The Ripple Effect: How Punishing Corporate Fraudsters Affects Their Peers

A study by CUHK Business School on Chinese firms has revealed that punishment of fraud firms has an effective and far-reaching impact on their peers

By Fang Ying, Senior Writer, China Business Knowledge @ CUHK

Rapid economic transformation in transition economies often aggravates the problem of corporate financial fraud. China is no exception. A study by CUHK Business School on Chinese firms has revealed that punishment of fraud firms has an effective and far-reaching impact on their peers.

Firms are deterred from committing fraud if their peers in its industry are caught and punished and such deterrence effects are subject to how the observing firm evaluates the possibility of being caught and the likelihood it will be punished the same way if it violates similar prohibitions. This is the finding of a research conducted by Prof. Daphne Yiu, associate professor at the Department of Management of the Chinese University of Hong Kong Business School and her collaborators, Yuehua Xu from Sun Yat-Sen University and William Wan from the City University of Hong Kong.

“Our study shows that in transition economies such as China where unambiguous formal institutions regulating firm behaviors are still lacking, listed companies learn by observing the corporate behaviors and consequences of their industry peers,” says Prof. Yiu.

Social Learning Theory

According to the researchers, in transition economies, the transition of an economic system from a centrally planned economy to a market economy provides firms with many opportunities to make a fortune and become successful quickly. However, the development of legal, market and cultural institutions is often still not mature, which easily leads to various corporate financial fraud cases. As such, companies usually learn by observing their peers, and the punishment of fraud firms can send out a clear signal to them as to what types of behaviors are permitted or prohibited. As a result, they will regulate their own behaviors and do the right thing accordingly.

Actually, this social behavior is not new and it stems from a theory called “social learning theory”. According to the theory, learning can be obtained through the processes of vicarious learning, by observing the behaviors and the related consequences of others. As a result of the observations, the observer can be affected and then change their behaviors accordingly. For example, when a child sees another child being punished for stealing a crayon from a peer, he or she will be less likely to do the same. As such, the deterrence effect takes place when an observer sees someone punished for a behavior and then refrains from the replication of similar behaviors in the future.

“When witnessing the negative consequences of the fraudulent behaviors of industry peers with similar status, the observing firms likely will perceive increased probabilities of being caught and punished if they commit similar frauds.” – Prof. Daphne Yiu

The Study

Collecting data from a sample of 604 observations of Chinese firms listed on either the Shenzhen or Shanghai Stock Exchange, the study looked into all the corporate financial fraud released and published by the China Securities Regulatory Commission (CSRC) from 2002 to 2008. According to the researchers, the sample period was chosen because it was a period when China was actively moving away from a centrally planned regime and undergoing gradual institutional transition. Moreover, this sample period is after the promulgation and enforcement of several major legislations related to the corporate governance of Chinese listed firms, such as the Provisional Regulations Against Securities Fraud in 1993, the Company Law in 1994, the Securities Law in 1999, the Accounting Law in 2000, and the Rules of Internet Accounting Control (Basic Rules) in 2001.

“We used China as the study context because China’s stock market has just developed and is in constant flux,” Prof. Yiu says.

With the purpose of exploring whether and how fraud punishment levied on industry peers can deter other firms from committing such fraud, the study has four important findings:

Firstly, it finds that the number of punishments of industry peers for corporate financial fraud is negatively related to the likelihood of fraud commitment of an observing firm in that industry. The researchers explain that when more firms in the same industry are caught and punished, the observing firms will witness the danger and even ‘visualize’ the negative consequences more vividly and then become more hesitant to commit fraudulent behaviors.

Secondly, the study finds that the negative effect of industry peers’ fraud punishments on the likelihood of an observing firm’s fraud commitment is strengthened by the total number of fraud punishments of prominent firms in the stock exchange. Stated simply, if more prominent firms in the same industry are caught and punished by committing financial fraud, the observing firms will be less likely to do the same. “Because of the high visibility of prominent firms, punishments of these firms may attract heightened attention from all other firms,” Prof. Yiu comments. “And such attention may arouse anxiety and fear in the observing firms and propel them to search for more information about the credibility of the regulatory enforcement.”

Thirdly, the study reveals that the negative effect of industry peers’ fraud punishment on the likelihood of an observing firm’s fraud commitment is weakened when the level of law development is higher. That is to say, the deterrence effect of vicarious punishment is weaker when law development is more developed, which means that when law development and implementation are mature, firms do not have to rely as much on observational learning when it comes to certainty of punishment.

The last major finding of the study is that similar-status industry peers’ fraud punishment is more negatively related to the likelihood of fraud commitment of an observing firm than dissimilar-status industry peers’ fraud punishment. In other words, deterrence effect of a fraud punishment will vary among firms, with the effect being stronger for similar firms than for dissimilar firms.

“Firms will be particularly alert to learn from the mistakes made by their peer firms with similar status in the industry,” Prof.Yiu says. “The similarity in status of the fraud firm and the observing firm plays a crucial role in the social learning process. When witnessing the negative consequences of the fraudulent behaviors of industry peers with similar status, the observing firms likely will perceive increased probabilities of being caught and punished if they commit similar frauds.”

Implications for Policy Makers

Although the study focuses on the learning side of the firms, Prof. Yiu says that it actually has implications for the “teaching side” of the regulators and policy makers in transition economies, especially when they ponder how to make use of the prevailing institutions and governing mechanisms to strengthen corporate governance of listed firms.

As such, the study concludes that regulators need to be careful in the enforcement of rules and regulations on corporate financial fraud, because the manner and targets of such enforcement will likely have important implications for other listed firms in the stock exchanges. Since the findings of the study clearly indicate that more prominent firms being caught will accentuate the effects of vicarious punishment, the regulators should be aware of the fact that vicarious punishment is more effective to the extent that other firms perceive the fairness of enforcement, which also means that to thwart other firms from engaging in fraudulent behaviors, targeting the “big fish” may yield better outcomes.