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http://ssrn.com/abstract=1590447
 
 

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Epidemics of 'Control Fraud' Lead to Recurrent, Intensifying Bubbles and Crises


William K. Black


University of Missouri at Kansas City - School of Law

April 15, 2010


Abstract:     
“Control frauds” are seemingly legitimate entities controlled by persons that use them as a fraud “weapon.” A single control fraud can cause greater losses than all other forms of property crime combined. This article addresses the role of control fraud in financial crises. Financial control frauds’ primary weapon is accounting. Fraudulent lenders produce exceptional short-term “profits” through a four-part strategy: extreme growth (Ponzi), lending to uncreditworthy borrowers, extreme leverage, and minimal loss reserves. These exceptional “profits” defeat regulatory restrictions and turn private market discipline perverse. The profits also allow the CEO to convert firm assets for personal benefit through seemingly normal compensation mechanisms. The short-term profits cause stock options to appreciate. Fraudulent CEOs following this strategy are guaranteed extraordinary income while minimizing risks of detection and prosecution.

The optimization strategy causes catastrophic losses. The “profits” allow the fraud to grow rapidly by making bad loans for years. The “profits” allow the managers to loot the firm through exceptional compensation, which increases losses.

The accounting control fraud optimization strategy hyper-inflates and extends the life of financial bubbles. The finance sector is most criminogenic because of the absence of effective regulation and the ability to invest in assets that lack readily verifiable values. Unless regulators deal effectively with the initial frauds their record profits will produce imitators. Control frauds can be a combination of “opportunistic” and “reactive”. If entry is easy, opportunistic control fraud is optimized. If the finance sector is suffering from distress, reactive control fraud is optimized. Both conditions can exist at the same time, as in the savings and loan (S&L) debacle.

When many firms follow the same optimization strategy a financial bubble hyper-inflates. This further optimizes accounting control fraud because the frauds can hide losses by refinancing. Mega bubbles produce financial crises.

Number of Pages in PDF File: 37

Keywords: Corporate law, Financial crisis, Financial regulation, Banking, Banking regulation, Securities, Securities regulation, Control fraud, Fraud

JEL Classification: K14, K22, K23, K42, G18, G28, G38

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Date posted: April 16, 2010  

Suggested Citation

Black, William K., Epidemics of 'Control Fraud' Lead to Recurrent, Intensifying Bubbles and Crises (April 15, 2010). Available at SSRN: http://ssrn.com/abstract=1590447 or http://dx.doi.org/10.2139/ssrn.1590447

Contact Information

William K. Black (Contact Author)
University of Missouri at Kansas City - School of Law ( email )
5100 Rockhill Road
Kansas City, MO 64110-2499
United States
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