Introduction
With the passage of the Dodd-Frank Act, incentives have been created for employees or other insiders to report fraud and misconduct directly to the Securities and Exchange Commission (“SEC”). Through research from organizations like the Association of Certified Fraud Examiners (“ACFE”) it is known that tips uncover more fraud than any other detection method. What is unknown is how much fraud goes undetected because those with information choose not to report it. Moreover, there have historically been more disincentives for employees to whistle blow than there were incentives. However, the incentives contained within the Dodd-Frank Act now present financial rewards for those individuals to report their knowledge of securities law violations. As a result, public companies will need to be ready to respond to an increase of claims and tips of fraud and misconduct.
Dodd-Frank Act
On July 21, 2010, President Barrack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”) with the goal of “promoting the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”1 The Act was in response to the recession of the late 2000s where Wall Street firms and large banks were blamed for causing a financial crisis that ultimately led to the loss of over 8 million jobs and government bailouts for much of the financial sector.2
Contained within the Act is a provision that provides for cash rewards to individuals (“whistleblowers”) that provide the SEC or the Commodity Futures Trading Commission (“CFTC”) with information regarding violation of securities laws, which can cover anything from insider trading to fraudulent financial statements like in the case of Enron and WorldCom. This reward can range between 10% and 30% of monetary sanctions collected over $1 million and is intended to encourage whistleblowers to present information of wrongdoing.3
The Sarbanes-Oxley (“SOX”) Act enacted in 2002 contained anti-retaliation provisions for whistleblowers as a response to the major frauds of the time; however, it did not contain any rewards for whistle blowing nor did it provide the ability for reporting directly to a governmental unit.
Fraud Detection
Nearly half of all fraud detected is the result of tips.4 This statistic has remained the same since 2002 and is almost three times greater than any other detection method. Thus, creating avenues and incentives to provide tips is the most likely way fraud will be detected. Other detection methods are listed below5:
Nearly half of all tips received are from employees of victim organizations but other sources of tips can be from outside of the organization.6 Examples include:
It is not surprising that most reported fraud is from employees of victim organizations as employees are insiders of the organization and have the most knowledge of the business. In addition to having the most knowledge, employees also have direct access to business records, and they spend more time working with those records than any external auditor or investigator. Aside from working with records on a daily basis, employees can be the first to recognize red flags or changes in behavior, which may uncover motives of potential perpetrators, such as financial pressure.
Fraud Not Reported
Even though tips far outweigh any other methods of detection, it is difficult to estimate how much fraud is not uncovered due to non-reporting by the very individuals who possess the information to blow the whistle. There are several reasons an employee with critical information might not want to blow the whistle.
In fact, several human behavior experiments have revealed that humans are more likely to follow authority and avoid confrontational situations; circumstances similar to whistle blowing. In 1973 Yale Professor Stanley Milgram published results of several experiments where subjects administered electric shocks to other individuals for incorrect answers as part of a learning study. (Note that no actual shocks were administered in the experiment. The subjects believed they were administering shocks to individuals who were actors imitating being shocked.) Sixty percent of the participants administered lethal shocks of 450 volts, despite voicing their concern or objection in doing so. Milgram noted: “The subjects do not derive satisfaction from inflicting pain, but they often like the feeling they get from pleasing the experimenter.”7 In short, an employee’s desire to please the boss may outweigh his or her motivation to blow the whistle.
The Act should tip the scale on the value placed on the incentives to blow the whistle on potentially fraudulent acts. Historically, even though the protections have been increased for the whistleblower, the value of those protections would not outweigh the costs of such action; examples include 1) the lack of trust by anyone within the organization, 2) difficulty in developing internal colleague networks, 3) being passed over for promotions, or 4) being socially ostracized outside of the work environment particularly in a community where many residents rely upon the Company for their source of income. Without an incentive to report fraud it is easy to see why those who discover fraud may not wish to do so.
Cynthia Cooper, the former Vice President of Internal Audit at WorldCom, who blew the whistle on one of the largest corporate frauds in history, stated in an interview with Time Magazine that most whistleblowers remain for less than a year after blowing the whistle. She only stayed at WorldCom for two years after she reported the fraud because she was waiting for the majority of her staff to find other jobs as she did not feel they would continue to be employed after she left.8
Incentives to Report
For the first time ever, those with information on fraudulent misconduct now have an incentive to disclose that information. Individuals who provide a tip will be compensated for the information they provide. In 2010, the median cost of Financial Statement fraud was $4.1 million.9 An individual who provides a tip on that amount is eligible for an award of over $1.2 million. With that type of incentive, a whistleblower has the financial security to take an early retirement or be comfortably unemployed while searching for another position.
In 1986, legislation was passed that, among other things, changed the way rewards were paid out for tips regarding the False Claims Act. The False Claims Act makes it illegal for a vendor of the U.S. government to submit any claims for payment that would defraud the government and offers rewards for individuals who provide such information. The criterion for payout was amended to provide a payout between 15% and 30% of the government’s recovery. As a result of the legislation change, the tip rate for False Claim Act violations increased 990% over a 10-year period from 1987 through 1996.10
Cost of a Blown Whistle
Public companies need to be aware of these new incentives for individuals to report possible violations as it is highly probable that more tips may be reported. Now that tips can be made directly to the SEC, an organization can be blindsided by an SEC investigation. The monetary and non-monetary costs of these investigations can accumulate quickly and can be exhausting to a company. For example, Goldman Sachs disclosed that it spent more than $700 million in legal fees in 2010 when the SEC sued it for securities fraud.11 The non-monetary loss of productivity and opportunity costs can be even greater.
Perhaps the costliest of all is the damage to corporate reputation when an SEC investigation hits the media. Consumers may avoid products as a brand develops negative connotations or company stock may lose value or, worse, be delisted or bankrupt (e.g., Enron).
While many tipsters may have good intentions in reporting a suspected fraud, financial incentives will also likely bring false claims in those looking for a payout. Companies that are proactive in addressing fraud claims may reduce the costs to address those claims and may even save the embarrassment of a false claim going public. If a serious violation needs to be reported to the SEC, at least a company can be prepared if it has the benefit of investigating prior to the SEC and can fully cooperate with the right information. In addition, most public companies invested heavily in their internal control structure through compliance with SOX Section 404. Keeping tips internal preserves the internal control and reporting structure that was developed to prevent and detect fraud. Overriding of internal controls at any level in an organization should be considered carefully and avoided when possible.
Section 301 of SOX requires all public companies to have a mechanism where employees can confidentially disclose fraudulent acts of the company. It would be advantageous for companies to encourage employees to use the mechanisms already in place rather than to report directly to the SEC. The Dodd-Frank payouts actually contain an additional incentive if the potential violation is first reported directly to a company.12 By encouraging employees to report fraud internally as opposed to the SEC, a company can better position itself to cooperate in correcting a violation or in support of why a tip is not a violation.
Employee training and education can have a profound impact on the encouragement of internal reporting. Training sets the correct tone at the top that management takes these claims seriously and can increase the comfort level of an employee to report directly to the company. If an employee feels like the company will treat a claim the same way as the SEC, there is little incentive to report directly to the SEC.
Conclusion
The costs of a blown whistle may be great; however, it is important to remember that reporting misuse and abuse is positive and productive not only for the organization but to society as a whole. The passage of the Dodd-Frank Act will most likely increase the number of tips that are placed for potential violations within or by companies. It will likely increase the percentage of frauds detected by tips. Organizations that place high emphasis on ethics and quality financial reporting will be well equipped to maintain compliance if any claims of fraud are made. Executives and management in companies that have perpetrated or are considering perpetrating fraud should be on high alert since there is a stronger mechanism to reward those who report them.
