In 2011, the Securities and Exchange Commission (SEC) introduced a Whistleblower (WB) program as part of the Dodd-Frank Act to protect investors through greater deterrence of securities law violations and more effective enforcement. The program offers financial incentives to provide original information that leads to a successful enforcement action. SEC officials have called the program a “game changer,” improving their ability to detect illegal conduct and speed investigations with fewer resources.[1] Since the program’s introduction, the SEC has received over 18,000 tips, with the highest number coming in three categories: corporate disclosures and financials (financial reporting fraud); Ponzi schemes and offering frauds; and violations of the Foreign Corrupt Practices Act. With the number of tips increasing every year – the agency received 4,218 in 2016 alone – the effectiveness of the program depends on the SEC’s ability to effectively process this high volume of information. In recent years, there have been reports of companies trying to circumvent the new rules by using confidentiality and other employment agreements to prevent whistleblowers from providing information to the SEC.
Despite challenges, new research provides evidence that the SEC WB rules have been effective. One study examines corporate lobbying and investors’ responses to events leading up to the enactment of the WB Program to compare competing arguments about the program’s likely success.[2] Proponents of the rules argued that the WB program would improve shareholder protection by allowing the SEC to leverage its limited resources through partnerships with insiders with critical knowledge of corporate misconduct, thereby providing benefits to investors. Companies lobbying against the rules argued that the internal reporting and compliance systems they had put in place under the Sarbanes-Oxley Act (SOX) would be undermined, impeding their ability to promptly investigate and correct internal wrong-doing. Inconsistent with these latter claims, the paper finds that lobbying companies had significantly weaker internal compliance systems than those of non-lobbying companies, with reduced emphasis on employee reporting and with less independence in the channels of reporting. This study also examines stock returns around event dates between 2009 and 2011 leading up to the introduction of the program. In reported results, cumulative stock returns to U.S. companies were significantly positive relative to Canadian and global benchmarks, suggesting that investors expected net benefits for U.S. companies from the proposed WB Program.
In a current study, we consider the deterrent role of the new WB Program and focus specifically on the impact on aggressive financial reporting.[3] We use two measures for aggressive financial reporting. The first estimates the normal level of accruals like accounts receivable for a company to identify unusual patterns of reporting.[4] Greater “abnormal” values represent more aggressive reporting and can be either income-increasing (such as premature recognition of revenue) or decreasing (such as overstatement of expenses to create “cookie jar” reserves). Examining a large sample of publicly traded U.S. companies over the period 2006 to 2014, we find that abnormal accruals are significantly lower in the years following the introduction of the SEC WB Program than the years prior, with an overall reduction of approximately 11 percent. Our second measure estimates the probability of financial reporting fraud.[5] Using this measure we also document a significant reduction in the probability of fraud following the introduction of the new rules.
We include several additional tests to ensure that our findings are attributable to the WB Program and not other simultaneous changes during out sample period. In one test we compare changes in reporting for our general population of companies with companies in the health care sector. As health care companies were already subject to similar whistleblower provisions under the False Claims Act (FCA), they are less likely to be affected by the introduction of the SEC program. Consistent with our expectations, abnormal accruals do not decline significantly for these companies. We also conduct a difference-in-differences test to measure reductions in aggressive reporting by U.S. companies relative to Canadian companies, and find that reductions in aggressive reporting are significantly greater for U.S. companies. As a final approach, we consider whether reductions in aggressive reporting vary by the strength of the company’s internal compliance and reporting programs. By exploiting cross-sectional differences in changes that relate specifically to our context, we can gain confidence that our results relate to the SEC Program. Using a sample of 224 companies with ratings of internal reporting program quality just prior to the introduction of the SEC WB Program, we find that reductions in aggressive reporting are greater for companies with poorer internal reporting programs. These findings suggest that the benefits to the new WB Program are most prevalent for companies with weaker systems of employee reporting of fraud.
As one mechanism for improving financial reporting is improved internal controls, we also consider changes in those controls around the introduction of the new rules. We find that the reporting of internal control weaknesses decreased significantly in the years following the introduction of the SEC WB Program for both Section 302 and 404 SOX disclosures. We also consider whether companies improve their internal compliance and reporting programs. If employees at companies with weak compliance programs have greater incentives to report externally, we expect those companies to strengthen internal programs in the hopes of encouraging potential whistleblowers to report internally first, allowing the companies to deal quickly with issues. Using specific Section 302 disclosures that relate to internal and compliance programs, including ethics hotlines, we find that weaknesses decrease significantly following the SEC rules.
These findings provide evidence of significant benefits of the SEC WB Program and underscore the role that whistleblowers can play in the detection and deterrence of fraud. While companies argue that regulations are costly and onerous, this research reinforces the argument that these regulations help the SEC leverage limited resources and encourage companies to improve their financial reporting and strengthen internal controls.
ENDNOTES
[1] A. Ceresney, Speech, “The SEC’s Whistleblower Program: The Successful Early Years”, September 14, 2016. Retrieved from: https://www.sec.gov/news/speech/ceresney-sec-whistleblower-program.html.
[2] Baloria, V., C. Marquardt, and C. Wiedman. 2017. A lobbying approach to evaluating the whistleblower provisions of the Dodd-Frank Reform Act of 2010. Contemporary Accounting Research 34 (3): 1305-1339.
[3] Wiedman, C. and C. Zhu. 2017. Do the SEC Whistleblower Provision of Dodd Frank Deter Aggressive Financial Reporting? Working Paper, November 2017. Available for download at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3105521.
[4] The model describes changes in accruals in terms of past, current and future operating cash flows, changes in revenue, and levels of property plant and equipment. See McNichols, M. F. 2002. Discussion of “The quality of accruals and earnings: The role of accrual estimation errors.” The Accounting Review 77: 61-69.
[5] Beneish, D. M., C. M. C. Lee and C. D. Nichols. 2013. Earnings manipulation and expected returns. Financial Analysts Journal 69 (2): 57-82.
This post comes to us from Professor Christine I. Wiedman at the University of Waterloo and Chunmei Zhu, a PhD candidate at the university. It is based on their recent paper, “Do the SEC Whistleblower Provisions of Dodd Frank Deter Aggressive Financial Reporting?,” available here.