Overinvestment and Corporate Fraud in Efficient Capital Markets
49 Pages Posted: 15 Mar 2006
There are 2 versions of this paper
Overinvestment and Corporate Fraud in Efficient Capital Markets
Date Written: March 14, 2006
Abstract
Overinvestment in certain firms or sectors induced by corporate fraud, where informed insiders strategically manipulate outside investors' beliefs by exaggerating financial performance and economic prospects, has been endemic historically and has recently attracted much attention. We present a theory that reconciles corporate fraud and overinvestment with rational capital markets. While considering incentive-efficient managerial compensation contracts, we show that the optimal contract induces overstatements by managers (e.g., exaggerated disclosures regarding future investment opportunities) and subsequent overinvestment by rational investors. Our theory builds on the coordination problem faced by dispersed owners of widely-held firms; in particular, their inability to credibly precommit to an aggregate investment response to information provided by insiders. Faced with their investment coordination constraints, owners of widely held firms attempt to design managerial compensation contracts to both elicit valuable information from insiders and to ameliorate their investment coordination problem. In equilibrium, shareholders (via managerial compensation contracts) optimally determine the probability of fraud and the extent of overinvestment. In particular, it might be optimal to elicit less precise information from insiders in order to reduce expected compensation costs. Intuitively, there are three types of equilibrium: one in which disclosures are truthful, one in which disclosures reveal no information, and finally an equilibrium in which disclosure is not truthful but still have valuable content. The theory helps explain why instances of corporate fraud and overinvestment tend to follow the introduction of new technologies, concentrate in industries with valuable growth options, and intensify when firms have better access to external capital markets. We also demonstrate how managerial career concerns may increase the likelihood of overinvestment and how internal capital markets may lead to more precise disclosures by insiders. Finally, we examine the role of the Corporate Charter in minimizing firms' cost of capital.
Keywords: Overinvestment, Investor Coordination, Fraud, Managerial Control
JEL Classification: G31, D23, D82
Suggested Citation: Suggested Citation
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