Back in 1970, in a seminal paper titled The Market for Lemons, George Akerlof highlighted how vitally important accurate information was to the effective functioning of the financial markets. It stands to reason: if the information reported by firms cannot be trusted, few would want to invest. The obfuscation and fraud practiced at Enron, WorldCom and other entities in the 1990s and disguised under a façade of positive earnings reports provided devastating proof, however, that the markets had not developed effective mechanisms for tackling information asymmetry, which occurs when one party to a contract knows a great deal more than the other. The recent financial crisis provided further evidence. The triple-A credit ratings assigned by agencies such as Moody’s and Standard & Poor’s turned out to be ‘fake news’. In response, Congress passed the Dodd–Frank Act, which as part of its mandate to reform Wall Street and protect consumers instituted the Office of the Whistleblower under the aegis of the U.S. Securities and Exchange Commission.
Akerlof, in his insightful magnum opus, analyzed the role of information by examining the market for used cars, which has ‘peaches’ (good cars) and ‘lemons’ (bad ones). Since buyers are acutely aware that sellers of lemons are likely to pass off their cars as peaches, they lower their bids on all cars. This, however, drives many owners of good cars to take their peaches off the market. Naturally, those selling bad cars are unperturbed by the fall in prices and are quite happy to continue offering their lemons. The average quality of cars offered, consequently, falls, since there are less peaches but the same number of lemons. This initiates a vicious cycle, with buyers further lowering their bids and more peaches leaving the market. Akerlof’s insight was to show that informational asymmetry diminishes transactions in any marketplace by driving out quality. He went on to marry Janet Yellen, the present Chair of the Federal Reserve, in 1978 and to win the Nobel Prize in Economics for his work in 2001.
Despite the lament in a recent New York Times article (http://dtn.fm/bo07E) on the SEC’s apparent deafness when an employee at giant mortgage insurer Radiant Group complained his employer was materially understating estimates of claims liability, the Whistleblower program appears to have had some measure of success. In its 2016 Annual Report to Congress, the SEC announced that since its inception on August 12, 2011, the Whistleblower program had ‘awarded more than $111 million to 34 whistleblowers’, with one award in 2014 being worth a whopping $30 million. That’s an awful lot of money for blowing a whistle, and, although the program was designed to provide insiders with incentives to report bad behavior by their employers, the size of the payouts is beginning to attract the attention of outsiders as well.
The Gulf News (http://dtn.fm/aUn1G) tells how two vigilant analysts stand to win as much as $2.5 million after tipping off the SEC about discrepancies in the earnings reports of Texas-based medical device maker Orthofix International NV. Their million-dollar award will come out of the $8.25 million the errant company has to pay. They are not the only ones. In January 2016, the SEC paid ‘more than $700,000 to a company outsider who conducted a detailed analysis that led to a successful SEC enforcement action’. The agency has said that ‘just over a third of the more than $111 million awarded to whistle-blowers went to outsiders such as analysts or short-sellers’. Those numbers have increased. At May 2, 2016, approximately $154 million had been awarded to 44 whistleblowers.
The law requires whistleblower awards to be a minimum of 10 percent of monetary sanctions collected; however, they can go up to a maximum of 30 percent. With its Whistleblower program, the SEC is encouraging investors to do their due diligence and get paid for it. Hopefully, this will encourage market participants to keep their operations as clean as a whistle.