Market penalties for corporate fraud

We heard during the Sarbox regulatory panic, and still hear, that harsh civil and criminal penalties against firms for disclosure violations are necessary to keep firms and managers honest. This contradicts theory and evidence that the market is capable of levying harsh penalities on its own.

Recent evidence comes from Karpoff, Lee and Martin, The Cost to Firms of Cooking the Books (July 25, 2005).  Here’s the abstract

We examine the penalties imposed on all 585 firms that were targeted by SEC enforcement actions for financial misrepresentation from 1978-2002. Consistent with the view that penalties are small, monetary fines were imposed on only 7% of the firms. A larger fraction, 36%, faced class action lawsuits from investors. Overall, however, the penalties imposed on firms through the legal system appear to be small, as the unconditional mean total of all legal penalties is only $14.3 million per firm. The penalties imposed by the market, in contrast, are huge. Our point estimate of the reputational penalty - which we define as the expected loss in the present value of future cash flows due to higher contracting and financing costs - is over twelve times the sum of all penalties imposed through the legal and regulatory system. For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $2.47. Of this additional loss, $0.18 is due to expected legal penalties and $2.29 is due to lost reputation. This evidence belies a widespread view that financial misrepresentation is disciplined lightly. To the contrary, reputational losses impose substantial penalties for cooking the books.

Interestingly, this is from the pre-Sarbox period, ending 2002.

So does this mean that out-of-control managers are hurting shareholders?  Well, there's a reputational penalty to managers too, as detailed by Desai, Hogan, and Wilkins, The Reputational Penalty for Aggressive Accounting: Earnings Restatements and Management Turnover, forthcoming Accounting Review, finding that there's more executive turnover for firms restating earnings, and that the employment prospects for these executives are worse than in control firms, controlling of course for relevant firm characteristics.

It’s worth wondering whether the reputational penalty to firms, and perhaps to managers, now exceeds the social harm because it’s jacked up by the press and by entrepreneurial regulators and prosecutors, e.g., Spitzer.