The Effects of Regulatory Scrutiny and Corporate Governance on Fraud Detection in Financial Firms: U.S. Evidence

Abstract

In this paper, we provide evidence on the effects of the adequacy of regulatory scrutiny practices and strength of corporate governance mechanisms on fraud detection in publicly held financial firms. We do that by empirically examining whether increasing the resources allocated to the SEC, as a main regulatory body primarily responsible for fraud detection in U.S. publicly held firms, together with the presence of stronger firm-level corporate governance mechanisms could enhance fraud detection by the SEC and internal sources, namely audit reviews, back office reviews, periodic internal reviews, tightened controls, employers, employees and other firm insiders, in U.S. public financial firms. We utilize the FIRST operational loss database, provided by Algorithmics Inc., to count the number of internal and external fraud events going on and detected in each firm-year in a sample of defrauded U.S. public financial firms during the period 1980-2007. Then, we model the expected number of fraud events detected by the SEC and internal sources using a Poisson specification. We find convincing evidence that setting higher SEC’s regulatory budget could help both the SEC and internal sources detect higher number of fraud events going on. It is also evident that bigger and more active audit committees are the most effective board governance mechanism that could help the SEC and internal sources detect fraud. Additionally, longer-tenured CEOs or chairman CEOs might not exert enough efforts to enhance their firm’s internal controls or cooperate effectively with the SEC to achieve the goal of fraud detection. Meanwhile, higher CEO’s stock ownership could motivate him to exert more efforts to help the SEC and internal sources detect fraud. On the other side, allocating more resources to the SEC could boost its direct and indirect efforts regarding fraud detection. Consequently, such boosted efforts could help discipline the negligent performance of chairman CEOs, motivate CEOs with weaker equity incentives and enhance the effectiveness of less active audit committees in the context of fraud detection. These findings shed light on the role of the SEC in protecting public investors through remedying the deficiencies in internal corporate governance mechanisms in the context of fraud detection. Finally, we find no evidence supporting the premise that external corporate governance mechanisms, namely large outside shareholders, lower number of anti-takeover provisions and BIG-4 external auditors, might help the SEC or internal sources detect fraud. Furthermore, it does not seem that boosted SEC’s efforts should necessarily help detecting more fraud event in financial firms with weaker external corporate governance mechanisms.