by Philip G. Berger and Heemin Lee 

From left to right: Philip G. Berger and Heemin Lee

In 2011, the U.S. Securities and Exchange Commission (SEC) implemented the Dodd-Frank whistleblower program (Section 922 of Dodd-Frank added new Section 21F, entitled “Securities Whistleblower Incentives and Protection” to the Securities Exchange Act of 1934). It provides financial rewards to whistleblowers who provide high-quality tips on securities law violations that lead to successful SEC and other agency enforcement actions. Anyone with information concerning a potential securities law violation can submit tips to the SEC. Whistleblowers are eligible for monetary rewards of 10% to 30% of the cash collection from successful enforcement actions with monetary sanctions exceeding $1 million. Since the inception of the program, the SEC has awarded more than $1.3 billion in 328 awards to individuals.[1]

Although whistleblowers make a tremendous contribution to the agency’s ability to detect securities law violations, little is known about the effectiveness of the Dodd-Frank whistleblower provision in ‘deterring’ accounting fraud, which is the ultimate goal for regulators. Managers of firms will be less inclined to engage in fraud if they are concerned about a whistleblower reporting their misconduct to the regulator under the Dodd-Frank law. Even managers not involved in fraud may be concerned, because they are unaware of all ongoing fraud that potential whistleblowers know about. Once frauds are detected by the SEC, it is very costly for the firm to settle or pay penalties. The concerned managers thus likely tighten internal controls to detect ongoing fraud and correct it before whistleblowers move first. Taken together, faced with enhanced risk of whistleblowing under the Dodd-Frank whistleblowing provision, it is plausible that managers will take action in a way that reduces the likelihood of accounting fraud (i.e., deterrence effect).

It Is Challenging to Test the Deterrence Effect

Despite its importance and regulatory implications, testing the deterrence effect of the Dodd-Frank whistleblower provision empirically is challenging. The provision is a part of Dodd-Frank, so it applied to all public U.S. firms at almost the same time. It is thus hard to find an appropriate control group and isolate the deterrence effect from other concurrent events. In our study “Did the Dodd-Frank Whistleblower Provision Deter Accounting Fraud?,” we address this empirical challenge by using the passage of False Claims Acts (FCAs) by some U.S. state governments in the years preceding the passage of Dodd-Frank as a research design setting.

The False Claims Act and State Pension Funds

The federal FCA is the oldest U.S. whistleblower law. Any entity knowingly submitting a fraudulent claim to the government or defrauding the government violates the law. Under the federal FCA, fraud against shareholders was not considered a matter of public concern because securities fraud does not directly harm the federal government. State governments, however, view financial fraud differently, as they invest in publicly traded companies via state retirement or pension funds. Thus, financial fraud involving the state pension funds is potentially a subject of false claims against the state government (Rapp 2007).

States have adopted their own versions of FCAs modeled after the federal FCA at staggered times since 1987 and the coverage of fraud also vary across states. As of 2010, 17 states and the District of Columbia had FCAs that cover frauds including financial fraud (general FCAs) whereas 11 states had FCAs that protect against only Medicaid fraud (Medicaid FCAs). The remaining 22 states had not yet adopted FCAs.

The Dodd-Frank Whistleblower Provision Reduced the Probability of Fraud by 12% to 22%

When the Dodd-Frank whistleblower law went into effect in 2011, some states had their own FCA in place, under which accounting or financial fraud in firms invested in by the state’s pension fund(s) can be interpreted as defrauding the state government if their FCAs include a general qui tam provision (i.e., general FCA). We predict that, faced with the increased risk of whistleblowing, managers of firms not previously exposed to a state FCA have stronger incentives to avoid accounting misstatements and improve financial reporting quality when they get exposed to the Dodd-Frank whistleblower law in 2011. In addition, because both the Department of Justice and the SEC place a premium on a firm’s self-disclosure of problems, managers would want to uncover existing problems before whistleblowers report and regulators investigate. Hence, the Dodd-Frank whistleblower provisions can create incentives for companies to detect and correct fraud and prevent the development of new fraud. As a result, we predict the probability of accounting fraud will decrease. We measure the underlying probability of fraud by using a proxy of the probability of accounting manipulation: the F-score (Dechow et al. 2011).

We find the probability of fraud, as measured by the F-score, decreases by 12% to 22%, depending on the model we use, when firms not owned by general FCA state pension funds become subject to Dodd-Frank relative to firms that were exposed to state FCAs previously. These findings are consistent with exposure to Dodd-Frank’s whistleblower provision having a strong deterrence effect. Dyck et al. (2021) produce two rough estimates helpful for putting our finding into context: (1) an average of 11.2% of large, publicly-traded U.S. firms are engaged in fraud and (2) the annual expected cost of fraud is 1.7% of equity market capitalization. The Dodd-Frank whistleblowing risk reduces the likelihood of fraud by 17% (the mid-point of our 12% to 22% range). Combining this figure with the Dyck et al. estimates implies that frauds are avoided by 1.9% of large, publicly-traded firms and that these prevented frauds reduce the annual expected cost of fraud by 0.29% of equity market capitalization.

We also evaluate whether the state FCAs have a deterrence effect. We find the probability of fraud decreases by 11.5% after firms become exposed to general state FCAs. Interestingly, we find that the deterrence effect of state FCAs increases in the strength of whistleblowers’ monetary incentives.

Although our research does not assess the potential costs of whistleblowing provisions, our results are consistent with whistleblower regulation with a bounty model motivating managers to prevent and avoid fraud, and we provide reasonable causal quantification of this effect. Our paper thus informs the debate over the effectiveness of whistleblowing provisions in preventing fraud.

Footnote

[1] https://www.sec.gov/files/2022_ow_ar.pdf

References

Dechow, P. M., W. Ge, C. R. Larson, and R. G. Sloan. 2011. Predicting Material Accounting Misstatements. Contemporary Accounting Research 28 (1): 17–82.

Dyck, A., A. Morse, and L. Zingales. 2021. How Pervasive Is Corporate Fraud? Working paper.

Rapp, G. C. 2007. Beyond Protection: Invigorating Incentives for Sarbanes-Oxley Corporate and Securities Fraud Whistleblowers. Boston University Law Review 87: 92–156.

Philip G. Berger is Wallman Family Professor of Accounting at the University of Chicago Booth School of Business. Heemin Lee is an Assistant Professor of Accounting at Baruch College, City University of New York.

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