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Employee Whistle-blowers as an Effective Mechanism to Uncover Fraud

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One of the more predictable discoveries in Anton Valukas’ report on Lehman was the fate of the lone employee whistleblower and the reaction of the audit firm to the whistleblower’s allegations. Much ink has been spilt on improving the regulatory framework to avoid another Lehman (See for example TED). Improving the incentives for employee whistleblowers to come forward is an important regulatory imperative that has not received the attention that it deserves. All whistleblowers, not just employees, play a key role in uncovering fraud in corporations. The bulk of this post is derived from the excellent work done in this regard by Dyck, Morse and Zingales(henceforth DMZ) and Bowen, Call and Rajgopal.

Compared to other whistleblowers, employees have the best access to the information required to uncover fraud. They also possess the knowledge to analyse and parse the information for any signs of fraud. This is especially important in a field such as banking where outsiders rarely possess the knowledge to uncover fraud even when they possess the raw information – a key reason why the media is so ineffective in uncovering banking fraud compared to its role in other industries which DMZ highlight.

One might ask why auditors are so ineffective in uncovering fraud despite possessing the relevant information. One reason is the aforementioned lack of knowledge required to uncover fraud in complex situations. But a more crucial reason is that auditors are incentivised to ignore fraud. In DMZ’s words: “we find a clear cost for auditors who blow the whistle. The auditor of a company involved with fraud is more likely to lose the client if he blows the whistle than if he does not, while there is no significant evidence that bringing the fraud to light pays him off in terms of a greater number of accounts.”

So what prevents more employee whistleblowers from coming forward? As DMZ note, many whistleblowers prefer to remain anonymous because : “In spite of being selected cases (for which the expected benefit of revealing should exceed the expected cost), we find that in 82 percent of cases, the whistleblower was fired, quit under duress, or had significantly altered responsibilities. In addition, many employee whistleblowers report having to move to another industry and often to another town to escape personal harassment. The lawyer of James Bingham, a whistleblower in the Xerox case, sums up Jim’s situation as: “Jim had a great career, but he’ll never get a job in Corporate America again.”….. consequences to being the whistleblower include distancing and retaliation from fellow workers and friends, personal attacks on one’s character during the course of a protracted dispute, and the need to change one’s career. Not only is the honest behavior not rewarded by the market, but it is penalized.” i.e. employers prefer loyal employees to honest ones, just as they prefer loyal auditors to honest auditors.

Sarbanes-Oxley contained many provisions aimed at protecting whistleblowers. Quoting from Bowen, Call and Rajgopal: “In response to Enron, WorldCom and other scandals, Congress passed the Sarbanes-Oxley Act (SOX) in July 2002, which in part made it unlawful for companies to take negative action against employees who disclose “questionable accounting or auditing matters.” (See SOX section 806, codified as title 15 U.S.C., § 78f(m)(4).) Under the whistleblower provisions of SOX, employees who disclose improper financial practices receive greater protection from discrimination. (See title 18 U.S.C., § 1514A(a)(1).) SOX also ruled that every company quoted on a U.S. Stock Exchange must set up a hotline enabling whistle-blowers to report anonymously (Economist 2006).” DMZ offer many possible explanations for why these provisions have not succeeded: “One possible explanation is that rules which strengthen the protection of the whistleblowers’ current jobs offer only a small reward relative to the extensive ostracism whistleblowers face. Additionally, just because jobs are protected does not mean that career advancements in the firm are not impacted by whistle blowing. Another explanation could be that job protection is of no use if the firm goes bankrupt after the revelation of fraud.”

So what else can be done to encourage employees to come forward? Unsurprisingly, DMZ find that monetary incentives have a role to play and I agree. Employee whistleblowers play a more significant role in industries such as healthcare where Qui tam” suits are available. I would assert that monetary incentives have an even stronger role to play in uncovering fraud in banking. The extremely high lifetime pay expected in the course of a banking career combined with the almost certainly career-ending implications of becoming a whistleblower means that any employee will think twice before pulling the trigger. Moreover, the extremely specialised nature of the industry means that many senior bankers have very few alternative industries to move to.

The focus of SOX on making it harder to fire whistleblowers is misguided as well as ineffective. The focus must be not to keep whistleblowers from losing their jobs but to compensate them sufficiently so that they never have to work again. As it happens, the scale of fraud in financial institutions means that this may even be achieved without spending taxpayer money. The whistleblower may be allowed to claim a small percentage of the monetary value of the fraud prevented from the institution itself, which should be more than sufficient for the purpose.

The obvious objection to my proposal is that this will lead to a surge in frivolous claims from disgruntled employees. For one, the monetary reward is dependent on fraud being proven in a court of law and the likely career-ending nature of becoming a whistleblower should be enough to prevent any frivolous allegations. Indeed, DMZ find that the percentage of frivolous lawsuits is lower in the healthcare industry where “qui tam” suits are available.

As DMZ point out, “the idea of extending the qui tam statue to corporate frauds (i.e. providing a financial award to those who bring forward information about a corporate fraud) is very much in the Hayekian spirit of sharpening the incentives of those who are endowed with information.” This is even more crucial in uncovering fraud in a complex industry such as banking where even qualified outsiders may struggle to put the pieces together and informed insiders face such steep deterrents that prevent them from rocking the boat.

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Written by Ashwin Parameswaran

March 17th, 2010 at 5:13 pm

Posted in Financial Crisis

5 Responses to 'Employee Whistle-blowers as an Effective Mechanism to Uncover Fraud'

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  1. The TARP Act expressly provides for qui tam liability. Any whistleblower who is interested in turning in a TARP-relief holder for fraud is heartily encouraged to contact me.

    Michael F. Martin

    24 Mar 10 at 9:06 pm

  2. Michael – Thanks for that. My point was to argue for a “qui tam”-like incentive that extends beyond just those actions that constitute fraud against the government and extend also to those actions that are fraudulent against the organisation itself i.e. equityholders and creditors. Such an incentive could be paid out by the organisation itself.

    But I’m no lawyer and this is just a speculative idea. What I am certain about is that most financial frauds can only be caught by insiders. Even the most informed regulator is unlikely to catch fraud in some of the more complex banking functions.

    admin

    28 Mar 10 at 4:44 am

  3. [...] of his suggestions for a better financial systems include paying off whistleblowers in order to uncover [...]

  4. I am lower level management for Multi Billion Dollar Retail Mortgage Platform- National Player, Ranked in TOP 10 lenders in USA, and I have documentation reflecting fraud with HUD/FHA, illegal joint ventures, fraudlant government audit responses, Multiple levels of senior management / executives within working the system…. I would blow whistle however i would be terminated so fast- and the odds of same industry moving forward would be impossible i presume (without references…)

    Facts, loan level data, documentation to support, executive fraud, illegal government activities re: HMDA, 60% of all files have TILA violations, etc.

    Sales getting caught for fraud at processing level, management covering it up/ making it go away, loan officer still employed…etc.

    just venting- my point- blowing the whistle isnt worth the trouble it brings as you exhale into the whistle

    AnonymouslyME

    19 Mar 11 at 8:18 am

  5. [...] is a career-ending if not a job-ending move. I strongly agree. Over at Macroeconomic Resilience Ashwin Parameswaran says, Compared to other whistleblowers, employees have the best access to the information required to [...]

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