01 December 2015

Whistleblowing

'A Theory of Whistleblower Rewards' by Yehonatan Givati in Journal of Legal Studies (forthcoming) comments 
To enforce the law, the government must learn about violations of the law. One way of obtaining such information is by employing police officers and investigators. An alternative way is by rewarding whistleblowers. In this paper I consider two basic questions relating to whistleblower rewards. First, what is the optimal size of whistleblower rewards? Second, how should we choose between employing police officers and rewarding whistleblowers? I develop a model which highlights two features of the whistleblowing context: whistleblowers bear a personal cost, and a reward may encourage false reports. I find that there is a non-monotonic relationship between the personal cost to whistleblowers and the optimal reward, and between the risk of a false report and the optimal reward. Furthermore, offering a whistleblower reward dominates the employment of police officers and investigators when the risk of a false report is small. 
Givati argues
To enforce the law the government must know, at least in some cases, when the law is violated. Since Becker (1968), a central assumption in the literature on the public enforcement of law is that information about violations of the law can be obtained only by investing real resources in the employment of police officers and investigators. Violations of the law, however, are almost always known to non-violators, such as employees, neighbors or family members of the violator. Therefore, an alternative way of obtaining information on such violations is simply to pay those people a whistleblower reward for reporting this information.
A central advantage of obtaining information on violations of the law from whistleblowers rather than from police officers and investigators is that the employment of police officers and investigators consumes real resources, whereas whistleblower rewards are mere wealth transfers. Despite this advantage, relative to the use of police officers and investigators, whistleblower rewards seem to be infrequently used. Still, their use has been increasing in recent years.
To illustrate, in 2006 the Internal Revenue Service (IRS) made fundamental changes to its informant awards program. Under the new law the payment of rewards to whistleblowers is no longer discretionary, and rewards were increased to 15-30% of the collected proceeds. In 2010, The Dodd-Frank Act directed the Securities and Exchange Commission (SEC) to reward individuals who provide original information that leads to successful enforcement actions resulting in monetary sanctions. Rewards were set to equal 10-30% of the monetary sanctions collected, and an Investor Protection Fund was established to fund those rewards. In 2012 the IRS awarded $104 million to a whistleblower for divulging schemes used by UBS to encourage American citizens to evade taxes. In 2013 the SEC paid $14 million to a whistleblower for reporting a Chicago-based scheme to defraud foreign investors seeking U.S. residency.
Despite the increased reliance on whistleblower rewards, we know little about their desirability and design. In this paper I address two basic questions regarding the use of whistleblower rewards. First, what is the optimal size of whistleblower rewards? Second, when rewards are set optimally, how should we choose between employing police officers and rewarding whistleblowers?
To address these questions I develop a simple stylized model, with an employer and an employee. The employer decides whether to violate the law. The employee may blow the whistle on the employer's violation of the law, to obtain a reward. Though the model uses the employer-employee relationship for concreteness, it can easily be applied to other settings.
Two important features of the whistleblowing context are captured in the model. First, the employee bears a personal cost when blowing the whistle. This captures the idea that whistleblowers bear a personal cost, because of social ostracization, a psychological toll, or due to a reduction in their future employment prospects. Second, the employee may falsely report a violation of the law by the employer, and this false report has some chance of succeeding. This captures the idea that whistleblower rewards may tempt people to make false reports of violations of the law, which they may be able to support because of their relationship with the person they are reporting.
With this basic setup I analyze the optimal, social welfare maximizing, whistleblower reward. First, I show that there is a non-monotonic relationship between the personal cost to whistleblowers and the size of the optimal reward. The reason is that, as the personal cost of whistleblowing increases, a higher reward is required to induce reports and maintain deterrence. However, when the personal cost to whistleblowers is very high, it is desirable to provide no whistleblower reward. Though this means the law will be violated, the high social cost of whistleblowing will be avoided.
Second, I show that there is a non-monotonic relationship between the risk of false report and the size of the optimal reward. This is because, as the risk of a false report increases, the relative benefit to the employer from not violating the law decreases. To induce the employer not to violate the law the relative cost of violating the law must be increased. This can be achieved by increasing the reward for whistleblowing, which increases the risk of a violation being reported. However, when the risk of a false report is sufficiently high, the reward that is required to deter the employer is so high that it is very likely to induce a false report. In such a case it is therefore desirable to provide no whistleblower reward. Though this means that the law will be violated, the social cost of a false report will be avoided.
How should we choose between employing police officers and rewarding whistleblowers? I show that, when the risk of a false report is sufficiently small, whistleblowing dominates policing as a law enforcement strategy. The reason for this is that, as the risk of a false report decreases, false reports are less likely to be made, which means that the social cost of the optimal whistleblower reward, which deters the employer from violating the law, is reduced. Accordingly, as the risk of a false report tends to zero, so does the social cost of rewarding whistleblowers. By contrast, the employment of  police officers and investigators always involves a social cost.
The law and economics literature has devoted much attention to the question whether laws should be enforced by a public authority or by private competitive firms that are paid for performance (Becker and Stigler 1974, Landes and Posner 1975, Polinsky 1980). This paper, by contrast, assumes the public enforcement of law, and asks when the public authority should employ whistleblower rewards as an alternative to the employment of police o¢ cers and investigators.
The costs and benefits of rewarding whistleblowers have been analyzed informally by Howse and Daniels (1995) and Ferziger and Currell (1999), who discuss a long list of issues relating to the design of whistleblower programs and the effect of whistleblower rewards. Others have compared a court-centric mechanism for rewarding whistleblowers to an agency-centric mechanism (Casey and Niblett 2014, Freeman Engstrom 2014). Different mechanisms designed to promote whistleblowing are also compared by Feldman and Lobel (2010), who use experimental surveys to examine the outcomes of anti-retaliation protection, duty to report, liability fines, and monetary incentives. Dyck, Moore and Zingales (2010) investigate empirically who blows the whistle on corporate fraud using data on all reported fraud cases in large U.S. companies between 1996 and 2004. They ├ľnd that corporate fraud is often reported by employees and the media, who are driven by ease of access to information, and by monetary and reputational incentives.
Formally, Heyes and Kapur (2008) analyze a model of whistleblower policy in which, unlike in this paper, whistleblowers are not rewarded. They present three behavioral theories as to why whistleblowers report violations of the law, despite it being against their self interest (conscious cleaning, social welfare maximizing, and cost imposing). For each theory they consider the determination of two policy variables: the responsiveness of the enforcement agency to whistleblowers and the size of the sanction for violating the law.  Outside economics there is an extensive literature on whistleblowing in the areas of sociology, psychology, business, and public administration (see surveys in Miceli and Near 1992 and Miceli, Near and Dworkin 2008).
There is a small informal literature on paying witnesses. Posner (1999) discusses expert witnesses who are paid by parties, noting the risk that they may mislead judges and juries, but concluding that this risk is low since expert witnesses are repeat players and therefore have a financial interest in preserving a reputation for being honest, and because they must satisfy the methodological standards in their field and be subject to intense scrutiny by the opposing party. Friedman and Kontorovich (2011) argue that fact witnesses should be paid, since this will increase the number of people actually witnessing an event. Though they acknowledge the risk that such payments may lead to increased incentive for perjury, they argue that the incentives to perjury may already be high under the current regime, where the primary producers of testimonial evidence are interested parties, and therefore witness payment could reduce the proportion of perjured testimonies. Furthermore, they argue that unlike expert witnesses, fact witnesses do not need to curry client favor, since they are not repeat players, and that the increase in the number of people witnessing an event due to the payment may reduce the likelihood of perjury. Levmore and Porat (2012) discuss the prohibition on monetary payments to witnesses, noting that such payments may induce false testimonies, but arguing that the most useful explanation for this prohibition is that monetary payments give witnesses monopoly power.
The paper proceeds as follows. Section 2 provides an overview of the different whistleblower laws in the U.S., showing a trend towards an increased reliance on whistleblowing as a law enforcement strategy. Section 3 develops the model, and analyzes the optimal whistleblower reward and its determinants. Section 4 analyzes the choice between employing police officers and rewarding whistleblowers as law enforcement strategies. Section 5 extends the analysis in the paper, and considers the joint employment of whistleblower rewards and police officers, a sanction for unsuccessful whistleblower reports, the employer bribing the employee not to report a violation of the  law he witnessed, and the payment of a whistleblower reward in an equilibrium in which the employer is deterred. Section 6 offers three concrete policy implications of the model, and Section 7 concludes.