Earlier I wrote a piece about the SEC's new suggestions for preventing Madoff-esque hedge fund fraud. A few I liked, a few I didn't. But I unabashedly professed my love for the idea of enhancing bounties for tips that lead to catching fraudsters. As promised, I wanted to expand on why that idea is so good.

Empirical data would actually suggest the opposite: bounties have not been particularly successful for the SEC. The letter from Inspector General Kotz says:

Although the bounty system has been in place at the SEC for more than 20 years, there have been relatively few awards made.



But it continues:

The SEC program is limited to insider trading cases, and the stated criteria for judging bounty applications are broad, somewhat vague and not subject to judicial review.



It seems completely obvious that a similar bounty system should be applied to all cases of securities fraud. Legal obstacles to obtaining those bounties should be removed. Those bounties should also be generous. After all, many whistleblowers could be risking their jobs.

How generous? That's where it gets sticky. I think the tattle should receive the greater of some set minimum award or a larger size proportion-based reward if massive fraud is discovered. I'll leave it up to others to work out those details, but even smaller cases of fraud need to be brought to light, so that minimum is important.

The problem, of course, is that if you have a flood of tips coming in, then the SEC might not be able to manage the workload. The simple solution here is to hire more people. Still, you don't want to waste resources chasing bad leads. But there are ways to cope with that problem. Perhaps a small tip fee of, say, $100 could be required along with your tip. That $100 will be repaid as part of the bounty once your tip checks out. This would result in discouraging bad tips, but not good ones. There might be better methods of discouragement out there, but this is one suggestion.

Another barrier I see has to do with relationships involving confidentiality. For example, if you are a lawyer and realize that one of your clients is running a Ponzi scheme, can you rat him out? I consulted a few law professors about this. Apparently, the SEC has actually insisted that some of its own rules require breaches of confidentiality under some circumstances. Securities fraud seems like an obvious circumstance that should require such a breach. Lawyers could not ethically collect a bounty, but if the SEC decided to compel them to come forward when learning of fraud, then the threat of law would fall upon them instead.

In general, any duties to confidentiality should be ignored when it comes to securities fraud. I don't mean to sound like a utilitarian, but in any professional capacity, if you realize that fraud is occurring that affects dozens or hundreds of people, your duty should be to the people getting swindled -- not to the fraudster. This shouldn't damage the credibility of professional relationships. Honest businessmen would have nothing to hide anyway. It would just mean that white collar criminals would have a harder time finding business associates they could trust. I'm okay with that.

As I mentioned in my earlier post, encouraging people who learn of fraud to come forward is tremendously more effective than trying to discover it from scratch. Well thought out fraud can be very difficult to detect. That's why someone on the ground, close to the parties committing the fraud is more likely to stumble upon it sooner. But if an insider realizes what's going on, s/he needs some kind of significant incentive to come forward.

Is there a fear that we could be come a nation of tattlers? Not really. Ever since elementary school, it's been insulting to be considered a tattletale. I've always found that strange. Whistleblowers that help bring criminal activity to light deserve our praise, not our condemnation. I'd much rather live in a nation of tattlers than a nation of fraudsters.

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