Do we
admire fraudsters? I know you want to answer negatively, but there is a great
deal of admiration of the clever fraudster expressed in popular culture, as
seen in novels and in movies such as Ocean’s Eleven. Much of the admiration has
to do with how clever and innovative fraudsters are, unlike most of us. From an
outsider’s point of view, it is almost as if someone with a known history of
deception in business and private life could get sufficient votes to win an
election to a public office.
An important
premise of the admiration is that fraud and innovation are found in the same
people and the same firms. So, maybe those who fraudulently get money are the
ones who will use it most innovatively? Whether that is true is the topic of
research by Yanbo Wang, Toby Stuart, and Jizhen Li recently published in Administrative Science Quarterly. Their idea was simple and powerful. One of
the main ways that firms do fraud is by misstating their financial statements.
For example, a fraudster might report huge losses and no wealth to the tax
authorities and tell everyone else that he is a billionaire. The benefit of the
fraud is to get something valuable – paying less taxes while getting trust and
resources from others.
Wang,
Stuart, and Li were able to find data proving that such fraud took place
because they could compare Chinese firms’ regular financial statements with
those they reported when applying for innovation grants. Obviously, reporting
success can help a firm get innovation grants, even if the report is false. After
all, when the state grants innovation funds it acts like an angel investor or a
venture capital firm – it chases success.
For those of
you who value honesty, I should start with the authors’ finding that half the
firms were honest. How you react to this finding depends on what you thought
was true, of course, but it can be either relief or disappointment.
What follows is worse. Fraud pays. Exaggerating success helped firms get money, so the final pool of firms getting innovation grants was less honest than the initial pool of applicants. Also, fraud leads to waste. Honest firms winning grants increased their hiring overall, including R&D hiring, whereas fraudulent firms winning grants only increased non-R&D hiring. It is unclear what exactly the fraudulent firms were using their innovation grants for, but it clearly was not pursuit of innovation. Logically, they would succeed in innovating only if they were smarter than the honest firms to begin with. Were they?
What
follows is even worse. Fraud produces smoke and mirrors only. Honest firms
winning grants produced more innovations that they patented, whereas fraudulent
firms winning grants did not. However, the fraudulent firms excelled at
producing utility patents, which is a form of patent that establishes legal
claim over a non-innovative feature of a product. Utility patents can be ways
of claiming progress when there is none, but they can also be a way to get the
legal means to become a patent troll.
Clearly
this is one type of fraud that did nothing good for society and in fact
produced significant waste of resources. And why should we expect otherwise?
The brilliant (and good-looking) fraudsters in Ocean’s Eleven are fiction, and
the fun of fiction often lies in that it is very different from reality.
People
still have illusions that invite fraud, because success looks so wonderful that
even those who should have better judgment often do not stop to ask whether
what they are seeing is true. For example, in retrospect it seems strange that
the bold claims of innovative blood testing by Theranos could seem true. They
were still able to recruit a stellar board of directors including people like Riley
Bechtel of the famous Bechtel Corporation, William Foege, who had been with the
CDC (yes, the people trying to save the U.S. from Covid-19), Fabrizio Bonanni
who had been with the biotech firm Amgen, and James Mattis, Marine Corps
general. Of course, it ended well for James Mattis, who was awarded for his
good judgment in Theranos by being picked as President Trump’s Secretary of
Defense.
Fraudsters win
because others are naïve and optimistic. They win especially easily when lack
of transparency enables fraudsters to tell different things to different
people. So when we know that information is being concealed, we should pay even
closer attention.
