[Reprinted from Perspectives Fall 2011]
What happens when the government offers employees of U.S. companies a substantial monetary award for uncovering and reporting corporate wrongdoing in their firms? Will such an incentive protect investors by encouraging employees to blow the whistle earlier and louder on potential fraud? Or is it more likely to result in a flood of meritless tips by disgruntled or financially motivated workers? Will it force companies to beef up their own compliance programs and employee ethics training to encourage internal reporting? Or could it create a race between employees to beat a path to the Securities and Exchange Commission to report wrongdoing?
We’re about to find out.
Earlier this year, the whistleblower provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act went into effect. The legislation authorizes the SEC to provide financial awards to eligible individuals who provide original information that leads to an enforcement action in which more than $1 million in sanctions is ordered.
Some call it an award; others call it a bounty. Most everyone calls it a challenge-a challenge for companies, compliance officers, and the SEC. And the next year or two will tell the tale of just who is up to that challenge.
Bringing in the Big Guns
As vice president of Enron Corporation, Sherron Watkins may well be one of the country’s most famous whistleblowers. In August 2001, she alerted then-CEO Ken Lay to accounting irregularities within thecompany, warning him that Enron “might implode in a wave of accounting scandals,” a statement that proved prescient. That scandal, along with others, led Congress in 2002 to pass the Sarbanes-Oxley Act, which set new standards for all U.S. public company boards, management, and public accounting firms. It also provided whistleblowers with heightened protection from retaliation.
Less than a decade later, legislators felt even more needed to be done to encourage reporting, and so the monetaryawards were approved by the SEC as part of Dodd-Frank. The idea is that incentivizing employees will lead to fraudbeing uncovered earlier, which will protect investors, preserve the integrity of the U.S. markets, and hold wrongdoers accountable.
“People wondered if there would have been far less damage at Enron if Sherron Watkins had stepped up earlier,” says Steven Pearlman, an attorney at Seyfarth Shaw in Chicago and a 1994 ILLINOIS graduate. “So it wasn’t surprising that legislative protection was developed to prohibit retaliation, which SOX did. But Dodd-Frank is far different. It’s not about curtailing retaliation; it’s about providing carrots.”
And they’re some pretty big carrots. The range for payments is between 10 percent and 30 percent of any sanctions collected, which means whistleblowers could receive anywhere from $100,000 on the low end to millions on the highend.
That money will come from the sanctions or from the $450 million Investor Protection Fund. Some believe the incentives will actually save the government money because the tips will provide direction for SEC attorneys andinvestigators, creating efficiencies in bringing action against companies and individuals who have violated securities laws.
Growing Fraud,Growing Bounty
If there is potential for fraud to be uncovered earlier and investors to be protected, then why are many in thecorporate community concerned about this provision of Dodd-Frank? There are several reasons.
“SOX required very robust certifications and internal compliance infrastructures to be developed,” says Pearlman. “Corporations put millions of dollars into their programs, and now employees don’t even have to use them.” That’s because Dodd-Frank allows for employees to go to the SEC first, instead of reporting directly to the company.
“There are risks when employees bypass the internal reporting channels,”says Pearlman, who created a national whistleblower practice within his firm to counsel companies. “Shareholders are better protected when a prompt andthorough internal investigation is done. The longer a fraud can grow, the more evidence can get lost and the more damage can be done. The new structure through Dodd-Frank creates a perverse incentive for fraud to grow because the bigger the fraud, the bigger the bounty.”
In response to such concerns, the SEC’s procedures provide higher awards for employees who do use the internalreporting channels. In addition, if a whistleblower goes to their company first and then the company reports directly to the SEC, the employee is credited for all the information the company reports.
There is also the concern that the prospect of an award will create a flood of employee “tips,” many meritless, that could hamstring the SEC.
“With so much money to be gained, I think without question you will see adramatic uptick in complaints to the SEC,” Pearlman predicts. “The SEC is equipped to deal with this at present, but there is a risk that they could become bogged down with unmerited complaints.” Others worry that just the sheer volume could lead to a lesseffective system.
But some argue just the opposite-that is, that higher quantity could lead to higher quality. Though the SEC hasn’t yet released any hard numbers on complaint volume, SEC Enforcement Chief Robert Khuzami told The Wall Street Journal earlier this year that the monetary incentives hadn’t prompted the flood of tips some had argued would overwhelm the agency. The article also quotes Stephen Cohen, SEC enforcement director, who told The Wall Street Journal that the agency is now more likely to receive tips on conduct “that quite candidly, we really wouldn’thave had any capacity to discover without a whistleblower coming forward.”
A NewBreed of Whistleblower?
How much of an incentive will the SEC’s bounties be for whistleblowers? Pearlman is not alone in believing thesheer size of a potential award will be a motivating factor for many. But others aren’t so sure.
“Our research indicates that whistleblowers are more morally driven,” says Ruth Aguilera, associate professor ofbusiness administration and a fellow at the Center for Professional Responsibility in Business and Society at ILLINOIS.
Mohammed Ahmed, a senior manager at Deloitte Financial Advisory Services LLP and the co-author of a whitepaper on the potential impact of the whistleblower provisions of Dodd-Frank, agrees. “Past experience demonstrates that many whistleblowers are incentivized by their moral compass.” However, he states that a financial incentive could appeal to a different breed of employee who might never have considered whistleblowing previously.
“Many employees truly want to do the right thing and would be likely to report internally if that is the culture the organization has created,” Ahmed says. “Organizations cannot control how whistleblowers choose to report, but they can create an environment that fosters an ethical culture of behavior.”
Abhijeet Vadera earned his Ph.D. in business administration from ILLINOIS and collaborated with Aguilera on whistleblower research, which, he says, “shows on average that observers of wrongdoing blow the whistle because they are morally outraged not because of any cost-benefit analysis.” However, because his research did not account for financial incentives of the size and scope proposed by Dodd-Frank, Vadera adds that it’s possible such awards may play a different role in motivating potential whistleblowers.
“I personally believe that this legislation may have a huge negative impact because potential whistleblowers may now wait for crimes to reach a significant level before blowing the whistle so that they get more ‘bounty’ out of it. This delay may have significant detrimental consequences for the organization and our society. The financialincentive may lead to more tips, but these tips will come at a price.”
Has the Dodd-Frank legislation gone too far?
“Whistleblowers should be treated as an asset,” says Steven Pearlman, an attorney and ILLINOIS graduate who heads the whistleblower practice at Seyfarth Shaw.”They should be encouraged to come forward, and they should know they will be protected.But the current legislation is way too lopsided in my opinion.”
And many, including U.S.Representative Michael Grimm, agree with him. In July,Grimm introduced the Whistleblower Improvement Act to address several concerns that corporations and the lawyers who represent them have about the way Dodd-Frank tips the scales toward direct reporting to the Securities and Exchange Commission.
Specifically, the bill would require employees who seek the SEC’s monetary award to first report their information to their employer and then to the SEC, addressing the concern that the current legislation could undermine internal compliance programs.There are exceptions,however. For instance, if an employer does not have an internal compliance system that allows for anonymous reporting or a policy that prohibits retaliation, then internal reporting would not be a precondition for themonetary award.
Other changes include: