Social networks and loss of capital

Economic sociologists and white-collar criminologists offer competing predictions about the outcomes of socially embedded transactions. Economic sociologists stress the protective and beneficial role of social networks. Their evidence shows that social ties improve transaction outcomes. White-collar criminologists focus on the harmful and exploitative role of social networks. Their evidence shows that social ties facilitate successful economic crimes. Our case permits a critical test of the protective versus harmful effects of social ties: a business that operated as a legitimate enterprise and also engaged in ongoing financial fraud. This case is strategic because the role of social networks ex post is theoretically ambiguous for a legitimate-fraudulent business. Do social networks lower, raise, or have no effect on the probability of loss of capital, given that an investment has been made? The probability of loss of capital depends on due diligence and type of social tie. Investors who fail to conduct due diligence and do not use social ties have a 79% probability of loss of capital, controlling for other factors. Investors who conduct due diligence (and do not use social ties) have a 49% probability. Investors with preexisting social ties to the principals, sales representatives, or employees of the company (and do not conduct due diligence) have a 39% probability of loss, while those with this type of social tie who also conduct due diligence have a 14% probability. Investors with preexisting social ties to prior investors are not significantly more or less likely to lose their capital. Even in a business that was partly fraudulent, preexisting social ties to the company played a protective and beneficial role. Ironically, fraudulent behavior lowered the probability of loss for investors with this type of social tie: Illegal practices allowed the company to favor friends and acquaintances in the ex post allocation of proceeds. © 2004 Elsevier B.V. All rights reserved.