The Impact of Whistleblowers on Financial Misrepresentation Enforcement Actions

The following post comes to us from Andrew Call of the School of Accountancy at Arizona State University, Gerald Martin of the Department of Finance and Real Estate at American University, Nathan Sharp of the Department of Accounting at Texas A&M University, and Jaron Wilde of the Department of Accounting at the University of Iowa.

In our paper, The Impact of Whistleblowers on Financial Misrepresentation Enforcement Actions, which was recently made available on SSRN, we investigate the effect of employee whistleblowers on the consequences of financial misrepresentation enforcement actions by the Securities and Exchange Commission (SEC) and Department of Justice (DOJ). Whistleblowers are ostensibly a valuable resource to regulators investigating securities violations, but whether whistleblowers have any measurable impact on the outcomes of enforcement actions is unclear. Using the universe of SEC and DOJ enforcement actions for financial misrepresentation between 1978 and 2012 (Karpoff et al., 2008, 2014), we investigate whether whistleblower involvement is associated with more severe enforcement outcomes. Specifically, we examine the effects of whistleblower involvement on: (1) monetary penalties against targeted firms; (2) monetary penalties against culpable employees; and (3) the length of incarceration (prison sentences) imposed against employee respondents. In addition, we investigate the effect of whistleblowers on the duration of the violation, regulatory proceedings, and total enforcement periods. We examine the effects of whistleblowers conditional on the existence of a regulatory enforcement action. This distinction is important because our tests exploit variation in consequences to SEC or DOJ enforcement with and without whistleblower involvement; we do not measure the effects of whistleblower allegations for which there are no regulatory enforcement actions.

Of the 1,133 financial misrepresentation enforcement actions between 1978 and 2012, 145 are associated with at least one whistleblower complaint made after the beginning of the violation and before the end of the regulatory proceedings period. Using guidelines published by the SEC and DOJ [SEC 2006, USSC 2013], we identify a broad set of controls for other factors related to the magnitude of penalties and sanctions. Specifically, we control for the breadth, depth, scope, and egregiousness of the violation. We employ proxies such as abnormal stock returns on the date the financial misrepresentation became public, the length of the violation period, the number and type of violations involved, the number of C-level executive respondents named in the enforcement action, and indicator variables based on whether the firm was involved in foreign bribery, whether the firm misled the auditor, and whether the firm was credited with cooperating with regulators when penalties were determined. We also control for firm characteristics, such as size, growth, capital structure, and other monitoring and governance mechanisms that are potentially associated with both the existence of a whistleblower and enforcement outcomes.

We find that whistleblower involvement in an enforcement action is associated with a significant increase in penalties. After controlling for various factors that affect the amount of penalties assessed in an enforcement action, we find that whistleblower involvement increases firm penalties by an average of $76.96 million. Furthermore, penalties assessed against employees average $39.29 million more when a whistleblower is involved. Finally, when whistleblowers are involved with an enforcement action, employees at targeted firms receive prison sentences that are, on average, 21.55 months longer than if no whistleblower had been involved. In total, we estimate whistleblowers enabled regulators to obtain judgments (firm plus employee penalties) of $16.86 billion beyond what they would have obtained without whistleblower involvement. This increase in monetary penalties accounts for approximately 56% of the $30.09 billion in penalties assessed against firms and employees with whistleblower involvement, and 21% of the $79.46 billion in total penalties assessed in all enforcement actions from 1978 to 2012. Restricting the analyses to only the enforcement actions subject to the provisions of the Sarbanes-Oxley Act yields similar results. These findings indicate whistleblowers are a valuable source of information for regulators in the investigation and prosecution of firms and their managers.

We also examine whether whistleblower involvement affects the duration of enforcement actions. If information from whistleblowers provides a “road map” that facilitates the SEC’s or DOJ’s case, whistleblower involvement could expedite the resolution of enforcement actions. Alternatively, because whistleblowers provide regulators with additional information to investigate, their involvement could prolong the enforcement process. We find that the total duration of the enforcement action increases approximately 10 months (10.9%) with whistleblower involvement. These results suggest the benefits whistleblowers provide come at the cost of prolonged enforcement efforts.

We also address the issue of selection bias by employing a treatment effects model using inverse-probability-weighted regression adjustment (IPWRA) and focus our analysis on the average effect of whistleblowers on enforcement actions to mitigate both the endogeneity and missing counterfactual problems (Greene, 2012; Frolich and Melly, 2013). The results of this analysis suggest whistleblower involvement in enforcement actions accounts for 27.5% of total penalties assessed in all enforcement actions from 1978-2012 and increases the length of prison sentences for culpable employees by more than 25 months, confirming the important role of whistleblowers in the enforcement process.

The full paper is available for download here.

 

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