Compliance professionals have another neato academic study to start your week, this one finding that the whistleblower provisions of the Dodd-Frank Act reduce the risk of accounting fraud at publicly traded firms by as much as 22 percent.
Measuring the effect of Dodd-Frank’s whistleblower provisions has long been tricky business, because the law went into effect for all publicly traded companies in 2011 — so there’s no natural control group to compare against, where you could ponder, “What about the public companies not affected by Dodd-Frank?” All public companies were.
An undaunted pair of business professors, however, recently cooked up an approach to do just that. They studied companies that had been exposed to the whistleblower provisions of state-level False Claims Act statutes, and with some clever statistical analysis reached the conclusion that Dodd-Frank reduced fraud risk at large companies by a range of 12 to 22 percent.
Keep that in mind next time the board or management asks, “Is this internal reporting stuff really worth the cost?”
The authors of the study are Philip Berger at the University of Chicago and Heemin Lee at City University of New York. Their study was published in January and is freely available online, although I’d advise anyone who flunked statistics in college (which includes me) to read carefully and slowly (which I did).
The gist of things is that numerous states have had False Claims Act statutes on their books since long before the Dodd-Frank Act came along in 2010. Those statutes offered whistleblower bounties to people reporting fraud against state governments — and because many state pension funds invest in publicly traded companies, accounting fraud at those companies qualified as something that could be reported under the state False Claims laws.
Crucially, only some state statutes include the reporting of accounting fraud; other states don’t. So some companies were exposed to whistleblower provisions, because their stock was held by states whose False Claims statutes covered accounting fraud; and other companies weren’t exposed to those whistleblower provisions, because they were held by states whose statutes didn’t. That distinction gave Berger and Lee the control group they needed.
What They Did and What They Found
Berger and Lee analyzed more than 6,700 publicly traded companies. They compared companies that were exposed to state-level False Claims statutes that included accounting fraud, against companies that weren’t. Then they asked: for those companies that weren’t, how did their fraud risks change when the Dodd-Frank provisions arrived?
In theory, one would assume that the first group of companies had greater incentive to implement anti-fraud controls even before Dodd-Frank, because a whistleblower could still report accounting fraud under the state False Claims statutes. Then, when Dodd-Frank arrived in 2011, the second group of companies would essentially catch up with the first, because Dodd-Frank brought those whistleblower pressures to their doorsteps.
(For those of you saying, “Wait! The Sarbanes-Oxley Act allows for whistleblower reporting of accounting fraud too!” That’s correct, but SOX doesn’t provide rewards for whistleblowers. Dodd-Frank does, which means it gives whistleblowers a greater incentive to report.)
To get a sense of how complicated the math gets, this is the equation Berger and Lee used to calculate the effect on fraud risk:
If you ask me to explain what all these variables mean, I will unfriend you on LinkedIn.
Berger and Lee’s main point is that after the Dodd-Frank whistleblower provisions went into effect, that drove down the probability of fraud among companies that hadn’t previously had to worry about state-level False Claims enforcement, by anywhere from 12 to 22 percent.
Moreover, we should remember that accounting fraud does have real financial consequences for companies once it comes to light. Other academic studies estimate that roughly 11 percent of all large, publicly traded U.S. companies are engaged in fraud in any given year, costing roughly 1.7 percent of the fraudulent company’s market cap.
So if you assume that Dodd-Frank reduces the likelihood of fraud by 17 percent, Lee and Berger said (17 being the midpoint of that 12 to 22 percent range they found), that implies that frauds are avoided by 1.9 percent of large, public firms, and that these prevented frauds reduce the annual expected cost of fraud by 0.29 percent of market cap. That’s real money.
Whistleblower Studies Through Time
Berger and Lee’s work is only one of several academic studies done in recent years to quantify the benefits of a strong whistleblower regime.
The most notable study came in 2018, when researchers at George Washington University and the University of Utah found that companies with higher rates of internal reporting also had better business performance across numerous metrics, such as fewer lawsuits filed against the company and higher return on assets. That one makes sense when you think about it for a moment, because higher rates of internal reporting mean that you have a corporate culture willing to discuss and resolve problems; of course a company like that is more likely to thrive.
Berger and Lee’s study is different in that they only focus on accounting fraud — but accounting fraud is a mighty big problem to have. It leads to regulatory enforcement, shareholder lawsuits, people getting fired, and depressed share price. So even though the Dodd-Frank Act forced companies to take internal reporting and anti-fraud controls more seriously, those expenditures are prophylactic measures well worth the cost.