor optimism? Not necessarily, says Winton. “If investors are really optimistic, there’s no need to commit fraud,” he explains. “We found anecdotal evidence of this in the late 1990s and early 2000s, when a lot of companies went public without any revenue—and often without business plans. They weren’t committing fraud, but investors were so optimistic that there was no reason for the companies to cook the books.”

By contrast, Winton adds, regulators did find evidence of financial shenanigans at several major telecom industry firms over the same time period. Why? “Investors were optimistic about telecoms, but not so optimistic that they didn’t want to see financial reports and the like,” he says, explaining that the increased scrutiny helped expose some of the fraudulent behavior.

One key takeaway, Wang notes, is that deceit can emerge when you’re least likely to expect it. “Our findings suggest that investor monitoring will not be effective at preventing fraud when investors are optimistic about industry conditions,” she says. “It is somewhat counter-intuitive, but the time to be looking for fraud is during boom times, rather than down times.”

Because of the study, economists at the Securities and Exchange Commission are now reviewing how and when they allocate their resources.

“Corporate Fraud and Business Conditions: Evidence from IPOs” T. Wang, A. Winton, et al, Journal of Finance, 65, 2255-2292 (2012)