The Shortseller Enrichment Commission?: Whistleblowers, Activist Short Sellers, and the New Privatization of Public Enforcement

Alexander I. Platt is an Associate Professor at the University of Kansas School of Law. This post is based on his recent paper, forthcoming in the Washington Law Review. 

Two developments have transformed the detection of corporate fraud since the global financial crisis: the SEC whistleblower bounty program (WBP) and the rise of activist short sellers. Considered separately, these are generally understood to be two valuable innovations that help detect and deter fraud.

But, it turns out, they are not so separate.

In a new paper, I document extensive activist short involvement in the WBP, show why this involvement may undermine deterrence, and offer reforms.

Drawing on data obtained under the Freedom of Information Act, I find that activist shorts and other outsiders account for about 40% of awards issued by the WBP in the most recent years. In addition to supplying their own tips directly to the SEC, activist shorts also frequently recruit insider tipsters to participate – in some cases offering up trading profits in exchange for cooperation. These well-financed outsider tipsters often go far beyond providing factual evidence, and also provide the SEC with legal analysis, expert reports, witness lists, and draft pleadings.

The WBP is now an outsourcing program: the SEC uses the WBP to pay private professionals to do work that traditionally would have been done by its own staff. In recent years, this outsourcing amounts to the equivalent of roughly 12% of the SEC enforcement budget.

This privatization of public enforcement might be defensible, indeed laudable, if it yielded more efficient deterrence than what the SEC could achieve on its own. Unfortunately, it may not.

When the WBP rewards insider tipsters, the SEC pays for information that it would not have been able to obtain any other way. No amount of surveillance or investigation may be able to uncover the truth where knowledge of a fraud is possessed exclusively by a few corporate insiders. And since insiders are legally barred from trading or profiting from material non-public information about their firms, the prospect of a public bounty is the only way to elicit the information.

This justification falls apart when the WBP rewards outsiders. An activist short who spots a fraud through surveillance and investigation is doing the same sort of work done by SEC civil servants. The same is true when an outsider provides the SEC with legal analysis, witness interviews, and draft pleadings. Outsider tipsters are not generally restricted by insider trading restrictions and so already have powerful market-based incentives to bring information forward (by shorting the stock themselves and/or selling the information to others who will do so).

Because the probability of winning an SEC bounty is extremely remote and uncertain, the prospect is unlikely to provide any marginal incentive that leads activist shorts to bring forward information beyond what the prospect of private market profits already induce. Numerous activist shorts have confirmed as much, as I show in the paper.

Thus, the SEC seems to be paying activist shorts for information they would have made public even without the prospect of bounty. In such cases, the bounty payment does nothing to incentivize additional fraud detection and is merely a windfall. These funds could be better spent – either expanding the SEC’s own enforcement staff or paying insider tipsters.

To that end, the SEC may consider amending program rules to require an accounting of tipsters’ private profits when making awards. While current program rules limit bounty-eligibility for tipsters who receive bounties from other whistleblower programs, they are silent with regard to tipsters’ private profits. The perverse result is that, under current rules, if tipster A has previously earned $5 million by using information to short the target’s stock, and tipster B has earned a $5 million bounty by supplying the same information to a different whistleblower program, only Tipster B’s prior earnings will count against his prospective SEC award.

These issues deserve further scrutiny. Unfortunately, the SEC has made this scrutiny all but impossible. Prior to FY 2022, every annual report from the WBP included basic information regarding the proportion of awards issued to insiders and outsiders, but two most recent reports omit this information without any explanation. When questioned, the agency stated that it no longer even tracks this information.

In all likelihood, the SEC will increasingly rely on private professionals to execute its core enforcement functions. But privatization does not justify abandoning good governance. A starting place would be for the SEC to resume tracking and disclosing basic information about the WBP.

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