The Deterrent Effect of Whistleblowing on Insider Trading

One of the many significant reforms enacted in The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 was the creation of a whistleblower bounty program within the SEC. The program increased monetary rewards for whistleblowing and provided protections from retaliation with the goal of encouraging more whistleblowers to report their information to the SEC. While there is a growing literature investigating the effects of many facets of Dodd-Frank, an unanswered question is whether the whistleblower program affected illegal insider trading – an activity that is traditionally hard for the SEC to detect and prosecute. In my recent paper, I answer this question by examining the effectiveness of the program in reducing informed trading by corporate insiders.

Prior research has shown that whistleblowers are effective at detecting and deterring financial fraud that involves the falsification of documents and many potential participants. Insider trading, though, is often an individual activity that doesn’t necessarily leave behind paper trails. It may therefore be difficult for potential whistleblowers to gather the necessary evidence to bring a claim to the SEC.

In the research for my paper, I identify firms that are more sensitive to the whistleblowing program and examine the change in the profitability of their insider purchases. If insiders are more concerned about a whistleblower reporting their illegal behavior following the implementation of the Dodd-Frank whistleblowing law, I should observe a decrease in sensitive insiders’ trading profits in the post-Dodd-Frank period, because decreased trading profits likely indicate less information-based trading. I identify sensitive insiders in three ways. My primary identification defines sensitive insiders as those in firms that lobbied against the Dodd-Frank whistleblower program, as firms that lobbied against the law were likely doing so to preserve their own private benefits. As a secondary measure, I identify sensitive insiders based on the strength of their firm’s internal whistleblower program, with insiders at firms with weak internal systems being identified as more sensitive. Finally, since the previous two measures rely on firm-level decisions, I use a third market-based measure to identify sensitive insiders. Specifically, I measure the market reaction around the passage date of the Dodd-Frank whistleblower program and identify insiders at firms with a positive market reaction as being sensitive to the law. A positive market reaction indicates that market participants may think the firm would benefit from the additional regulatory oversight provided by the whistleblower program.

I gather data from Thomson Reuters’ Insider Filing database, COMPUSTAT, and CRSP. My final sample consists of 19,999 insider purchases made by top corporate executives over the period 2007-2014.

My results show a significant and economically meaningful reduction in sensitive insiders’ trading profits after the implementation of the Dodd-Frank whistleblower program. For the sample of insiders at firms that lobbied against the whistleblower provisions of the act, I find that the profitability of insider purchases is significantly reduced (in the range of 0.05 percent to 0.10 percent daily return) in the post-Dodd-Frank period relative to non-sensitive insiders. I find similar results when using both the strength of the firm’s internal whistleblower program and the market reaction around the passage date of the Dodd-Frank whistleblower program to identify sensitive insiders. Together, these results support the idea that sensitive insiders are making less information-driven purchases following Dodd-Frank, which would be consistent with them changing their behavior in response to the increased likelihood of being caught by a whistleblower.

I also look at event-specific settings where insider purchases and sales are likely to be information-driven and examine whether there is a reduction in informed insider trading around these events after Dodd-Frank. Specifically, I look at insider trading before earnings announcements and M&A announcements. I find evidence that, after the implementation of the whistleblower program, insiders are less likely to sell before events with negative market reactions and less likely to buy before events with positive market reactions. These results suggest that insiders are trading less opportunistically in the post-Dodd-Frank period, which also provides evidence in favor of the effectiveness of the whistleblower program in deterring illegal insider trading.

My paper provides further evidence of the effectiveness of the Dodd-Frank whistleblower program. My results suggest that the program has been successful at deterring illegal insider trading by corporate insiders, an activity that the SEC has historically struggled to prevent. This paper should be of interest to researchers and regulators who are searching for deterrent mechanisms to prevent illegal insider trading.

This paper comes to us from Professor Jacob Raleigh at Monash University. It is based on his recent paper, “The Deterrent Effect of Whistleblowing on Insider Trading,” available here.

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