Calculating SEC Whistleblower Awards: A Theoretical Approach

On October 23, the Securities and Exchange Commission is scheduled to vote on whether to adopt proposed amendments to the rules governing its whistleblower bounty program.  The most controversial proposed amendments are to Rule 21F-6, which governs the way the SEC calculates the amount of an award. In a recent paper, available here, I analyze the wisdom of the proposed amendments to Rule 21F-6.  My take: They are wise, but incomplete.

Under the Dodd-Frank Act, SEC whistleblowers are entitled to between 10 and 30 percent of the money collected by the SEC in an enforcement action that the whistleblower’s tip helped lead to, if the monetary sanctions imposed exceed $1 million and certain other eligibility requirements are met.  Within the 10-30 percent range, the statute grants the SEC unreviewable discretion to set the award amount.  Rule 21F-6 in turn requires that the SEC, in exercising this discretion, consider certain plus/minus factors to determine the percentage of collections to award within the statutory 10-30 percent range, but the SEC cannot consider the dollar amount the percentage arrived at would actually yield.  So, in deciding that a 25 percent award is appropriate based on the factors laid out in the rule, the SEC is required to ignore that this would yield only $250,000 in a covered action with $1 million in monetary sanctions collected or a whopping $125 million in a covered action with $500 million in monetary sanctions collected.  The proposed amendments to Rule 21F-6 would operate to free the SEC to take account of the dollar size of the award in order to make upward adjustments to very small awards (up to $2 million) and downward adjustments to very large awards (down to $30 million), within the statutory parameters.

These changes provoked controversy when first proposed, with Commissioner Robert Jackson and former Commissioner Kara Stein dissenting.  Do they make sense?  To begin to answer that question requires an understanding of the purpose of whistleblower awards and an evaluation of how well the existing award calculation methodology advances that purpose. In my paper, I provide both.

The departure point for my analysis is the assumption that the whistleblower program is designed to encourage tips by altering the internal cost-benefit calculation a potential whistleblower might be expected to conduct when deciding whether to come forward – but not without qualification.  Encouraging tips is but a means to the end of helping the SEC in its deterrence mission, and not all tips will have this effect; to the contrary, some will impose more costs than benefits on the SEC.  These include the cost of sorting through tips to determine which are worthy of pursuit, the cost of mistakenly pursuing tips that turn out not to be fruitful, as well as the cost of the award payments themselves – money that could be put to other socially valuable use if not paid out to whistleblowers.  To the extent the program encourages individuals to bypass or undermine a company’s internal compliance system (often the most direct and effective way to identify and halt violations), that too produces costs that need to be taken into account.  Depending on the nature and quantity of the tips elicited and the amounts paid out in awards, these costs could outweigh the benefits of the program.

Thus, a more refined statement of the goal of the whistleblower program is to encourage desirable tips (viz., those that create more benefits than costs, and thus push the SEC closer to its goal of optimal deterrence), without simultaneously encouraging the submission of undesirable tips (namely, those that create net costs, and thus undermine the SEC’s deterrence objective).  Tip desirability is a continuum, and where along that continuum tips become more burdensome than helpful to the SEC will be a function, in part, of how efficiently the SEC can sort through tips and identify which are worthy of pursuit.  It will also be a function of both the strength of the suspicion that underlies the tip, as well as the nature of the misconduct the tip relates to.  Tips based on stronger suspicions are more likely to lead to the discovery of wrongdoing rather than innocent conduct, avoiding wasted investigative costs, and tips related to more serious offenses are likely to create greater deterrence payoffs.

A rational whistleblower would tip if the expected award (discounted to reflect its riskiness), plus any other benefits the whistleblower expects to receive by virtue of reporting, exceeds the costs the whistleblower expects to incur by coming forward.  To further the goal of the whistleblower program, then, the award calculation methodology should strive to produce award amounts that, on a discounted expected value basis, exceed the costs potential whistleblowers with desirable but not undesirable tips expect to bear.  Furthermore, even if the SEC could costlessly sort through tips, award amounts should not be set arbitrarily high, because the funds in excess of what is needed to achieve the program’s goals could be redeployed to more socially productive uses.

Expected awards are the product of an award’s probability and its anticipated magnitude.  Award probability is appropriately sensitive to tip desirability under the current rules governing the SEC’s whistleblower program: Awards can only be paid on tips that actually lead the SEC to impose $1 million or more in sanctions, and tips based on relatively stronger suspicions and concerning relatively more serious misconduct are more likely to meet this requirement.  By tying award magnitudes to 10-30 percent of the monetary penalties collected, the percentage method that the SEC currently uses to calculate whistleblower awards also laudably creates differential incentives to report based on tip desirability.  This is because the size of the monetary penalties collected will typically be correlated with the seriousness of the offense, such that, all else being equal, a whistleblower with a relatively more serious tip is more likely to find that the benefits of tipping outweigh the costs.  The factors that Rule 21F-6 requires the SEC to consider in setting the precise percentage within the 10-30 percent range also differentially reward more desirable tips (for example, by making participation in internal compliance systems a plus factor and interference with such systems a minus factor).

But while the current methodology creates differential incentives to report based on tip desirability, it is essentially blind to whistleblowers’ actual costs.  If the penalties imposed in a covered action reflect its deterrence value, then capping whistleblower awards at a fraction of monetary penalties collected ensures that an award will not exceed the deterrence value of the tip. But the percentage method does not ensure that awards will not vastly exceed what is necessary to give whistleblowers an incentive to come forward. Nor does it ensure that awards will not be so high as to encourage undesirable low-probability tips or, conversely, that they will be high enough so as to encourage desirable tips. This will all depend on the actual costs whistleblowers expect to bear by coming forward, which the SEC does not currently take into consideration when setting award amounts.

One could imagine an alternative award calculation methodology keyed to whistleblower costs rather than the penalty imposed. For example, whistleblowers whose tips resulted in an enforcement action imposing at least $1 million in penalties could be guaranteed a set multiple of any costs they incurred from coming forward, with the multiple set to reflect the minimum probability of success the SEC wants the tips elicited to possess in the eyes of whistleblowers, with a kicker to offset risk aversion.  If the SEC wanted to encourage tips with lower probabilities of success if they relate to more severe misconduct, it could apply different multipliers in cases involving different types of allegations (e.g., a higher multiple could be promised to whistleblowers whose tips lead to the discovery of a scienter-based offense). If implemented well, a cost-based method would more reliably encourage reporting than does the percentage method. But it would be administratively more burdensome to apply and, importantly, it would encourage reporting even if the award payout would exceed the deterrence benefits produced by the tip. Just as the percentage method is disconnected from whistleblowing costs, the cost-based method is disconnected from the actual deterrence benefits achieved as a result of the tip.  What is needed is a hybrid approach that takes both the deterrence value of the tip and whistleblower costs into account.

The proposed revisions to Rule 21F-6 move precisely in this direction.  They would allow the SEC, in a subset of cases at least, to consider the dollar amount of an award in order to determine whether the award would be too small, or larger than necessary, to reward the whistleblower and encourage desirable tips in the future, and to adjust the award upward or downward if it so finds (within the statutory bounds).  This would invite the SEC to focus on whistleblower costs, which are essentially ignored under the current methodology, within a percentage framework that is tied (albeit imperfectly) to the deterrence benefit produced by the tip.  Such a hybrid approach is attractive from a theoretical perspective for the reasons outlined above.  It becomes unattractive only if we assume that the SEC will intentionally or inadvertently get the adjustments wrong or will consume so many resources in making the adjustments that the change would produce more costs than benefits.  For reasons that I explain in the paper, I do not think this is a serious concern.

My analysis therefore suggests that the proposed reforms to Rule 21F-6 are wise and should be adopted, but it also suggests two other important reforms that are worthy of consideration.

  • First, the SEC’s whistleblower program would better align whistleblowers’ incentives to tip with the SEC’s deterrence mission if awards were tethered to the value of all penaltiesimposed in the covered action rather than simply to monetary penalties collected.  How much the SEC collects in monetary penalties is, after all, not just a function of the size of the monetary penalty it chooses to impose, it is also a function of the defendant’s ability to pay – even the SEC cannot squeeze blood out of a turnip.  The monetary penalties collected in an enforcement action against an individual, for example, will typically be substantially smaller than the monetary penalties collected in an enforcement action against a public company, because of disparate solvency constraints.  The SEC may impose severe non-monetary penalties on defendants as a supplement to, or substitute for, monetary penalties, such as officer and director bars, referral to the Department of Justice for criminal prosecution, structural reforms, as well as other forms of injunctive relief.  Although the SEC often stresses that non-monetary remedies are critically important to its deterrence mission, non-monetary relief is not properly rewarded in SEC whistleblower awards today.  In my paper, I outline ways that the SEC could remedy this.
  • Second, the SEC should be required to be more transparent about the percentages it is awarding and why.  The SEC almost never makes the percentage it has determined to award public. This opacity is unnecessary and likely increases the risk discount that potential whistleblowers apply to expected awards when deciding whether the benefits of tipping outweigh the costs.

This post comes to us from Professor Amanda Rose at Vanderbilt University Law School. It is based on her recent paper, “Calculating SEC Whistleblower Awards: A Theoretical Approach,” available here.

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