Corporate Fraud and Investment Distortions in Efficient Capital Markets

Inefficient investment allocation induced by corporate fraud, where informed insiders strategically manipulate outside investors' beliefs by exaggerating financial performance and economic prospects, 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. While managerial compensation contracts and investment policies are designed to elicit valuable information from insiders, 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