Full text of DOI:10.1016/S1053-5357(00)00061-5

Journal of Socio-Economics 29 (2000) 189–201
Corporate fraud, systematic risk, and
shareholder enrichment
Dale O. Cloninger*, Edward R. Waller
School of Business and Public Administration, University of Houston–Clear Lake, 2700 Bay Area Blvd.,
Houston, TX 77058, USA
Abstract
The impact of the disclosure of alleged illegal corporate activities together with the possible
motives for their use increasingly has become the subject of research by financial scholars. These
studies primarily analyze the disclosure’s effect on the market returns of the firm’s equity. The
consensus of these studies is that the initial disclosure of alleged illegal corporate activities results
in significant negative abnormal returns to the existing shareholders. The size of these abnormal
returns generally exceeds the actual fines, fees and penalties that the firms eventually experience.
The impact of these disclosures on systematic risk and their possible implications for managerial
behavior and corporate policy have suffered from relative neglect. The present research seeks to
establish what, if any, impact the disclosure of alleged corporate fraud has on systematic risk.
Using the data set provided by Karpoff and Lott (1993, The reputational penalty firms bear from
committing corporate fraud. J Law Econ, 34, 757–802), this research tests whether securities
experience any significant beta shifts upon the initial disclosure of alleged corporate fraud.
Empirical tests find evidence consistent with the theory that agents engage in illegal activity in an
attempt to enhance share price. The empirical results also provide additional insight into the
question of why corporations engage in criminal activity. © 2000 Elsevier Science Inc. All rights
reserved.
1
. Introduction
The impact of the disclosure of alleged illegal corporate activities together with the
possible motives for their use has increasingly become the subject of research by financial
*
Corresponding author. Tel.: ϩ1-281-283-3210.
E-mail address: cloninger@cl.uh.edu (D.O. Cloninger).
1
053-5357/00/$ – see front matter © 2000 Elsevier Science Inc. All rights reserved.
PII: S1053-5357(00)00061-5

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scholars. These studies primarily analyze the disclosure’s effect on the market returns of the
firm’s equity. The consensus of these studies is that the initial disclosure of alleged illegal
corporate activities results in significant negative abnormal returns to the existing sharehold-
ers. The size of these abnormal returns generally exceeds the actual fines, fees and penalties
that the firms eventually experience. The impact of these disclosures on systematic risk and
their possible implications for managerial behavior and corporate policy have suffered from
relative neglect. The present research seeks to establish what, if any, impact the disclosure
of alleged corporate fraud has on systematic risk. These results together with existing
research provide useful implications for corporate policy.
2
. Previous research on illegal corporate behavior
Cloninger (1981, 1990) tied the supply of criminal offenses function developed by Becker
(1968) and subsequently tested by Ehrlich (1973) to the abandonment model of Robichek
and Van Horne (1967). Cloninger developed a model that treats the supply of arson as a
function of risk, return and opportunity costs. Previous research on arson sought to identify
correlates of arson without attempting to specify any model. Empirical tests validate Clon-
inger’s model both in the original sample and in the 1990 update incorporating Tobin’s Q.
Subsequently, Cloninger (1982) formulated the generalized hypothesis that agents may resort
to illegal or unethical activity as additional means of enhancing share price. Even though
efforts by agents to reduce risk by unethical means affects total risk, Cloninger has shown
how these same efforts can specifically influence systematic risk. Thus, the rise in systematic
risk upon the disclosure of alleged corporate criminal behavior may be interpreted as
evidence of agents’ desire to enhance share price.
Strahan, Smith, and Beedles (1983), using standard event study methodology, reported
empirical results consistent with the share price enhancement motive, although they made no
effort to attribute any motive to the illegal behavior. They found the presence of excess
negative returns upon the first disclosure of alleged illegal corporate activity. Cloninger
(1985a) further developed the theoretical basis for the use of illegal or unethical activities as
a means of enhancing share price. Empirical support for this position is provided in
Cloninger (1985b) through the case study of Hitachi’s alleged corporate espionage against
IBM. He found that upon the disclosure of the alleged theft of corporate secrets from IBM,
Hitachi’s stock price suffered significant declines while IBM’s stock price experienced
significant gains.
Lean, Ogur, and Rodgers (1985) found evidence that the disclosure of illegal activities by
corporations adversely affects their profitability as measured by accounting returns. Clon-
inger, Skantz, and Strickland (1987) and Skantz, Cloninger, and Strickland (1990) provided
further empirical support for the presence of excess negative (market) returns upon the
disclosure of alleged price fixing. However, Oppenheimer and Stanley (1989) found only
short-lived adverse affects on stockholder returns.
More recently, Karpoff and Lott (1993), in perhaps the most comprehensive study to date,
examined the impact of corporate fraud on market returns of firms accused of fraudulent
activity. Their research indicates that market returns suffer significant negative abnormal

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191
returns upon the disclosure of alleged corporate fraud. The resultant decreases in share prices
average six times the ultimate fines, penalties and legal fees associated with the illegal
activities. Karpoff and Lott concluded that the affected firms suffer significant decreases in
reputational capital. The authors did not attempt to measure the possible impact upon
systematic risk or impute any motive for the fraudulent behavior.
Cloninger (1982, 1995) suggests that firms through their agents may use illegal activity as
another means or enhancing share price by either increasing the returns or reducing the risk of the
firm’s assets. Thus, illegal activity is one way in which agents may attempt to “hedge” legal
activities. Criminal activities like fraud, if successful, can reduce the risk or enhance the returns
of otherwise legal activity while incurring what is perceived as minimal risk of detection. This
hedging hypothesis suggests that agents engage in certain illegal activities as a means of
enhancing the firm’s returns or smoothing its cash flows thereby reducing variability. Cloninger
(1982) argues that less variability in the firm’s cash flows should translate into a lower market
beta. In either case, successful attempts to hedge otherwise legitimate returns or cash flows by
illegal or unethical means will result in enhanced share value
Higher post event betas, vis- a` -vis pre-event betas, could serve as evidence that the firm’s
market risk has increased as a result of the disclosure of alleged fraudulent activities—an outcome
consistent with the hedging hypothesis, that is, the shareholder enrichment motive. Of course,
lower post event returns could also be consistent with the hedging hypothesis. This paper limits
its analysis to the effect of alleged fraudulent activity on the variability of returns. Karpoff and
Lott provide a detailed analysis of the effect of these activities on market returns.
Lower post event betas could serve as evidence that the market anticipates lower risk
associated with the cessation of the firm’s illegal activities. Reichert, Lockett, and Rao
(1996) argue that the latter result serves as evidence that agents employ fraudulent activities
that the market perceives as “speculative” and destabilizing to the firm’s returns. If so,
disclosure and anticipated subsequent cessation of the fraudulent activities should cause the
firm’s beta to fall. However, the authors fail to explain why agents would knowingly engage
in activities that would destabilize the stock’s returns. Such action would be rational only if
the agents expect the illegal activities to increase returns sufficiently to enhance the firm’s
value at the expense of higher risk, or if the agents expect to expropriate any anticipated gains
from the activities. If the agent’s motive were to expropriate any anticipated gains for
themselves the speculative hypothesis would not be at work. Significant abnormal returns in
excess of the fees, fines and penalties upon the disclosure of these activities suggest that the
agents do not extract a significant portion of any possible gains.
Additionally, Reichert, Lockett, and Rao suggest that investors may anticipate subsequent
changes in management personnel, operating policies, and controls that would lead to a
reduction in beta. This result does not, however, imply that the agent’s actions (speculative
or otherwise) are inconsistent with the shareholder enrichment motive (the hedging hypoth-
esis). The subsequent changes in management may simply address what directors perceive
as an agency problem. The changes represent an effort to discourage future illegal activities
by the firm’s agents. Because of the anticipated managerial changes, a decrease in beta upon
the disclosure of illegal activities is not necessarily inconsistent with the hedging hypothe-
sis—the shareholder enrichment motive. Decreases in betas that are the result of corrective
actions taken subsequent to the disclosure are easily reconciled with the shareholder enrichment

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motive. Even if the market perceives illegal practices as speculative, there is nothing inherent in
the nature of these pursuits that is inconsistent with the shareholder enrichment motive.
Against the hedging and speculative hypotheses is the naive argument that corporate crime
is not the result of systematic, deliberate corporate behavior but is, instead, the result of the
random acts of a few unscrupulous agents. In this context, corporate crime may be addressed
by standard agency theory including appropriate screening processes for recruitment, pro-
motion and compensation policies. As a result, firm value will be affected by agency costs
but unaffected (other than by the anticipated fines, fees and penalties) by the initial disclosure
of alleged illegal activities. Cloninger refers to this hypothesis as the Rotten Apple Theory
(RAT). Under this hypothesis, postdisclosure betas may not differ significantly from their
predisclosure counterparts. However, a case could be made that some actions by rogue agents
acting on their own behalf could be of such a nature that they significantly affect the firm’s
systematic risk. Of course, if the rogue agents were acting on the firm’s behalf, their actions
would fall within the stockholder enrichment motive. A finding of no significant postevent
change in beta could be interpreted as consistent with the rotten apple theory or with attempts
by agents to enhance share value by hedging the firm’s returns.
These hypotheses may be complimentary rather than competing thereby explaining different
instances of illegal corporate behavior. Reichert, Lockett, and Rao argue that the issue of which
hypothesis is correct is an empirical one. The authors offer no explanation as to why, in a market
setting, these hypotheses must be mutually exclusive. It is conceivable that the market may
interpret the disclosure of illegal corporate behavior differently depending upon the nature, type
and extent of the disclosed activities. A security’s beta may rise, fall or remain unchanged as a
result of the disclosure of illegal behavior depending upon how the market perceives the
disclosure and how any anticipated subsequent managerial changes will impact the security’s
returns and systematic risk.
Using the data set provided by Karpoff and Lott, the present study tests whether firms accused
of engaging in corporate fraud experience any significant changes in their market betas. One
objective is to rationalize corporate decisions to commit fraud with the shareholder enrichment
motive. Undetected fraud may provide firms with returns in excess of what legal corporate
activity would otherwise dictate. In like manner, the fraud may also reduce the legitimate business
risk of the firm without a commensurate increase in the risk of disclosure. Karpoff and Lott and
others provide evidence of the former. Reichert, Lockett and Rao find similar evidence but fail
to discern any significant changes in systematic risk as a result of the disclosures. The empirical
tests herein address the issue of whether and how the disclosure of alleged corporate fraud
produces a significant impact on the accused firm’s market beta. The results of this research
provide evidence and additional insight into the question of why corporations engage in criminal
activity.
3
. Empirical tests
The sample provided by Karpoff and Lott contained 132 cases of corporate fraud
involving 71 firms. Using standard event study methodology, we duplicated the results of
Karpoff and Lott with respect to returns. Using the same sample of 129 cases in which

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193
complete data were available, we calculated pre- and postdisclosure betas. Because each
allegation of fraud may generate multiple announcement dates, the first announcement date
defines the predisclosure period, and the last announcement date defines the postdisclosure
period. This procedure avoids contaminating the relevant estimation periods. The estimation
periods for the beta calculations are the two 100-day periods ranging from t ϭ Ϫ130 through
t ϭ Ϫ31, where t ϭ 0 is the first announcement date appearing in the Wall Street Journal
(WSJ) and t ϭ ϩ31 through t ϭ ϩ130 where t ϭ 0 is the last announcement date. In each
case the WSJ announcement dates apply to each allegation of fraud as recorded by Karpoff
and Lott. The independent variable is the Center for Research in Security Prices (CRSP)
value-weighted index of market returns. OLS regression tests employing the CRSP equal-
weighted index of market returns produce similar results.
The t-test of sample means (assuming unequal variances) yields a marginally significant
t value of Ϫ1.95. This result could be interpreted, using the criteria suggested by Reichert,
Lockett, and Rao, as consistent with the speculative hypothesis. However, upon closer
inspection, the 129 disclosures included 42 whose betas significantly increased (t ϭ 6.31), 22
whose betas did not change significantly (t ϭ 0.045), and 65 disclosures whose betas
significantly decreased (t Ͻ Ϫ7.93). There appears, therefore, to be a set of disclosures that
is consistent with the hedging hypothesis, a set that is consistent with the rotten apple theory
and a set that is consistent with the speculative hypothesis. Table 1 provides an analysis of
these breakdowns based on the standard error of the entire sample.
Any large sample of means could be partitioned into values that increased, remained the
same and decreased. Statistical tests of differences in means depict the significance of the
average change. Normally this procedure yields an appropriate solution. However, in the
present case the average difference is only marginally significant while both the average
decrease and average increase are highly significant. In this case the average change and its
significance (or lack thereof) is very likely misleading. The full sample beta change disguises
the subsamples results that appear consistent with each of the respective hypotheses. This
result is not unlike a community where half of the residents live at near subsistence while the
other half live in luxury villas. The average household living at a middle income level does
not exist. We interpret the present findings of highly significant but directly opposite changes
in beta as unique to the nature and type of events studied.
Table 2 depicts the results of partitioning the sample into quintiles by the size of the
predisclosure beta. The first quintile (lowest) betas significantly increased from the predis-
closure to the postdisclosure periods (t ϭ 3.86) while quintiles three, four and five signifi-
cantly decreased. The second quintile betas evince no significant change. As the size of the
predisclosure beta increases the ratio of postdisclosure betas to predisclosure betas decreases.
These results could indicate the presence of measurement errors in predisclosure betas that
are resolved over time. The resolution results are also consistent with the disclosure of
alleged fraudulent activities by firms. Information contained in the first announcement of
alleged fraudulent activity, vis- a` -vis time alone, appears to be responsible for the adjustment
in beta.
A second possible explanation for this predisclosure beta effect is that investors may
perceive that the cessation of corporate fraudulent activities will result in less volatile returns
for securities previously identified as high risk (high beta) equities particularly in the

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Table 2
Comparison of predisclosure and postdisclosure betas by size of predisclosure betas
Quintile
Beta
Difference
(t-statistic)
Probability
N
Standard Error
1
Pre-Beta
Post-Beta
0.517
0.858
(3.80)*
0.0898
26
26
26
26
25
0.3411
Ϫ0.0042
Ϫ0.1888
Ϫ0.2779
Ϫ0.6733
0.000826
0.955926
0.026826
0.025326
0.000725
2
3
4
5
Pre-Beta
Post-Beta
0.940
0.936
(Ϫ0.06)
0.0742
†
Pre-Beta
Post-Beta
1.240
1.051
(Ϫ2.36)
0.0800
†
Pre-Beta
Post-Beta
1.518
1.240
(Ϫ2.38)
0.1168
Pre-Beta
Post-Beta
2.357
1.684
(Ϫ3.89)*
0.1730
*
Significant at the 1% level.
Significant at the 5% level.
†
presence of anticipated changes in management personnel, policies and controls. This
interpretation is consistent with Clarkson and Thompson (1990), who found that the release
of additional information on securities that possess little information reduces the uncertainty
about the exact parameters of the return distributions thereby resulting in beta decreases. On
the other hand, investors may perceive that securities enjoying highly stable returns (low
betas) may have achieved that stability through the use of certain types of corporate fraud.
If so, investors could reasonably anticipate an increase in the firm’s systematic risk (beta)
upon the cessation of the fraudulent activities. In these cases, any anticipated change in
management may be perceived as destabilizing.
Third, if investors perceive that certain unscrupulous agents are the cause of the alleged
instances of corporate fraud, then the equity value would be affected only to the extent of the
agency costs and any anticipated fines, fees, and penalties associated with the illegal
activities. In such case, no significant difference between post- and predisclosure betas would
be expected. unless, of course, the actions of the rogue agents were so perverse that there
were destablizing to the firm’s market returns.
Using paired t tests, partitioning the sample into quintiles by the relative size of the
average prediction error, the dollar value of the market equity, and the dollar size of the
residuals yields no consistent or systematic significant differences between pre- and
postevent betas. Further, partitioning by type of fraud (defined by Karpoff and Lott as
government, stakeholder, regulatory, and financial) also fails to produce any significant
differences between pre- and postdisclosure betas. (See Karpoff and Lott for detailed
definitions of each fraud type.)
To determine whether announcements of allegations of fraud affect market betas inde-
pendently of predisclosure beta size, we estimate the regressions suggested by the valuation

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197
results of Reichert, Lockett, and Rao (1996). The dependent variable is the natural logarithm
of the ratio of postdisclosure beta to predisclosure beta. Dummy variables that assume a
value of 1 for various fraud types and 0 otherwise are included as explanatory variables.
PREBETA is the ordinary least squares (OLS) estimate of the firm’s beta for a 100 day
period consisting of day t 130 through day t 31 relative to the first WSJ announcement of
fraud. The hedging hypothesis suggests PREBETA should be negative. To test whether
effects are greater for smaller firms, the market value of the firm, LOGEQUITY, is included
and is the log of the market value of equity two days preceding the first report of fraud. The
market value is calculated as the product of the stock price on day t ϭ Ϫ2 relative to the first
WSJ announcement of fraud and the number of outstanding shares. To test whether similar
effects exist for firms with smaller excess returns, the average stock return forecast error,
RETURN, for the two-day interval consisting of the day the first report of fraud appears and
the immediately preceding day is specified as a variable. The financial intermediation
literature suggests the reputational penalties of lower values and higher market betas imposed
on financial firms may be greater than the penalties imposed on nonfinancial firms (Allen and
Santomero, 1997). To test whether effects are greater for financial firms, FINCFIRM is
included as a variable and assumes a value of 1 if the announcing firm is a financial firm and
0
otherwise.
We included qualitative variables in the regression specifications to test whether fraud
announcements affected market betas independently of other factors, particularly size of
predisclosure beta. GOVFRAUD assumes a value of 1 for those events consisting of
government procurement fraud or government program fraud and 0 otherwise. REGFRAUD
assumes a value of 1 for those corporate activities that violate federal or state laws, but may
not be material to stakeholders, and 0 otherwise. FINFRAUD assumes a value of 1 when
there are fraudulent misrepresentations in financial statements and 0 otherwise. STKFRAUD
assumes a value of 1 when actions are taken by agents of the corporation to defraud
customers, employees, suppliers, or franchises and 0 otherwise.
The regression results identify four variables with statistically significant coefficients that
are not identified by the paired t tests—GOVFRAUD, REGFRAUD, FINFRAUD, and
STKFRAUD. GOVFRAUD, REGFRAUD, and STKFRAUD are positive and significant at
the 1% level (Table 3), suggesting beta changes are larger for these announcements relative
to announcements of financial reporting fraud. Similarly, the FINFRAUD coefficient is
negative and significant at the 1% level suggesting beta changes are relatively smaller than
those for frauds of government, stakeholders, and regulators. The coefficients for
LOGEQUITY, RETURN, and FINCFIRM are not statistically significant at the usual
confidence levels. The results are robust in numerous tests using various combinations of the
explanatory variables. Table 3 provides a summary analysis of the regression results.
Three findings emanate from the statistical analysis. First, there appears to be three distinct
types of disclosures: those in which betas significantly increase, those where betas signifi-
cantly decrease and those where betas do not change significantly. Second, the size of the
predisclosure beta appears to determine the direction and magnitude of the change in beta.
Third, the fraud type influences the direction and magnitude of the beta shift with financial
fraud more likely to be associated with post disclosure decreases in beta.
These empirical results suggest that there are only two viable hypotheses regarding the

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Table 3
Cross-sectional regressions to measure the effect on changes in beta of prior beta levels, firm size, excess
returns, firm type, and fraud type
Equation 1
Variable
Equation 2
Variable
Coefficient
Coefficient
PREBETA
Ϫ0.4579
PREBETA
Ϫ0.4613
(Ϫ4.94)*
0.0041
(
Ϫ4.83)*
0.0018
0.04)
Ϫ1.1518
Ϫ1.17)
0.1277
0.87)
0.5854
2.61)*
0.5479
2.60)*
0.64451
2.68)*
Ϫ0.1619
Ϫ0.49)
LOGEQUITY
RETURN
LOGEQUITY
RETURN
(
(0.11)
Ϫ1.1663
(Ϫ1.21)
0.1265
(1.02)
Ϫ0.5749
(Ϫ2.87)*
(
FINCFIRM
GOVFRAUD
STKFRAUD
REGFRAUD
INTERCEPT
FINCFIRM
FINFRAUD
(
(
(
(
INTERCEPT
0.4041
(1.29)
(
R2
F
0.2457
(5.58)*
R2
F
0.2433
(7.85)*
*
Significant at the 1% level.
Results of ordinary least squares regressions (OLS) where the logarithm of the postdisclosure/predisclosure
beta ratio is the dependent variable for a sample of 129 announcements of fraud. The independent variables are
defined as follows: PREBETA is the ordinary least squares (OLS) estimate of the firm ´ı s beta for a 100-day period
consisting of day t 130 through day t 31 relative to the first Wall Street Journal announcement of fraud. RETURN
is the average stock return forecast error for the two-day interval consisting of the day the first report of fraud
appears and the immediately preceding day. LOGEQUITY is the log of the market value of equity two days
preceding the first report of fraud. GOVFRAUD assumes a value of 1 for those events consisting of government
procurement fraud or government program fraud and 0 otherwise. REGFRAUD assumes a value of 1 for those
corporate activities that violate federal or state laws, but may not be material to stakeholders, and 0 otherwise.
FINFRAUD assumes a value of 1 when there are fraudulent misrepresentations in financial statements and 0
otherwise. STKFRAUD assumes a value of 1 when actions are taken by agents of the corporation to defraud
customers, employees, suppliers, or franchises and 0 otherwise. FINCFIRM assumes a value of 1 if the
announcing firm is a financial firm and 0 otherwise.
possible motive for corporate fraud: the hedging hypothesis and the rotten apple theory and
that both of these hypotheses may be simultaneously at work in the market. The rotten apple
theory is a clear example of agency problems extensively addressed in the literature. The
speculative hypothesis can be interpreted as a special case of the hedging hypothesis where
agents attempt to hedge the firm’s returns at the expense of its risk.
An argument could be made that the distinctions among the various theories of errant
behavior are not particularly useful because, regardless of its cause, the behavior taints the
firm’s reputation thereby inducing wealth losses on the part of shareholders. The distinctions
among the theories are important because of the implication the possible motives have for
future behavior. If illegal acts are random occurrences, the implications for future policy are
one thing while if the acts are the result of systematic practices and policies, the implications

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199
are quite different. Ascribing motives for errant corporate behavior is important because their
knowledge can lead to changes that lessen the likelihood of future occurrences.
4
. The hedging story
In those disclosures in which an agency problem is not an issue, the market discovers a
history of alleged corporate fraudulent activities. Presuming that the disclosure of these
activities reduces the likelihood of and the extent to which the firm will be able to pursue
these activities in the future (in addition to any associated fines, fees and penalties), the
market reacts by lowering the equity value resulting in a downward adjustment in the
security’s return or a change in its systematic risk. For those securities whose predisclosure
betas are the lowest, the market increases their systematic risk upon the disclosure. As a
result of the increase in beta, the required return is higher and consistent with the decreased
share price. On the other hand, for those securities whose predisclosure betas are the greatest,
the market decreases their systematic risk. In the absence of any fines, fees, and penalties and
concomitant reputational costs, the lower beta would translate into lower required returns and
smaller (even positive) changes in market value.
The regression tests also indicate that the market discriminates between disclosures of
financial and nonfinancial firms. In cases where the disclosures involve securities possessing
low predisclosure betas, market reactions increase the beta in line with the significant
reduction in share price. The likelihood of this result increases if the securities involved are
financial and involve regulatory fraud. In cases where the disclosures involve securities
possessing high predisclosure betas, market reactions significantly lower systematic risk and
hence the required return. In the absence of anticipated fines, fees, penalties and reputational
losses, share price could even rise. The likelihood of the latter result increases if the securities
involved are nonfinancial. In either case, the change in equity value reflects the reduced
anticipated earnings caused by the cessation of illegal activities and any associated fines, fees
and penalties. In sum, the downward adjustment in the value of the securities results in an
upward adjustment in the systematic risk of previously low beta stocks and a significant
downward adjustment in the betas of previously high beta stocks.
The securities that experiences significant increases in beta and concomitant decreases in
share price clearly are consistent with the hedging hypothesis. These disclosures suggest that
the low pre-event betas enjoyed by this group were, in part, the result of the predisclosed
fraudulent activities. Any subsequent changes in management personnel, operating policies
and controls would thereby be perceived as destabilizing, vis- a` -vis, predisclosure returns. On
the other hand, the market reacts in a manner to reduce previously high beta values because
of the perception that the anticipated changes in management personnel, policies and controls
will be stabilizing. In sum, investors interpret any anticipated managerial changes and the
cessation of the fraudulent activities as destabilizing for previously low beta stocks and
stabilizing for previously high beta stocks. Both of these ex post events can be reconciled
with the ex ante stockholder enrichment motive leading to the conclusion that decreases in
beta do not conclusively support the speculative hypothesis (as a mutually exclusive theory)
nor do they necessarily refute the hedging hypothesis.

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5
. Summary
This article attempts to determine the effect of the disclosure of alleged corporate fraud on
a security’s systematic risk. Analysis of 129 cases of alleged corporate fraud yield three
distinct outcomes: 42 cases where beta significantly increases after the disclosure, 22 cases
where beta does not significantly change and 65 cases where beta significantly decreases.
Further analysis indicates that the size of the predisclosure beta, the amount of the abnormal
return, the market value of the equity and the type of firm significantly affect the difference
between post- and predisclosure betas. In those cases where beta increases (an outcome
predicted by the hedging hypothesis) the more likely it is that the residuals are significantly
negative, the market value smaller, the predisclosure beta lower and that the firm is a
financial institution. In those cases where beta decreases, the more likely it is that the
residuals are insignificantly negative, the market value of the firm greater, the pre-event beta
higher and that the firm is a nonfinancial corporation.
Because changes in beta vary inversely with the size of pre-event betas, significant
increases and decreases in beta can be reconciled with the hedging hypothesis. The high
pre-event betas fall in anticipation of corrective managerial changes and low pre-event betas
rise because the market perceives the anticipated managerial changes and the attendant loss
of hedging opportunities as destabilizing. Additionally, the perception by the market of
illegal activities as speculative does not preclude the presence of the shareholder enrichment
motive.
6
. Implications for corporate policy
Significant negative abnormal returns and significant increases in systematic risk coinci-
dent with the disclosure of illegal corporate behavior are unambiguously consistent with the
shareholder enrichment motive. Because a decrease in systematic risk is coincident with high
predisclosure betas, this result can be reconciled with the shareholder enrichment motive or
The Hedging Hypothesis. Insignificant changes in returns or systematic risk are evidence
consistent with an agency problem or RAT. Corporate policy has a long and continuing
relationship with agency theory. The conventional wisdom with regard to illegal or unethical
corporate behavior has naively treated all such behavior as an agency problem. There is,
however, an alternative hypothesis, the theory that some agents pursue the goal of share price
maximization through a variety of means, including illegal and unethical acts. If this
alternative hypothesis is correct, then the goal of share price enhancement should be
respecified.
Adequate specification of the moral and legal constraints within which the goal of share
price enhancement exists should counter the incentive for agents to resort to illegal behavior.
However, Cloninger (1995) argues that in the presence of asymmetric information and in
accordance with chaos theory, the mere specifying of constraints is insufficient. Because
asymmetric information provides agents with the opportunity to engage in illegal activities
and the share price maximization goal provides the motive, Cloninger argues that the goal of
share price maximization should be replaced with the goal of maximization of stakeholder

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201
value. In this context, any policy or practice that benefits one group of stakeholders at the
expense of another without due compensation violates the goal with which agents have been
charged. Chaos theory holds, in part, that the pursuit of a goal is the major motivating force
behind agent behavior. Goals that are consistent with ethical standards are more likely to
result in managerial behavior consistent with those standards.
Acknowledgments
We would like to express our appreciation to Professor Jonathan M. Karpoff, University
of Washington and Professor John R. Lott, Jr., University of Chicago Law School for sharing
their data set and providing numerous useful comments and suggestions on earlier drafts. We
assume full responsibility for any remaining errors or omissions.
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