Over a period of several years, the Brazilian unit of medical-devices maker Zimmer Biomet Holdings ran a massive kickback scheme, according to the Securities and Exchange Commission, which in 2017 levied a $30 million penalty against the Indiana-based company. The wrongdoing reportedly came to light when a Brazilian former orthopedic surgeon provided an anonymous tip to the company and then to the SEC. That won the whistleblower a $4.5 million reward from the US regulatory agency.

The bounty was authorized by the 2010 Dodd-Frank Act, which offers such whistleblowers 10–30 percent of cash funds collected from enforcement actions that top $1 million. Some critics question whether this provision is a good idea. A Bloomberg investigation recently found that the Dodd-Frank whistleblower program “often ignores its own rules, shields much of its work from the public, and has been a financial boon for law firms that hired former agency officials.”

But the program does effectively deter financial fraud, according to Chicago Booth’s Philip G. Berger and City University of New York’s Heemin Lee (a graduate of Booth’s PhD Program). Their research finds that the Dodd-Frank whistleblower provision has reduced the likelihood of corporate financial fraud by 12–22 percent, depending on how the calculations are done, without significantly affecting audit fees.

Whistleblower laws have a long history. In 1863, when Civil War profiteers were effectively robbing the public purse, the US Congress pushed through the False Claims Act, offering rewards to whistleblowers. Over time, lawmakers have broadened the application of the bounty incentive—and thus increased the number of people coming to regulators with allegations of wrongdoing.

In the first 10 years of the Dodd-Frank whistleblower program, the number of tips to the Securities and Exchange Commission rose steadily to more than 52,000, the researchers report, citing the SEC’s 2021 annual report to Congress. The SEC has collected almost $5 billion in sanctions and handed out more than $1.1 billion in bounties to 214 whistleblowers. But those data don’t really prove whether the program provides a deterrent, and “studying detected fraud does not tell us how much undetected fraud is occurring,” the researchers observe.

Because detected fraud could represent just a fraction of the greater problem, Berger and Lee focus instead on an indicator of the probability of fraud known as the F-score, developed in 2011 by University of Southern California’s Patricia M. Dechow and her coresearchers. Berger and Lee argue that the measure provides a reasonable approximation of underlying fraud. The F-score reflects financial-statement data showing accrual quality, business performance, and external financing measures. Higher scores signal a greater probability of accounting misstatements.

The other big research challenge was coming up with a before-and-after comparison for businesses likely to be affected by Dodd-Frank. Berger and Lee used false-claims laws, passed in 17 states before Dodd-Frank, which reward whistleblowers who provide evidence of securities fraud by companies whose stocks are part of state pension-fund portfolios. (In 1987 California passed a false claims act with a whistleblower provision, and others eventually followed.) These state laws incentivized companies to tighten up their accounting and take anti-fraud measures prior to the existence of the federal program, thus presenting a good opportunity for comparison with companies for which Dodd-Frank was their first exposure to whistleblower liability, the researchers argue.

When they analyzed the financial reports of more than 1,800 companies from 2008 to 2014 (before and after the passage of Dodd-Frank), they find that companies subject to the state-level laws saw F-scores decline by 12 percent between 2008 and 2010. The research suggests that the drop in the probability of fraud resulted from companies being exposed to a state program during this time period, either because of a newly implemented law or because a state pension plan invested in the companies. Businesses in the group that hadn’t had to worry about state whistleblower laws lowered their F-scores by even more—up to 22 percent—once Dodd-Frank went into effect, the researchers find.

Berger and Lee note that little has been known about the effectiveness of Dodd-Frank’s whistleblowing provision, and their work is the first to link such legislation to the probability of deterring corporate fraud.

“We contribute to the policy debate around the bounty model of whistleblowing by providing one crucial piece of evidence for the debate (quantification of the fraud reduction benefit),” Berger and Lee write. The findings suggest that whistleblower programs are effective in “motivating managers to prevent and avoid fraud,” they conclude.

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