The Ripple Effect: How Punishing Corporate Fraudsters Affects Their Peers

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 research1 conducted by 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.


By Fang Ying

“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.

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-status2 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.


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References

  1. Daphne W. Yiu, Yuehua Xu and William P. Wan, “The Deterrence Effects of Vicarious Punishments on Corporate Financial Fraud,” Organization Science, 2014.

  2. According to the study, a firm’s status in the industry is defined in term of market share. For example, a firm is considered to belong to the higher-status group if its market share is above or equal to the industry median and to belong to the lower-status group otherwise.

Got any comments, insights or questions? Post them here to further discuss the topic:

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11 COMMENTS

Ran AN
8/17/2016 8:21:40 PM
I like this study since it sheds light on the "market-wide" effect of regulation and enforcement. More broadly, it also provides good justification of mandatory reporting regulations in the sense of "externality" of such regulations. Here, we see that punishment on financial reporting frauds has some positive "externalities". However, thinking it in another way, is it possible that such punishment will also force observing firms to turn to more subtle fraudulent behaviors?
XU Jiayan
12/21/2015 11:34:48 AM
This article reminds me of the incident of melamine in milk powder in Mainland China. The food and the drug safety problems in China caused significant social and government concerns in recent years.
XU Jiayan
12/21/2015 11:30:36 AM
Yes. I admit that the punishment of the famous company or big fish will set a significant signal to other firms in similar status. While I think that the more effective way to prohibit such behavior is still to improve the legal system.
Megan
11/27/2015 11:50:10 PM
I found this study quite interesting. Instead of investigating the influence of punishment on the focal firm's following behaviour, it studies how the punishment is likely to influence other observers' behaviours. As we all know, it is obvious that we are less likely to conduct a certain practice when others who are similar to us get punished from the same practice. Interestingly, firms "behave" in similar ways.
Tao
11/27/2015 2:32:22 PM
The social learning of the punishment is the basic assumption for the effectiveness of law. The authors test this on the target of Chinese firms. It would be interesting to see when this ripple effect would not occur or become less effectiveness. Also, if the negative punishment has the ripple effect, when would this effect also occur when the learning content is positive. For example, whether rewarding the good companies could encourage other companies to behave well.
IrisZR
11/27/2015 11:24:01 AM
Since The Great Charter, English people succeeded in limiting royal power. Either the King or the government should never be above the law. I guess this is the fundamental way to eliminate corruption.
IrisZR
11/27/2015 11:23:48 AM
Though punishing corporate fraudsters affects their peers, I don’t think it’s the most efficient way to curb fraud. Respect and protect property rights has been proved to be the best choice according to western experience.
IrisZR
11/27/2015 11:23:33 AM
What are the relationships among the government, the corporation involved with fraud, and the media? What’s the intention of the government to punish the corporation fraud? I guess the incentive behind the government will significantly affect the ripple effect in peer companies and also in the media coverage afterwards.
IrisZR
11/27/2015 11:23:17 AM
Do different types of punishments affect the strength of the ripple effect in the research?
IrisZR
11/27/2015 11:23:00 AM
Will the results on ripple effect in the research be affected by the background of the company? Say, state-owned-enterprises receive less punishment compared to private enterprises.
IrisZR
11/27/2015 11:22:32 AM
Ripple effect exists in human society. It’s similar to Herd Effect to some degree. We care about peers. We learn from our peers. Moreover, we keep adjusting our behaviors using our peers as benchmarks.
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