Mitigating industry contagion effects from financial reporting fraud: A competitive dynamics perspective of non-errant rival firms exploiting product-market opportunities

Abstract

Existing studies show that financial reporting frauds by errant firms cause declines in stock market valuations for non-errant rival firms (i.e. industry contagion effects). We posit that contagion effects may be mitigated by investors’ expectations of non-errant rivals exploiting product-market opportunities at the expense of errant firms. We apply the competitive dynamics literature to argue that non-errant rivals experience lower contagion effects when they have more available slack to engage in competitive actions. This effect is expected to strengthen when rival firms have previously deployed more resources for research and development and advertising investments or have higher prior market share growth to demonstrate effective deployments of available resources. These arguments are supported for contagion effects from reports of U.S. Securities and Exchange Commission investigations from 2001 to 2004. We contribute to research and practice by going beyond discussions on corporate governance to evaluations of key competitive attributes that investors assess when reacting to such frauds.