The dissertation consists of two essays. Essay I proposes a theory which explicitly models the strategic fraud detection behavior of the regulator (e.g., the SEC), and studies the strategic interaction between corporate fraud commission and detection. The model generates several new testable empirical implications. Essay II empirically studies whether the SEC strategically responds to fraud commission and how effective Sarbanes-Oxley is in reducing fraud commission using detected fraud data of corporate America in the last 10 years.
Essay I: The paper considers an agency model of fraudulent misreporting which implies a rich set of relationships between the commission of fraud, the observation or detection of fraud, economic performance, and the compensation policy of the firm. The paper develops a number of testable empirical implications and highlights several interesting phenomena, including implications on exogenous variables that can cause an increase in the amount of fraud committed but a decrease in the amount of fraud being observed (and visa versa). Thus, empirical studies that seek to identify the firm or managerial characteristics associated with the commission of fraud cannot infer a relationship by simply examining how the amount of observed fraud varies with these characteristics. In addition, the paper also shows that an increase in an industry’s growth potential can cause that industry to fall from a high-productivity pooling equilibrium (with high levels of incentive compensation and effort and, as a result, many high-productivity firms) to the lower-productivity mixed-strategy equilibrium (with lower levels of incentive compensation and effort and, as a result, fewer high-productivity firms), resulting in a drop in economic performance.
Essay II: In the wake of recent financial scandals, there are heated debates over whether the SEC is effective in combating fraud as well as over the costs and benefits of the Sarbanes-Oxley Act. This paper investigates two research questions empirically: 1. Does the SEC strategically respond to fraud commission? 2. How effective is SOX in reducing fraud commission? Using a sample of firms subject to SEC litigations for fraud and employing the bivariate probit with partial observability technique, we find strong evidence in favor of theoretical predictions with the assumption that the regulator is strategic in combating fraud, but contradicting to theoretical predictions assuming that the fraud detection environment is exogenous or mechanical (i.e., without a strategic regulator). We also find that SOX has been very effective and decreased fraud commission by two thirds after its enactment. Our finding should provide some useful insight to policy makers in light of the current debates.