Rule Violation and Time-to-Enforcement in Weak Institutional Environments: A Good Faith Perspective

Abstract

Previous studies on corporate misconduct have focused mainly on preventing misconduct or remedying it after detection, but it remains unclear how misconduct can be effectively detected in the first place once it occurs. We apply the good faith perspective in the context of China, which represents a weak institutional environment, and argue that the ability of culpable leaders to conceal information may delay misconduct disclosure because such ability helps maintain the good faith of regulators. Moreover, we argue that because the regulators have faith in professionals (external auditors, institutional investors, and securities analysts) whose skills are in fact often underdeveloped in detecting misconduct in weak institutional environments, the impact of managerial concealment on disclosure delay becomes stronger when fraudulent firms are followed by such professionals. Using a sample of Chinese public firms involved in financial misconduct, we find support for these arguments—that is, compartmentalization in governance positions, which enhances culpable leaders’ ability to conceal misconduct, delays public disclosure by regulators. Furthermore, the relationship becomes stronger when the misconduct goes undetected by credible professionals.