William & Mary Law Review


Urska Velikonja


Under the dominant account, fraudulent financial reporting by public firms harms the firms' shareholders and, more generally, capital markets. This Article contends that the account is incomplete. In addition to undermining investor confidence, misreporting distorts economic decision making by all firms, both those committing fraud and those not. False information impairs risk assessment by those who provide human or financial capital to fraudulent firms, the firms' suppliers and customers, and thus misdirects capital and labor to subpar projects. Efforts to hide fraud and avoid detection further distort fraudulent firms' business decisions, as well as decisions by their rivals, who mimic or respond to what appears to be a profitable business strategy.

If fraud is caught, managers externalize part of the cost of litigation and enforcement to employees, creditors, suppliers, and the government as the insurer of last resort. Mounting empirical evidence suggests that harm to nonshareholders dwarfs that suffered by defrauded shareholders. Moreover, unlike investors, who can limit their exposure to securities fraud by diversifying their holdings and demanding a fraud discount, other market participants cannot easily self-insure. The Article supplies both theoretical and empirical support for the assertion that defrauded investors are not the only victims of accounting fraud. In conclusion, the Article outlines and assesses some alternative fraud deterrence and compensation mechanisms.