Second Thoughts About the S.E.C.’s Whistle-Blower Program

David Zaring is assistant professor of legal studies at the Wharton School of Business at the University of Pennsylvania.

The Securities and Exchange Commission’s rapid development of its whistle-blower program may well catch criminal activity that falls under the radar. The program sounds great, in theory, but there are several ways its success may harm the agency.

In a sense, the program privatizes enforcement just as the agency is struggling to get more public financing. It also may not add a necessary new incentive to some decent old ones, and it creates a perverse financial motivation for employees at corporations. A closer look at these problems:

Privatization Whistle-blower programs that offer a share of the spoils of any judgments are designed to encourage private citizens to police publicly traded firms. They also spur the development of an army of lawyers who will go out and find such citizens.

In this way, a whistle-blower program is a privatization approach, not unlike hiring a private company to run a prison. But for the S.E.C., it is law enforcement that is being privatized. Rather than being able to take aim at particularly worrisome corners of the securities markets, the program leaves the S.E.C. beholden to tippees. Moreover, if Congress believes whistle-blowers, rather than the agency, are doing the work, it will have yet another justification for placing tight limits on the agency’s budget.

For these reasons, it is depressing that Mary L. Schapiro, when she was the chairwoman, characterized the program as “critical” for an agency with “limited resources like the S.E.C.”

Need Although we regularly worry about undiscovered financial fraud, it is not clear that the answer lies in the bounties whistle-blowers receive. Encouraging whistle-blowing by insiders may not be worth it, given that suspicious competitors and irate customers already have good reasons to keep the agency informed of wrongdoing.

There are plenty of incentives to provide information about matters worthy of S.E.C. inquiry. Competitors, for example, seek a level playing field. Harry Markopolos, who was ignored by the agency when he first began to suspect Bernard L. Madoff of fraud, was originally assigned by his firm to try to understand how it was consistently outperformed by Mr. Madoff. By the same token, customers who feel defrauded are unlikely to keep their concerns to themselves.

Corporate Loyalty Corporations have become rightly worried about the prospect of their compliance officers, lawyers and accountants going straight to the government when they suspect wrongdoing, rather than first telling the firm that corrective action is needed. Why put these systems into place, they wonder, if they encourage sanctions, bad publicity and an appearance of noncompliance?

It is not a far-fetched situation. An outside consultant, not an insider, received the first (and so far only) award from the S.E.C.’s 20-month-old whistle-blower program. The prospect that the hired help might generally act this way led corporations to unsuccessfully seek an S.E.C. requirement that the whistle-blower present concerns internally before going to the agency.

The program does appear to create strange incentives within publicly traded corporations, where those who investigate internal wrongdoing must decide whether their loyalty lies with the firm or the S.E.C. â€" and the prospect of a cash payment.

Perhaps, then, it is unsurprising that the agency has, until now, approached whistle-blowers with caution. The S.E.C.’s so-called bounty program, which ran from the 1980s, provided awards only six times over two decades; the total expenditure amounted to $1.15 million. In the wake of the dot-com collapse, Congress gave the agency the authority to prevent businesses from retaliating against whistle-blowers. But the S.E.C. did nothing to provide incentives for whistle-blowers to come forward; its role was to protect them once they had done so.

The Dodd-Frank Wall Street Reform and Consumer Protection Act changed all that with its provision to share up to 30 percent of recovered money. The statute made whistle-blowing a potentially profitable sword to be wielded by the private sector, rather than a shield for leakers administered by the S.E.C.

The program’s only real parallel in government is so-called qui tam cases, which permit private individuals who uncover fraudulent claims for money from the government to receive a share of the spoils. Qui tam comes from a Latin phrase that translates roughly as “he who sues in this matter for the king as for himself.”

By taking a program that was meant to keep the government’s own house in order and repurposing it to police the financial markets, the S.E.C.’s whistle-blower program does more than protect the king’s assets. In many ways, it does the king’s work for him.