Of Snitches and Riches: Optimal IRS and SEC Whistleblower Rewards

Yehonatan Givati is Associate Professor at Hebrew University Law School. This post is based on his recent article, forthcoming in the Harvard Journal on Legislation.

The past decade has seen a dramatic shift in the enforcement of U.S. tax and securities laws away from reliance on public administrative agents and towards the use of paid whistleblowers. Traditionally, violations of tax law were detected by IRS auditors and agents, who reviewed tax returns and conducted investigations. Similarly, violations of securities law were detected by SEC agents, who conducted investigations to detect cases of insider trading, manipulation of market prices, or misrepresentation of important information about securities. Although IRS and SEC agents often relied on tips from various sources, there was no widespread and institutionalized payment of rewards for information on violations of the law.

In 2006 Congress made fundamental changes to the IRS informant awards program. Before these changes, whistleblower rewards were discretionary, and their maximum level was set at 15 percent of the collected proceeds. Under the new law, the payment of rewards to whistleblowers is no longer discretionary, rewards were increased to 15-30 percent of the collected proceeds, and whistleblowers were given rights to appeal their reward determination.

Similarly, prior to the Dodd-Frank Act, the SEC did not have a general authority to pay rewards to whistleblowers. In 2010, the Dodd-Frank Act directed the SEC to reward individuals who provide original information that leads to successful enforcement actions. Rewards were set to equal 10-30 percent of the monetary sanctions collected, and an Investor Protection Fund was established to fund those rewards.

These major changes in the law enforcement strategies employed by the IRS and the SEC have resulted in the payment of large rewards to whistleblowers in recent years. One month after paying 104 million to Bradley Birkenfeld, the IRS awarded $38 million to a whistleblower for information leading to the recovery of $127-254 million in corporate taxes from a top 500 public firm. On September 2014 the SEC announced that a foreign whistleblower would collect a record reward of more than $30 million. A year earlier, on September 2013, the SEC awarded $14 million to a whistleblower for a tip about a scheme to defraud foreign investors seeking U.S. residency. And on August 2016 the SEC awarded $22 million to a company insider who helped uncover a well-hidden accounting violations.

The transition by the IRS and the SEC in recent years to a greater reliance on whistleblowing as a law enforcement strategy has attracted much attention from legal scholars. However, the exiting literature has ignored one fundamental question regarding the use of whistleblower rewards: How much should whistleblowers be paid?

To fill this gap, my article develops a new economic model. Given the employment of whistleblowing as a law enforcement strategy, the model considers how illegal activities may be deterred with the lowest possible reward.

The model takes into account three central factors. The first is that whistleblowers often bear a personal cost. This cost can be the result of social ostracism, diminished prospects for future employment, or a physical and psychological health toll resulting from whistleblowing. The second is that not all whistleblower reports lead to the imposition of fines on the accused and the payment of a reward to the whistleblower. Agencies may not be convinced by the information provided by the whistleblower, or cases may not be pursued because of case overload. Lastly, offering rewards to whistleblowers may result in false reports driven by the desire to obtain a reward.

Using this model, the article shows that three central factors should be considered when setting whistleblower rewards: the gain to the violator from violating the law, the personal cost to the whistleblower, and the likelihood of a successful report.

A higher gain to the violator from violating the law, and more specifically a higher ratio of the gain to the sanction, requires a higher whistleblowing reward. This means that, counter-intuitively, reports of less severe violations of the law may require a higher whistleblower reward than reports of more severe violations of the law. The reason is that the law often prescribes a lower sanction for less severe violations. Given this lower sanction, to deter these violations a higher likelihood of being reported is required, which requires a higher whistleblower reward.

A higher personal cost to whistleblowers from blowing the whistle requires a higher whistleblowing reward. This means that different whistleblowers may receive different amounts, depending on their circumstances, even when the same type of information is provided. For example, it may be necessary to pay higher rewards to young employees at a start-up firm than to older employees who are about to retire from a car manufacturing firm, since the cost of blowing the whistle to the former group, in terms of the reduction in future employment prospects, is likely higher.

Lastly, in terms of the likelihood of a successful report, the more likely it is for a true report to fail, the higher the whistleblower reward should be. A lower likelihood of success makes whistleblowers reluctant to report, which reduces deterrence. In order to increase the likelihood of reporting and maintain deterrence the whistleblower reward must be increased. Moreover, and counter-intuitively, the more likely it is for a false report to succeed the higher the whistleblower reward should be. A higher risk of a successful false report means that the relative cost of violating the law is reduced, which reduces deterrence. Increasing the whistleblower reward increases deterrence, since it disproportionally increases the likelihood of the true report being made, so the relative benefit from not violating the law increases.

In August 2014 new regulations were adopted to guide the IRS in determining the percentage of the collected proceeds that should be paid to whistleblowers in each case. In June 2011 regulations were adopted to guide the SEC in determining the whistleblower reward in each case. Interestingly, none of the factors noted in these respective regulations correspond to the three factors highlighted by the economic model and noted above. It therefore seems that an improved whistleblowing policy would consider the abovementioned factors as central factors when determining the level of whistleblower rewards.

The full article is available for download here.

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