Tuesday, June 9, 2020

Are Fraudsters Innovative? Real-life Ocean’s Eleven

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.