Forensic finance

Abstract

Work in forensic finance typically shares some common elements: There is some rule that sets a standard for competitive behavior or fiduciary responsibility, which provides a benchmark for what findings might matter. There is good detailed data on the price, quantity, and timing of transactions, which is sometimes available from nonconventional sources like regulatory agencies, court proceedings, or datasets kept by businesses that are not primarily for academic research. And those doing the research possess a strong background understanding of how specific financial institutions or mechanisms work in a particular market. Finally, researchers have to consider whether an empirical pattern has an innocuous explanation, or whether it represents a situation in which a small group of financial market insiders is benefiting at the expense of the broader investing public. Many referees and editors - perhaps steeped in a mindset in which agency problems are mitigated by reputation effects, or perhaps out of a sheer naïveté common among academics - have proven loath to accept interpretations of the data that are not innocuous. Sometimes, however, statistical analysis uncovers patterns that do not have innocuous explanations. Unfortunately the slow process of publishing in academic journals means that regulators may react to a problem before the relevant study has had a chance to wind its way through the refereeing process. In this article, in the first three cases - late trading by mutual funds, the backdating of employee stock options, and the allocation of hot shares in initial public offerings to corporate executives - scores if not hundreds of individual participants were aware of unethical or illegal practices that went on for years. The fourth case, of changes in the dataset of equity analyst recommendations, appears to be the consequence of sloppiness by a data vendor rather than a deliberate attempt to remove embarrassing recommendations. Inquiries from academics, publicized by the financial press, led the data vendor to correct its errors and institute procedures to reduce the likelihood of similar errors occurring in the future. For the questions of potential interest to forensic finance, there is likely to be a useful interaction between academics, the financial press, regulators, and policymakers. Financial journalists can play an important role in bringing patterns of behavior to the attention of policymakers. Financial journalists, however, are not usually well-equipped to undertake careful empirical documentation and test alternative hypotheses. Academic researchers have generally not been the first to uncover controversial activities caused by agency problems, but academic researchers have frequently been able to provide large-sample evidence that sheds light on whether a problem is relegated to a few isolated instances or is more widespread. Regulators were slow to react to some long-standing industry practices that changed as soon as they were publicized. But the U.S. regulatory framework for the financial services industry does offer a variety of regulators: federal government regulators, like the Securities and Exchange Commission; self-regulatory industry agencies such as the Financial Industry Regulatory Authority, which is the merged successor to the earlier self-regulatory bodies for the New York Stock Exchange and the National Association of Securities Dealers; and state regulators. Sometimes critics tout the virtues of having a single regulator, like the one-stop Financial Services Authority in the United Kingdom. But competition between regulators does seem to result in some actions being taken that otherwise might not occur. Sometimes the cooperation between these groups is explicit, like in the Wall Street Journal's investigation of stock option backdating, where financial journalists worked jointly with academic researchers, or when academics serve as consultants to legal or regulatory proceedings. In other cases, forensic finance efforts will proceed along separate but parallel and reinforcing tracks. For academics, this collaboration with the media has its advantages and disadvantages. One advantage is that interacting with financial journalists in some cases has brought more attention than would otherwise be the case if journalists were restricted to examining isolated instances or if the academic research was conducted in isolation. On the other hand, unlike medical research, which imposes an embargo on publicizing research findings to nonspecialists until an article is published in a peer-reviewed journal, the academic economics and finance profession has no such protocol. There is a danger that academic researchers will attempt to publicize preliminary results that nonspecialists are not well-equipped to evaluate with appropriate skepticism. At this point, however, I am hard-pressed to think of an example in which financial economists have had an impact on corporate policy or regulators on the basis of preliminary research findings that were later severely questioned. Instead, the bigger problem for financial economics is the production of many papers that are of interest to only a handful of academic specialists.