If Fraud is Never Caught, did it Really Happen?

Criminal charges like the ones currently levied against FTX founder Sam Bankman-Fried raise an important question for corporate stakeholders: Is securities fraud rampant? Corporate America would undoubtedly bristle at the suggestion, deeming the cryptocurrency exchange’s case an isolated event and noting that Bankman-Fried is still awaiting trial. On the other hand, public opinion need not abide by the standard of “innocent until proven guilty,” and proving the executive class is not brimming with fraudsters is literally impossible.

A study published last month in the Review of Accounting Studies attempted to pin a number on the actual rate of corporate fraud. It didn’t paint a flattering picture, as the researchers estimated that 10% of publicly traded companies commit securities fraud each year. Meanwhile, the authors projected that only about one-third of such fraudulent activity is ever actually detected.

“Combining fraud pervasiveness with existing estimates of the costs of detected and undetected fraud, we estimate that corporate fraud destroys 1.6% of equity value each year, equal to $830 billion in 2021,” the authors concluded.

If those estimates are accurate, the Department of Justice could use them to back up its latest campaign to crack down on corporate crime. The head of DOJ’s criminal division, Assistant Attorney General Kenneth Polite Jr., expanded last month on some of the details of the department’s new policies aimed at rooting out wrongdoing. One of the highlights is a program granting greater leniency for companies that self-report their own misconduct to the government. In cases where companies blow the whistle on themselves, they can avoid prosecution by cooperating with investigators and implementing reforms to address the problems identified. According to the DOJ, those companies would instead enter into a deferred prosecution agreement or a non-prosecution agreement, rather than pleading guilty.

Leniency for self-reporting is far from a new stance on the part of DOJ. In the past, however, such policies have applied to what could be considered less serious offenses such as foreign bribery. Allowing self-reporting to serve as a mitigating factor in cases of more egregious misconduct, like securities fraud, breaks new ground.

In a memo on DOJ’s shift, lawyers from Morgan, Lewis & Bockius LLP pondered the possibility that 2023 could become “The Year of the Carrot” for Justice’s enforcement program – in reference to using rewards to incentivize good behavior at the corporate level. That would stand in stark contrast to the department’s focus in 2022, which they called “The Year of the Sticks.” They highlighted some of DOJ’s more punitive points of emphasis from last year, such as fraud convictions and bringing back corporate monitors.

Naturally, carrots are only effective in shaping behavior if they look good enough to eat. For example, disclosing misconduct to the authorities may get a company off the hook in the legal sense, but corporations can still take a serious reputational hit if that information becomes public. In light of such considerations, less scrupulous executives may decide they would rather roll the dice on not getting caught.