Dodd-Frank’s Missed Opportunity on Whistleblower Law

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One of the highest-profile provisions of the Dodd-Frank Act is Section 922. That provision provides protection and monetary awards for whistleblowers. To qualify, the whistleblower must provide information to the Securities and Exchange Commission that leads to the recovery of monetary sanctions. While many have argued that this provision does not go far enough in providing incentives for whistleblowers, the reality is that it goes too far. By providing protection and compensation for whistleblowers without imposing any costs, Section 922 attracts both low- and high-quality tips without providing the SEC with any means of differentiating the two. This will lead to an increase in the amount of tips received. But it will also lead to a decrease in the average quality of those tips. Because the SEC is resource constrained, this is likely to lead to less effective enforcement and ultimately to a reduction in fraud deterrence.

While it may seem counterintuitive that an increased whistleblower reward would lead to more fraud, the outcome is demonstrated in our new article, Noise Reduction: The Screening Value of Qui Tam. In that article, we compare Section 922 with the qui tam provisions of the False Claims Act to show that an optimal whistleblowing provision will include a cost imposition on the whistleblower.

Indeed, an effective whistleblower mechanism will be one that best deters fraud. But to do this, the mechanism needs to produce high-quality information that is not otherwise lost in the noise of low-quality information. Because whistleblower provisions are specifically targeted at uncovering hidden information, problems of asymmetric information make this a challenge. The recipient of the tip does not have the information necessary to verify its accuracy without a costly investigation. To remedy this, there needs to be a method of screening. While the value of screening has been recognized in other contexts of asymmetric information, it has been overlooked in the analysis and design of whistleblower provisions.

In our article, we present a model demonstrating how a qui tam provision – where the whistleblower brings suit on behalf of the government – achieves this goal. The private cost commitment required for the qui tam plaintiff to pursue the case creates a separating equilibrium that leads to fewer but better (in terms of accuracy) whistleblowers coming forward.

Unfortunately, Section 922 of the Dodd-Frank Act contains no qui tam mechanism. Nor does it contain any other cost-imposition mechanism. Thus, by creating an agency-controlled system rather than a court-centric private-plaintiff system, the Act fails to provide an effective screening mechanism. As a result, Section 922 is likely to be counterproductive. A more effective provision would align the level of imposed costs relative to the level of available awards to achieve the appropriate level of information screening.

The full article can be found here.

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