Overinvestment and Corporate Fraud in Efficient Capital Markets

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. Building on the coordination problem faced by dispersed and changing owners of widely-held firms, we present a theory that reconciles corporate fraud and overinvestment in efficient capital markets. Shareholders attempt to design managerial compensation contracts to both elicit valuable information from insiders and to ameliorate their investment coordination problem. However, for a wide range of conditions, the optimal contract induces overstatements by managers, i.e., exaggerated disclosures regarding future investment opportunities, and subsequent overinvestment by rational investors. Our framework 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 link managerial career concerns to the likelihood of overinvestment, compare information precision in internal versus external capital markets, and provide a new perspective on the design of corporate charters.