Leverage, Sanctions, and Deterrence of Accounting Fraud

The article argues that firm-level liability for fraud is justified by the need to secure the cooperation of the firm in pursuing individual wrongdoers ex post rather than in controlling top-level officers ex ante. Firm-level liability for fraud has often been criticized. The empirical evidence suggests that firms overpay for fraud liability and overspend on internal compliance mechanisms (which are generally ineffective at preventing fraud). Yet, insiders who commit fraud are rarely sanctioned for their wrongdoing, leading to moral hazard and underdeterrence of individuals. This article argues that two factors explain the failure to sanction managers who commit fraud. First, managers control the information that would reveal who was involved in accounting fraud and thus can impede external investigations (and hence sanctions). Second, managers also influence whether the firm will investigate and sanction accounting fraud internally. Director & officer insurance and managers' control over settlement further reduce the likelihood that dishonest managers will be sanctioned. The article proposes using leverage against the firm to incentivize disclosing private information, lowering enforcement costs, and increasing the probability that dishonest insiders will be sanctioned. The article develops a model where leveraged sanctions threatened against firms improve deterrence of accounting fraud generally, including in S.E.C. enforcement actions and securities litigation