Once Bitten, Twice Shy: Learning From Corporate Fraud and Corporate Governance Spillovers

Abstract

This paper finds that investors learn from their experience with corporate fraud and financial misconduct and modify their investment behavior to avoid suspicious firms and increase corporate governance efforts. More specifically, mutual funds that experienced corporate fraud at one of their portfolio firms subsequently chose firms with lower probabilities of fraud and financial misconduct, compared to otherwise similar funds that did not experience any corporate malfeasance incidents. Furthermore, mutual funds that experienced corporate fraud intensify their corporate governance activities and vote significantly more against management at other firms in their portfolios, compared to the voting behavior at the same firms by otherwise similar funds but that did not experience any fraud, especially on issues related to director election, audit, and financial statement. I find that fraud-experienced investors are significantly less likely to vote for problematic directors. Finally, I find that firms held by more fraud-experienced investors observe a significant drop in the propensity to get an accounting fraud sanction in subsequent years. Taken together, my results show that learning and experience play a critical role in corporate governance spillovers, fraud detection, and deterrence.