THE BLOG
12/15/2010 06:03 pm ET | Updated May 25, 2011

Blow the Whistle on Pointless Whistleblowing

As one would expect from a 2300 page bill enacted in such turbulent times, the Dodd-Frank bill which was enacted this year to address systemic problems in the financial system in order to reduce the likelihood of another 2008-style crash has its positive and negative elements and is subject to good faith discussion of its merits. However, one provision which appears to be unequivocally bad is the effort in the law and pertinent SEC proposed regulations to encourage whistleblowing by paying large bounties of up to 30 percent of the amount at issue to whistleblowers, who report to authorities corporate wrongdoing.

In the first instance, this effort is totally unrelated to financial stability. While the 2008 crisis and Great Recession were undoubtedly the result of terrible decisions on Wall Street, by mortgage originators and by borrowers on Main Street, in lending and borrowing beyond ability to pay, virtually none of this activity was even arguably illegal. As indicated by the absence of criminal prosecutions, there is nothing illegal about doing things which are really dumb. These new provisions in the law will do nothing to deter abject stupidity on the part of private actors which imperils the broader economy. As noted, doing the latter requires significant reform of corporate governance law. There is no credible evidence that illegality had anything to do with the financial meltdown.

What the new incentives for whistleblowers will do is at the least encourage and cause more whistleblowing and probably more -- not less -- wrongdoing. What is optimal for society is to deter and stop wrongful activity by business before it starts and not after it comes to fruition and does its damage. Giving people 10-30 percent of fines and settlements resulting from wrongdoing encourages those who become aware of such incipient wrongdoing to wait until it "ripens" to the point that a fine or settlement is in order. It also provides no deterrent for the firm in question if the fine or settlement is a fixed amount which is shared by the SEC and whistleblower.

This can only be bad for society, which would be far better off if the activity were stopped at the earliest possible date, before any ham is done. However, this would result in no financial benefit to one who is aware of the problem. Their interest is better served by lying in wait until an actual wrong occurs and then going to authorities with appropriate citations in hand. One more cynical than I, might even see the enhanced possibility of a form of entrapment, where the individual suggests or encourages wrongful activity. While this would not result in recovery, if proven, many unsophisticated people may not make that distinction. Given this bizarre, counterproductive structure, one wonders if it is a genuine effort to protect the economy or simply a sop to the plaintiffs' securities bar -- the Bill Lerachs of the world -- who only have grist for their mill when a wrong is said to occur, but not when it is prevented.

Several hundred large companies, including many having nothing to do with Wall Street, such as Delta, FedEx, Gap and Pfizer, have voiced these sentiments in a letter to the SEC, objecting to its proposed regulations. The letter summarizes the problem quite succinctly:

The proposed rules "disincent employees from looking for ways to improve or correct corporate behaviors, and incent them to find ways to profit from corporate wrongdoing," according to the letter, which is set to be released Wednesday. "Fraudulent misconduct, the bane of good compliance systems, then becomes the gold mine."

There was certainly a need for Congress to act in order to bolster the stability of our economic foundation and Dodd-Frank contains many provisions which are beneficial or at least arguably so. However, the whistleblower provisions do nothing except burden business with more adversaries and wasted time of senior people, which could be much better used competing in the marketplaces. At all times, especially today, when our economic recovery is still wobbly, we must avoid unproductive demands on the business community, while still insisting upon compliance with the letter and spirit of the law. If Congress can find a way to promote better decision-making by business and/or to increase its level of legal compliance, I'm all for it. This effort seems to be nothing more than a punitive, irrelevant (or counterproductive) measure reflective of only a class warfare mentality.

Those with a genuine interest in improving business behavior should tell the SEC that this is not the way.