Academic

In Leverage, Sanctions, and Deterrence of Accounting Fraud, Urska Velikonja proposes an alternative regime to deter accounting fraud, which she terms ?leveraged sanctions? ? a civil or regulatory sanction that is threatened against the firm or a group of insiders.  The firm (or group) can reduce or avoid these sanctions by divulging information to external enforcers, such as the SEC.  The hope is that the threat of sanction will provide the leverage needed to produce cooperation from the firm or group, inducing them to share information about individual wrongdoers with enforcers, who will then sanction the dishonest individuals.

I quite enjoyed the article ? Velikonja has carefully researched this topic, and demonstrates an admirable breadth of knowledge and command of the literature.  Moreover, though some will no doubt disagree with her contention that increased personal liability will more effectively deter accounting fraud, her arguments on this front held some resonance for me, at least in theory. 

Ultimately, however, I was not convinced by Velikonja?s central claim that a shift to a leveraged sanctions regime would substantially reduce accounting fraud, for several reasons.  First, at least as it relates to firm-level leverage, I?m not as confident as Velikonja that her proposed regime is such a radical departure from current SEC informal practice.*  As Velikonja notes, there are no legal impediments to the use of leveraged sanctions by the SEC, and the SEC already has at its disposal a variety of monetary and non-monetary sanctions with which to threaten firms that withhold cooperation.  It would thus be rather surprising if the SEC, in contrast to other enforcers, failed to use the carrots and sticks within its repertoire to induce any desired cooperation.   

Second, to the extent that the SEC doesn?t currently use leveraged sanctions to the fullest extent possible, it is worth asking, ?why??  Most likely, the SEC -- given a constrained budget, complex political realities, and an informational disadvantage vis-à-vis the firm -- simply does not consider leveraged sanctions the most effective means of deterrence, and with good reason.

There is a tendency within most organizations (which would be exacerbated under Velikonja?s proposal) to push wrongdoing downward to lower-level employees.  An explicit direction or delegation from higher-level management is probably unnecessary to accomplish this aim.  Instead, it is more likely that firms (meaning senior management) create the incentives for misconduct, and then turn a blind eye to apparent violations. 

So long as the misconduct remains undetected by relevant outsiders and is in the firm?s (or management?s) immediate interest, this state of affairs can continue indefinitely.  If, however, the misconduct comes to light and the firm or an insider group is pressed to cooperate and turn over the wrongdoers, there are lower-level scapegoats (who, as noted, are not free from blame) at the ready, allowing the firm or group to reap the benefits of cooperation. 

Velikonja dismisses this possibility, arguing that external enforcers are able to control such strategic cooperation by independently comparing publicly available information with information provided by the firm.   It seems to me that this is highly unlikely, as evidenced by many misreporting and fraud cases.

Corporate misconduct cases, including accounting fraud, are often complex, with many causes and several levels of fault and blame.  Most of the time, corporate insiders will be able to ?cooperate? by providing non-public information that is incomplete, but largely consistent with the even more incomplete public version of events.  After all, if enforcers had the means and desire to piece together the complete version of events from publicly available information, they would hardly need to leverage the firm or insider groups into cooperation.  And the more the SEC invests in investigation, the more it eviscerates any efficiency benefits associated with a leveraged sanction regime.

Don Langevoort?s work on the incentives and political realities of enforcers, such as the SEC, is particularly instructive here.   Though the times they are a-changin?, the political, economic, and institutional reality has so far been one in which the SEC doesn?t have the luxury for the sort of deep scrutiny and second-guessing of the ?official story? contemplated by Valikonja or similar proposals on any grand scale. 

Without some hard evidence ex ante, expending resources to investigate deeper in the face of a ready-made story of wrongdoing offered up by the firm or insider group is an unappealing prospect from the standpoint of the SEC.  Costly, and with a high risk of turning up little or nothing beyond what was given freely in cooperation, such a move risks embarrassment, and accusations of waste or overzealousness on the part of investigators. 

Velikonja?s article is a good one and well worth reading.  I trust that this and her other work (of which there is an astonishing amount already) will receive the attention it deserves in the academic community.  But I hope that the proposal gains no traction with the SEC or Congress.  My prediction for a world of leveraged sanctions is not more deterrence, but less liability for both firms and high-level insiders, with a corresponding increase in blame leveled at lower-level employees.

* Velikonja?s proposal also contemplates the possibility of leveraged sanctions against insider groups, including the audit committee, the entire board, and the top management team.  These options are currently not within the SEC?s regulatory arsenal and would require enacting legislation that, as Velikonja recognizes, is not likely to be forthcoming.  My analysis regarding scapegoating and SEC incentives is largely the same with respect to these variations on the leveraged sanction proposal.