The Impact of a Strategic Regulator on Executive Compensation and Fraudulent Misreporting

Abstract

The passage of Sarbanes-Oxley Act in 2002 reflects the regulator's strategic response to an epidemic of corporate fraud in the late 1990s. Recognizing the dynamic interplay between the manager's decision to commit fraud and the regulator's decision to investigate the firm, we empirically investigate the shareholder-manager-regulator nexus that determines the equilibrium relationships between the degree of reliance on equity based compensation (EBC), the firm's growth potential, the extent of fraudulent reporting, and the intensity of regulatory investigation. To incorporate the strategic behavior of the managers and the regulator we employ a bivariate probit model with partial observability. Using a sample of 233 firms subject to SEC enforcement actions within the last 10 years, we find that fraud has mainly been concentrated in high-growth, `new economy' industries and fraud has mainly been detected during the recent economic downturn in those industries. Furthermore, greater reliance on EBC increases both the probability of fraud being committed and the conditional probability of detecting fraud. Of particular interest to policy makers, we find that the greater fraud penalties associated with the enactment of SOX reduce both of the probabilities. This means that SOX has, as intended, reduced fraudulent misreporting; however, it has also reduced the amount of prosecuted frauds. This is a direct consequence of the reduced incentives to commit fraud, rather than due to a decrease in SEC enforcement intensity. Our empirical methodology allows us to disentangle these two effects. Using panel regressions, we also find strong evidence that EBC is positively associated with growth potential and negatively associated with fraud penalty in the (relatively fraud-prone) high-tech industries, while no such associations exist in the (relatively fraud-free) manufacturing industries. Overall, our empirical results highlight the importance of treating the regulatory agency as a strategic player in the fraud commission and detection game.