In recent years, one of the favored responses of legislative reformers and regulatory enforcement authorities to financial fraud and other corporate misconduct has been the encouragement of whistleblowing activity. Both the Sarbanes-Oxley and the Dodd-Frank Act contained elaborate provisions designed to encourage and even to reward whistleblowers. There seems to be no question that the provisions have in fact encouraged whistleblowing. But does all of this whistleblowing activity actually produce any benefits? What difference does all of this whistleblowing activity make?
As discussed in a March 4, 2015 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “The Impact of Whistleblowers on Financial Misrepresentation Enforcement Actions” (here), which in turn described their longer academic paper of the same title (here), four academics have examined the impact of whistleblowing activity on the outcome of regulatory enforcement actions for financial misrepresentation. The four authors are Andrew Call of the Arizona State University School of Accountancy, Gerald Martin of American University Business School, Nathan Sharp of Texas A&M University Accountancy Department, and Jaron Wilde of the University of Iowa Business School.
In order to examine these issues, the authors developed and analyzed a database of 1,133 enforcement actions by the SEC and DoJ from 1978 through 2012 involving allegations of financial misrepresentation. In order to identify whistleblowing activity, the authors obtained information from the Occupational Safety and Health Administration (OSHA), which agency the Sarbanes-Oxley Act tasked with fielding employee complaints of discrimination for blowing the whistle on alleged financial misconduct. The authors identified 934 allegations of financial misconduct in complaints filed with OSHA between 2002 and 2010. The authors also reviewed the enforcement complaints and other related documents to determine if any of the enforcement actions resulted from whistleblowing activity.
Through this process the authors determined that of the 1,133 financial misrepresentation enforcement actions between 1978 and 2012, 145 (or about 12.8%) were associated with at least one whistleblowing complaint.
The authors then developed a set of standards to identify the factors that determine the magnitude of the penalties and sanctions that were imposed in the cases in the database. For example, the factors included such items as the length of the period and magnitude of the financial misrepresentation. Based on this analysis, the authors developed a basis to predict the expected outcome of each case, and then compared this predicted outcome to the actual outcome of the cases in which whistleblowing activity was involved.
Using this approach, the authors identified “an association between whistleblowing involved and outcomes of enforcement actions,” which “suggests whistleblowers have an incremental impact on enforcement outcomes.”
First, the authors concluded that “whistleblowing involvement in an enforcement action is associated with a significant increase in penalties.” The authors concluded that whistleblower involvement increases penalties assessed against forms by an average of $76.96 million and that penalties assessed against employees average $39.29 million more when a whistleblower is involved.
The authors also concluded that in aggregate whistleblowers enabled regulators to obtain judgments (including penalties against both firms and their employees) of $16.86 billion beyond what they would have obtained without whistleblower involvement. The increase in monetary penalties attributable to whistleblower involvement accounts for approximately 56% of the $30.09 billion in penalties assessed against firms and employees with whistleblower involvement and 21% of the $79.46 billion in total penalties assessed in all enforcement actions from 1978 to 2012.
Second, the authors found that employees at targeted firms receive prison sentences that are on average 21.55 months longer than if no whistleblower had been involved.
Third, the authors concluded that these enforcement benefits come at a cost. The authors found that the total duration of an enforcement action increases approximately 10 months (or about 10.9%) with whistleblower involvement, as the involvement of whistleblowers has the effect of prolonging the enforcement process.
The authors also found that the existence of a whistleblower complaint significantly increases the likelihood that a firm will become involved in an enforcement action. Comparing the number of firms named in an enforcement action during the period covered by the enforcement action database to the number of companies listed during that period in the Compustat database, the authors found that the general risk of being involved in an enforcement action was 4.74%. However, when only the companies that were named in a whistleblower reports are considered, and taking into account how many of those companies were involved in an enforcement action, the authors found that the risk of an enforcement action increases to 20.49% — that is, the risk of an enforcement action is 4.78 times greater with a whistleblower complaint.
However, at the same time, the authors found that 520 out of the 654 (79.51%) firms named in at least one whistleblower complaint were not the subject of an enforcement action, “suggesting a large portion of whistleblower complaints either are frivolous, are not sufficiently informative to result in an enforcement action, or slip through the cracks. “ The authors note that the costs associated with these unproductive whistleblower reports likely offset some of the benefits gained through whistleblower involvement in enforcement actions.”
The authors’ extensive database of enforcement actions allowed them to make a number of observations about the enforcement activity during that period. Among other things, the authors concluded that a company executive was named as a respondent in the enforcement actions 84.1% of the time. The CEO is named as a respondent 60.8% of the time, other C-level executives 17.7% of the time, and a non-executive employee is named as a respondent 26.4% of the tie.
The authors also determined that the incidence of enforcement activity varied by industry. The most frequent industries with enforcement actions are Business Equipment (23.0%) of the time, Finance (14.0%), Wholesale, Retail and Services (12.4%), Manufacturing (9.0%) and Healthcare, Medical Equipment and Drugs (8.1%).
Given the disposition that legislators and regulators toward whistleblowing activity, it is reassuring to know that the track record so far seems to suggest that the involvement of a whistleblower seems to produce an improved enforcement outcome.
In addition, given the authors’ conclusion that the involvement of a whistleblower report seem to produce a much greater exposure for the companies named to become involved in an enforcement action, it appears to be the case that in at least some instances the occurrence of whistleblower activity results in the disclosure of at least some financial misconduct that might not otherwise come to light.
However, the authors’ analysis also suggests that the benefits associated with whistleblowing activity come at a cost. The added costs include not only lengthening of the enforcement process when whistleblowers are involved. The costs also include the burdens and expenses associated with the high number of whistleblower reports that do not result in enforcement activity. The authors concluded that fully four out of every five whistleblower reports were not associated with related enforcement activity. These unproductive reports impose costs on regulators and enforcement authorities. There may be no way to measure the aggregate burden associated with these unproductive reports. However, without taking the costs associated with these unproductive reports into account, it may be very hard to reach definitive conclusions whether the incremental benefits associated with the whistleblower activity outweigh the associated burdens. In that same regard, it should also be noted that the unproductive whistleblower reports not only involve burdens and expense for the regulators, they also mean distraction, burden and expense for the companies named in the whistleblower report.
A final question that needs to be asked given the high number of and the indeterminate magnitude of costs associated with unproductive whistleblower reports is whether in the end our social and political predisposition in favor of whistleblowing in fact means that there is less financial fraud. This seems like a question worth asking, because, even if we can’t determine with precision the extent of the burdens associated with the high number of unproductive whistleblower reports, it is clear that our social and political predisposition in favor of whistleblowing comes at a not insignificant cost.
Delaware Legislature Readies to Consider Litigation Reform Bylaw Legislation: As Francis Pileggi discusses in a March 6, 2015 post on his Delaware Corporate and Commercial Litigation Blog (here), the Corporation Law Section of the Delaware State Bar Association has submitted proposed legislation to the Delaware legislature that would limit the ability of corporations to adopt fee-shifting provisions in their charter and bylaws, but also provide additional support for adopting forum selection clauses in those same corporate documents. The proposed legislation can be found here, a memo describing the legislation can be found here, and a document addressing frequently asked questions can be found here.
Pileggi comments that this legislation will be the subject of enormous lobbying on both sides. He adds that “The only certainty about this proposed bill is that it will generate an enormous amount of commentary and discussion. I would not expect a final outcome until the last day of the session on June 30.” He concludes with the comment that “If some legislation is passed that ultimately limits the ability of a corporation to adopt fee-shifting bylaws, an interesting issue will be the impact, if any, that the legislation will have on those companies that already adopted fee-shifting provisions. Generally, there is a prohibition against ex post facto laws.”