Do Corporate Whistleblower Laws Deter Accounting Fraud?

Whistleblowers play a significant role in detecting corporate fraud. For example, recent high-profile financial frauds such as the Enron scandal and Bernard Madoff’s Ponzi scheme were brought to light by whistleblowers. To encourage more whistleblowers to come forward, the Securities and Exchange Commission (SEC) implemented in 2011 the Dodd-Frank whistleblower program, which provides enhanced protection and financial rewards to whistleblowers. According to the program’s 2016 annual report, the SEC received over 4,200 tips for the fiscal year 2016 and has awarded more than $111 million to 34 whistleblowers since the inception of this program.[1] In a recent paper, I examine whether a whistleblower-assisted increase in detection can help deter fraud in a broader group of firms. Studying the ex ante deterrence effect of whistleblowing threats, instead of an ex post effect of actual whistleblowing allegations, can inform the policy debate over the effectiveness of whistleblower regulation.

My paper uses U.S. firms’ exposure to state and federal whistleblower regulations as a measure of an increased threat of whistleblowing and examines whether the exposure reduces the likelihood of accounting fraud in these firms. I calculate fraud likelihood by using fraud prediction models developed in accounting literature that use inputs such as unusually high accruals, inflated sales, overstated inventory, and other conditions that are often associated with accounting manipulation.[2]

First, firms become subject to whistleblowing under a state False Claims Act (FCA) when their shares are owned by a state pension fund based in a state with an FCA. When such a firm commits fraud, whistleblowers can report the fraud to the state government that sponsors the pension fund and claim a financial reward.[3]

My research looks at 24 state pension funds in 16 states during a sample period of 2001-2010. State pension funds disclose their public equity holdings in SEC Form 13-F filings. After merging 13-F data with COMPUSTAT, I identify firms that were subject to state FCAs because their shares were owned by at least one state pension fund based in a state with an FCA. I find that being subject to state FCAs reduces fraud likelihood by 7 percent. It takes two to three years on average for firms to respond to the increased threat of whistleblowing and the lowered probability of fraud remains relatively stable afterward.

I also find that after firms are exposed to state FCAs, the amount they are charged for audits decreases by 5 percent.  Auditors tend to charge firms with weak internal controls high audit fees to compensate for the extra time and effort of an audit and the increased risk of being sued. Therefore, auditor fees should account for the lowered risk of fraud after the FCA exposure.

Second, I also examine the federal-level Dodd-Frank whistleblower program. One of the key features of the program is its bounty provision. Whistleblowers are eligible for monetary rewards of 10 to 30 percent of any cash collected if the information an individual provides leads to a successful enforcement action and monetary penalties exceeding $1 million.

I find that introduction of the Dodd-Frank whistleblower program in 2011 was followed by marked decreases in the fraud probability and audit fees for firms that were not previously covered by state FCAs. These firms had never before been subject to a whistleblower law with a bounty program. Although Sarbanes-Oxley is the first federal statute with a whistleblower provision covering financial fraud, it does not provide for bounties to whistleblowers. The mere anti-retaliation provision of SOX might not be enough to encourage employee whistleblowers to risk their careers.[4]

My paper provides evidence that financial incentives strengthen whistleblower regulations. My findings suggest that bounty programs can effectively lower managers’ incentives to misreport financial results. The findings also highlight the integral role of whistleblowers in promoting transparency and suggest that whistleblower provisions help improve the efficiency of financial markets.

ENDNOTES

[1] https://www.sec.gov/files/owb-annual-report-2016.pdf

[2] Beneish, M. D. 1999. The Detection of Earnings Manipulation. Financial Analysts Journal 55 (5): 24–36.; Dechow,   P. M., W. Ge, C. R. Larson, and R. G. Sloan. 2011. Predicting Material Accounting Misstatements. Contemporary Accounting Research 28 (1): 17–82.

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

[4] Rapp, G. C. 2012. States of Pay: Emerging Trends in State Whistleblower Bounty Schemes. South Texas Law Review 54 (53–79)

This post comes to us from Professor Heemin Lee at Baruch College of the City University of New York. It is based on her recent paper, “Does the Threat of Whistleblowing Reduce Accounting Fraud?,” available here.

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