Traditional anti-fraud measures can’t deal with systematic financial misconduct. Lawyer and superannuation executive David Galloway, writes in praise of the Dodd-Frank legislation.
Confronted with systemic financial misconduct on an unprecedented scale during the GFC, US law makers paused to ask why it occurred and came to what seemed like startlingly obvious conclusions.
Firstly, they reasoned that perpetrators were rewarded for their misdeeds and tended to be in positions of power, while those determined to do the right thing were on a hiding to nothing.
They also observed that some financial misconduct really was very astute, and wondered how to harness that ingenuity to prevent and detect fraud.
The result was a new approach based around s922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, in which a specially constituted commission was authorised to pay rewards (called awards) to whistle-blowers who provide original information leading to successful enforcement action yielding monetary sanctions over $1 million.
In other words, Congress put a bounty on the heads of perpetrators and declared open season on fraud.
While the law is considerably more nuanced, the idea came right out of an old “headum off at the pass” western and the results are difficult to argue against. In the 2011 financial year 334 reports of financial misconduct were made, which shot up to 3,001 the next year and 3,239 in the period to 30 June 2014.
Despite strict confidentially laws, enough information is available to be reasonably certain most of these reports relate to misconduct that was unlikely to be discovered using traditional anti-fraud measures. So, has Congress found a way to uncover future financial calamities before they inflict maximum damage?
Publicly available information confirms that reports made relate to a very broad range of complex financial misconduct, with the top three categories of misdeed being fraudulent corporate financials & disclosure (17 percent), fraudulent securities (17 percent) and market manipulation (16 percent).
Just as important is the range of individuals making use of the scheme. In September 2014, $300,000 was paid to a compliance professional who had made repeated attempts to deal with serious misconduct internally, while more than $30 million was paid to a whistle-blower who seems to have been on the fringe of a technically sophisticated fraud described as “very difficult to detect”.
The latter is particularly important because it breaks the business model on which large scale financial misconduct depends. Complex fraud is almost never perpetrated by a lone wolf. It requires at least the acquiescence of others, often obtained through intimidation or payment. But if the rewards of speaking up are so great that even co-conspirators can no longer be trusted, then the scope for large scale financial misconduct must be reduced.
Nor is this the only large scale fraud to be brought undone. The first award was paid on 21 August 2012 to an individual who identified a well organised multimillion dollar fraud. Later a large award was paid to three people who helped detect a sham hedge fund.
Interestingly, coverage of this case suggests the recipients were motivated to actively seek out evidence of wrong doing in order to obtain an award. The same may have occurred in the case of a $14 million dollar award approved on 1 October 2013 for detection of yet another complex mega fraud. Welcome to the age of financial bounty hunting.
Why it works
The Dodd – Frank scheme shows that, while financial markets have not transformed themselves into paragons of virtue following the GFC, systemic financial misconduct can be aggressively attacked given the right tools. But success relies on more than awards.
Only around 0.4 percent of reports lodged to date were made with a request to receive an award, meaning the majority were made for other reasons. Indeed, the scheme’s success seems to rest on three pillars.
Awards: To keep perpetrators nervous and motivate others to uncover what perpetrators are frantically trying to hide.
Confidence: The investigative model used more closely resembles a police investigation than a regulator inquiry, giving individuals confidence their reports will be followed-up with vigour. It’s also important that Congress has direct oversight of the program to ensure any investigative inertia is quickly called to account.
Confidentiality: Dodd – Frank includes a range of protections for whistle-blowers which are stronger than, but not dissimilar to, those appearing in the Corporations and SIS Acts.
These three elements, together in a single coherent legislative package, have helped undo multiple frauds that would have otherwise gone on to do far greater damage. They may not be the entire answer to systemic financial misconduct, but they’ve already proven more effective than relying on traditional methods alone.
Will it work here?
A plethora of reasons were put forward to explain why the Dodd – Frank award system wouldn’t work in the US, and all have been proven wrong. But that won’t prevent them being trotted out yet again in Australia.