This article was originally published in ChicagoBoothReview
High-profile financial frauds in recent years spurred state and federal authorities to implement or strengthen “whistle-blower” incentives, which offer tipsters financial rewards (and a shield from employer retaliation) for blowing the lid on corporate fraud.
These initiatives can help deter fraud, according to research by CUNY-Baruch College’s Heemin Lee.
Lee examined two classes of companies. One was made up of those subject to state-level False Claims Act (FCA) rules that have a qui tam provision, which allows a private citizen to file a lawsuit on behalf of the government and obtain a portion of any money recovered. The other was composed of companies that are subject to the Securities and Exchange Commission (SEC) whistle-blower program—implemented in 2011 as a part of the Dodd-Frank Act—which allows individuals to provide tips directly to the SEC and offers enhanced protection from retaliation and financial rewards if the information leads to successful enforcement actions. (Lee did not consider effects of the Sarbanes-Oxley Act of 2002 because the act does not provide financial bounties to whistle-blowers.)
Here, data suggest that exposure to the threat of whistle-blowing under state FCAs reduces a company’s probability of accounting fraud by 7 percent. The SEC whistle-blower program reduced the probability of fraud by a similar amount, Lee reports. (To gauge the effectiveness of federal programs, she analyzed companies—during a sample period of 2008–14—that had not been subject to state-level FCAs but were subsequently exposed to the SEC’s whistle-blower program.)
To determine the change in probability of accounting fraud, Lee used two prediction models that identify unusually high accruals, inflated sales, overstated inventory, and other conditions often associated with fraud.
The deterrent effect could have been noted by audit firms: their fees tended to fall by 5 percent after clients were exposed to state FCAs, Lee finds. When there’s a lower probability of fraud, there’s also reduced potential auditor liability.
Lee constructed her first sample using US public-equity holdings of state pension funds in jurisdictions that had enacted an FCA with a qui tam provision. Whistle-blowers in those states could obtain financial rewards by reporting financial fraud of any company, regardless of its location, whose shares were owned by the state’s pension fund. Lee then used within-company variations in state-pension-fund ownership as well as variations in state FCAs, such as the year of passage and the scope of coverage, to identify companies that were subject to whistle-blowing laws to some degree.
The second sample consisted of companies subject to the SEC whistle-blower program. Here, Lee’s control group consisted of companies that were previously exposed to state FCA provisions. Companies that had not previously been exposed to state FCAs tended to have a more marked response to the new federal whistle-blower provision.