Cash Incentives for Whistleblowers of Control Fraud

by William K. Black

Marty Robins’ December 15, 2010, column "Blow the Whistle on Pointless Whistleblowing" in The Huffington Post opposed the SEC implementing the Dodd-Franks Act’s provision that the SEC should develop a system of financial incentives for whistleblowers. Mr. Robins is a former corporate counsel with strongly conservative, anti-regulatory views. His purpose in writing was to enlist support for businesses lobbying the SEC to adopt a weak rule undercutting the Dodd-Frank’s whistleblowing provision. I’m interested in the SEC rule on its merits and as a serial whistleblower, but Mr. Robins’ primary arguments as to why this provision of the law was "pointless" is that fraud is trivial and played no material role in the crisis. As a white-collar criminologist and former senior financial regulator I find his claim as dangerous as it is astounding.

Mr. Robins does not evince any expertise in investigating sophisticated financial frauds, but he has strong views on such frauds.

In the first instance, this effort [to increase whistleblowing] 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 that are really dumb. These new provisions in the law will do nothing to deter abject stupidity on the part of private actors that 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.

Mr. Robins feels no need to cite any experts or data to support his assertions that fraud played no role in the crisis. He believes his case is demonstrated conclusively "by the absence of criminal prosecutions."

Mr. Robins timing on his column is embarrassing to his thesis, for it is contemporaneous with mea culpas and data refuting his thesis and excoriating the Justice Department for its lack of prosecutions. Joseph Stiglitz, Alan Greenspan, and Andrew Ross Sorkin have recently emphasized the prominent role of fraud in the crisis and decried the fact that elite bankers looted with impunity. These are remarkable advances. Until very recently Dr. Stiglitz refused to use the "f" word. Chairman Greenspan infamously refused to use the Fed’s unique statutory authority (under HOEPA) to regulate the unregulated lenders that made the bulk of the fraudulent loans. Greenspan refused to regulate on the grounds that the securities markets automatically excluded material fraud. The securities and contract markets must exclude fraud or they would not be "efficient" — and because all of "modern finance" and much of modern microeconomics was based on the efficient market and contracts hypotheses, it followed that fraud must not exist. Sorkin, the New York Times‘ leading columnist on financial elites, had never been willing to contemplate fraudulent elites. This made his epiphany all the more striking.

Many experts, of course, have been warning about the role of fraud in the crisis for a very long time. The FBI began using the word "epidemic" to describe mortgage fraud in September 2004 and predicting that it would cause an economic crisis if it were not contained. It was not contained. Instead the epidemic grew rapidly. The FBI warning was more than six years ago. Greenspan, Bernanke, and Geithner all ignored it — and produced a disaster of proportions not seen in 75 years. Criminologists that specialize in the study of white-collar crime, and economists that have expanded the canon to consider the findings of criminologists, have written, spoken, and testified about the driving role that control fraud played in the crisis and provided the data and analysis supporting their findings. Mr. Robins appears to be unaware of all of this, as he certainly attempts no refutation of the facts or analysis.

Mr. Robins’ claim that it is self-evident that insider fraud played no meaningful role in the crisis is curious. In the U.S., this is the third financial crisis in 20 years. The national commission that reported on the S&L debacle found that "fraud" was "invariably present" at the "typical large failure." Those frauds were led by the senior S&L officials and used accounting as their "weapon," i.e. they were "accounting control frauds." The Enron era frauds were also accounting control frauds. Why would this third in a series of recurrent, intensifying crises be uniquely free of fraud? Was it because private market discipline became far more effective? Did the banks, in 2003-2007, characteristically refuse to fund imprudent or fraudulent loans? Did banking and SEC regulation and supervision in 2003-2007 become substantially more effective? Did bank executive compensation become substantially more strongly tied to real, long-term bank profitability during that period? Did executive compensation fall sharply so that a CEO could no longer become wealthy by substantially inflating reported income for four years?

The banking environment became increasingly criminogenic during 2003-2007 precisely because each of the factors discussed above became more perverse as the crisis grew. Fraud also begets fraud. As an epidemic of accounting control fraud grows it can cause bubbles to hyper-inflate (which makes the environment increasingly criminogenic) and triggers "echo" epidemics. The mortgage fraud epidemic, for example, sparked an epidemic of fraudulent appraisals and loan applications by loan brokers.

The burden is on Mr. Robins to explain why this crisis has no fraud. Given an undisputed epidemic of mortgage fraud and a crisis that arose in mortgages he cannot meet that burden. The criminogenic environment that prompted this crisis exceeded the perverse incentives that drove the second phase of the S&L debacle and the Enron era frauds. Publicly available reports on the Icelandic and Irish crises also demonstrate severe insider fraud. Again, Mr. Robins does not even attempt to respond to these facts and the accompanying analytics.

Mr. Robins’ sole claim is that a lack of prosecutions proves "there is nothing illegal." That claim lacks any logical basis and has long been rejected by critics from the right and the left. The famous conservative economist Bastiat warned:

"When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it."

Edwin Sutherland, the scholar that identified and named "white-collar crime," warned that looking at criminal prosecutions systematically and massively undercounted elite financial crimes because powerful corporations were far less likely to be prosecuted when they violated the law.

Go back in time to early 1986. There were no prosecutions of elite savings and loan (S&L) officers. Seven years later, there were more than 1,000 successful felony prosecutions of elites for S&L frauds. The fraudulent conduct was endemic in 1986. The National Commission on Financial Institution Reform, Recovery and Enforcement reported in 1993 that "at the typical large failure" "fraud was invariably present." Criminal referrals by the Federal Home Loan Bank Board (Bank Board) were just beginning to ramp up at the direction of Bank Board Chairman Gray in early 1986. (Representative Barnard’s House investigation of the agency’s failure to file criminal referrals helped provide Gray with the impetus to make his reforms.) Superb criminal referrals by the regulators are a sine qua non for successful prosecutions of large numbers of sophisticated financial frauds by the officials who control banks (which white-collar criminologists refer to as "accounting control fraud"). It takes time for the FBI to investigate once the agency begins to file large numbers of criminal referrals and the interconnections between fraudulent lenders require many referrals and investigations to establish. The lack of criminal prosecutions in 2006 proved that the combination of deregulation and de-supervision at the agency level and the FBI’s inability to investigate successfully complex accounting frauds led by senior managers and the low priority that the FBI had assigned to such investigations created a self-fulfilling prophecy. If you don’t investigate effectively, you don’t find sophisticated financial frauds.

Go back in time to early 1985 when there were few prosecutions for insider trading — but widespread insider trading. The U.S. Attorney for the Southern District of New York, Rudy Giuliani, came into federal service denouncing the emphasis on prosecuting white-collar crime. He left that office to become mayor of New York City on the strength of his many successful prosecutions of elite white-collar criminals, particularly for insider trading. The most profitable investment banking firm in America, Drexel Burnham Lambert, was exposed as an accounting control fraud.

Go back in time to 2001. There were few prosecutions for accounting control frauds among major firms. President Bush chose Harvey Pitt to be the new chairman of the SEC because he was the leading opponent (in alliance with Rubin and Summers — the leaders of Clinton’s economic team) of his predecessor’s efforts to prevent the conflicts of interest among auditors that helped produce the criminogenic environment that triggered an epidemic of accounting control fraud. Chairman Pitt’s first major speech was to the accounting profession, in which he blamed his agency for not always being "kinder and gentler" in its dealings with auditors. By late 2002, the failure of the accounting control frauds helped drive a massive loss in the market value of U.S. stocks and prosecuting accounting control fraud would soon become a federal priority. By 2005, there were a series of largely successful prosecutions against the controlling officers of many enormous corporations.

In 2001, there were few federal investigations or prosecutions for a wide range of Wall Street frauds, for example mutual funds. By 2003, Eliot Spitzer’s investigations established the existence of widespread Wall Street frauds. The lack of federal prosecutions demonstrated the failures of the SEC and the Department of Justice, not the lack of crime. The failures intensified the criminogenic environment that made Wall Street the epicenter of control fraud.

Unfortunately, 2001 also brought the terrorist attacks on the U.S. and led the FBI to transfer more than 500 special agents from investigating white-collar crimes to national security. The rationale for the transfers was clear, but the refusal of the Bush administration to allow the FBI to hire replacements for the lost white-collar specialists seriously reduced the Justice Department’s capacity to respond to sophisticated financial frauds. (Criminologists refer to this as a "systems capacity" problem.) With most of its remaining top white-collar-crime special agents assigned to investigating the accounting control frauds of the Enron era, the FBI’s ability to counter the emerging accounting control frauds that drove the current crisis was crippled.

The FBI testified in September 2004 that there was an emerging "epidemic" of mortgage fraud and predicted that it would cause an economic crisis if it were not contained. More recently, FBI Deputy Director John Pistole testified before the Senate on February 11, 2009:

[I]t would be irresponsible to neglect mortgage fraud’s impact on the U.S. housing and financial markets.

The number of open FBI mortgage fraud investigations has risen from 881 in FY 2006 to more than 1,600 in FY 2008. In addition, the FBI has more than 530 open corporate fraud investigations, including 38 corporate fraud and financial institution matters directly related to the current financial crisis. These corporate and financial institution failure investigations involve financial statement manipulation, accounting fraud and insider trading. The increasing mortgage, corporate fraud, and financial institution failure case inventory is straining the FBI’s limited White Collar Crime resources.

In December 2008, the FBI dedicated resources to create the National Mortgage Fraud Team at FBI headquarters in Washington, D.C. The Team has the specific responsibility for all management of the mortgage fraud program at both the origination and corporate level. This Team will be assisting the field offices in addressing the mortgage fraud problem at all levels. The current financial crisis, however, has required the FBI to move resources from other white collar crime and criminal programs in order to appropriately address the crime problem. Since January 2007, the FBI has increased its agent and analyst manpower working mortgage fraud investigations. The Team provides tools to identify the most egregious mortgage fraud perpetrators, prioritize pending investigations, and provide information to evaluate where additional manpower is needed.

[T]he FBI has increased the number of agents around the country who investigate mortgage fraud cases from 120 Special Agents in FY 2007 to 180 Special Agents in FY 2008.

Mr. Pistole is now the head of the Transportation Safety Administration. Good for the struggle to safeguard us from terrorists, bad for the effort against mortgage fraud.

The current epidemic of accounting control frauds has caused massively greater damage than did their S&L counterparts, but the number of FBI agents assigned to deal with the current epidemic is far smaller than the staff assigned to the investigations of the S&L control frauds. DOJ has recently informed Congress that in Fiscal Year (FY) 1992 (the peak year for S&L prosecutions) there were:

• FY 1992 Actual Obligations: 2,926 positions (992 agents, 655 attorneys, and 1,279 other); 2,795 FTE; and 265,108,000.

• For mortgage fraud, in the coming year, DOJ said it is "projecting for FY 2009, approximately 500 positions and up to100 million… "

To provide fewer than one-fifth the staff and less than 40 percent of the budget (and that budget comparison ignores 17 years of salary and other cost increases) than proved necessary to deal with the vastly smaller epidemic of S&L accounting control frauds the DOJ has had to cannibalize other, already severely inadequately staffed efforts against other serious white-collar crimes. That makes us more vulnerable to the next epidemics of control fraud in other fields.

The mortgage industry informed its members that:

The FBI reports that, based on existing investigations, 80 percent of all reported fraud losses arise from fraud for profit schemes that involve industry insiders.

The data on the FBI’s grossly inadequate resources to deal with white-collar crime have several important implications for Robin’s claims. They help to show why the FBI has not conducted effective investigations against the accounting control frauds that drove the nonprime housing crisis. The data show that the FBI failed to even begin their investigations of the major nonprime lenders until 2007, after the secondary market in nonprime paper collapsed. If you don’t investigate, you don’t find. Even when the FBI began these investigations it faced crippling systems capacity problems. It takes roughly 100 FBI agents to staff the investigation of a huge fraud such as Enron. In the current crisis, the FBI authorized investigations of roughly 20 lenders of roughly the size of Enron (a number were far larger than Enron). As recently as FY 2008 it had a total of 120 agents to investigate all mortgage frauds. It had no national task force. Its agency was scattered across the nation in what the military would call "penny pockets." These tiny, scattered groups of agents with no national coordination, no systematic search for interconnections, and no national prioritization worked on whatever cases came to their local attention. They were overwhelmingly (almost exclusively) assigned to smaller cases rather than the large nonprime lenders. There is no indication that they engaged in wiretapping, bugging, or undercover investigations of any large lender. They had no chance of success in investigating any large lender under these limitations.

The current crisis is far worse than the S&L debacle on multiple dimensions. When I’m asked for my judgment I guesstimate it as 40 times worse. Pick whatever multiple you consider reasonable — and use it to estimate the FBI and DOJ resources essential to investigate the control frauds in this crisis. By any measure, the FBI’s resources assigned to mortgage fraud were and will be grotesquely inadequate to deal with the fraud epidemic even if they were optimally assigned. In reality, due to the death of effective supervision, the Treasury regulators (OCC and OTS) ceased making criminal referrals. Without the guidance, resources, and expertise of regulators, FBI resources were repeatedly misallocated to what should have been far lower priority cases. I will return in future columns to estimates of the incidence and injury of the accounting control frauds that drove this crisis and explanations of why DOJ prioritization became so ineffective in this crisis.

I will also return to the question of how best to incent whistleblowers in future columns. For now, I will simply explain that Mr. Robins has, inadvertently, prompted a discussion of a vital distinction. If control fraud were rare and not particularly damaging then the proposed financial incentives for whistleblowers would be more dubious. If one assumes that only junior officials commit fraud and that the corporation wishes to prevent their frauds and will take prompt, effective action against them upon another employee blowing the whistle, then paying whistleblowers will only cause a substantial reduction in fraud if it incents correctly blowing the whistle in cases where the employee would otherwise have failed to blow the whistle.

One cannot, however, assume that the firm will take action against the frauds when an employee blows the whistle on a control fraud. In the case of control frauds the firm’s controlling officials want the firm to engage in fraud. They will not take prompt, effective action against the controlling officers or those assisting the fraudulent controlling officers when the whistle is blown. Instead, they will typically retaliate against those that blow the whistle.

Control frauds cause massively greater losses than do "rogue" frauds by more junior officers and employees. Indeed, control frauds cause greater financial losses than all other forms of property crime — combined. Some variants of control fraud maim and kill (think Chinese infant formula) and others do great environmental damage. When epidemics of accounting control fraud concentrate in single field they are likely to cause financial bubbles to hyper-inflate and can cause economic crises. The SEC’s top priority should be to identify at the earliest possible time accounting control frauds and put them out of business. Financial incentives for whistleblowing may prove very effective in helping the SEC identify these frauds at an early point. It is an empirical question. (The SEC can counter the claim that financial incentives tied to loss could lead to delaying blowing the whistle until damages have grown by providing a sharp loss in incentive payments if the whistle blower delays unduly in blowing the whistle.)

It is essential for the SEC to understand that the status quo also employs financial incentives and they are far larger and totally perverse relative to the financial incentives the SEC is considering. The status quo is that accounting control frauds frequently use broad performance bonus programs. Fannie Mae, for example, had its internal auditors on such a plan — and the results were, as intended by senior management, the death of internal controls. These broad, generous bonus programs enlist thousands of potential allies (who can manipulate the accounts while providing those controlling the fraud with deniability — they will in many cases not know the exact means by which the firm made the "number"). The bonuses also align the interests of those who are supposed to provide internal controls, governance, and checks and balances with those that control the firm. Executive compensation typically further misaligns the interests of the CEO and the shareholder. Finally, the bonus programs eviscerate whistleblowing. The officer that blows the whistle not only loses his bonus, but also his peers and his employees lose their bonuses. Ostracism is already one of the worst forms of retaliation against the person who blows the whistle. The bonuses ensure that the ostracism will be brutal. Whistleblowers are one of the leading ways in which regulators learn of control fraud, so any reduction in blowing the whistle on control fraud is a major loss. To sum it up, once Mr. Robins’ false assumption that fraud played no material role in the crisis is cleared up, the distinction between control fraud and rogue frauds provides a powerful justification for the Dodd-Frank provisions calling for financial incentives for those that blow the whistle on corporate fraud.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He is a white-collar criminologist who has spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

This article originally appeared in Benzinga.