Getting the word out about fraud: a theoretical analysis of whistleblowing and insider trading.

• Author: Macey, Jonathan R.

The purpose of this Article is to show that corporate whistleblowing is not analytically or functionally distinguishable from insider trading when such trading is based on "whistleblower information," that is, the information a whistleblower might disclose to the authorities. In certain contexts, both insider trading and whistleblowing, if incentivized, would reduce the incidence of corporate pathologies such as fraud and corruption. In light of this analysis, it is peculiar that whistleblowing is encouraged and protected, while insider trading on whistleblower information is not only discouraged but criminalized. Often, insider trading will be far more effective than whistleblowing at bringing fraud and corruption to light, both because insider trading is more credible and because it does not depend on the efficiency of government actors. Whistleblowing and insider trading on whistleblower information, however, are different from blackmail, which also involves information about a third party's illicit conduct. While both whistleblowing and insider trading on whistleblower information should be encouraged, blackmail should be prohibited because it impedes the discovery of fraud and corruption. Finally, despite the theoretical similarities between whistleblowing and insider trading, there are some important practical differences in the ways that whistleblowing and insider trading affect markets, indicating that these activities are complements rather than substitutes in the fight against fraud and corruption.

TABLE OF CONTENTS INTRODUCTION I. DEFINING WHISTLEBLOWING A. Our Venerable Tradition of Compensating Whistleblowers B. Self-Interested Behavior and Whistleblowing 1. Sherron Watkins--A Paradigmatic Whistleblower? 2. Analyzing Sherron Watkins' Actions II. INSIDER TRADING AS WHISTLEBLOWING A. Dirks v. SEC B. Lessons from Dirks III. INSIDER TRADING AND WHISTLEBLOWING: IS THE COMBINATION THE NORM? IV. CREDIBILITY, PAYOFFS AND RELIANCE ON OTHER MECHANISMS OF CORPORATE GOVERNANCE A. The Failure of External Corporate Governance Mechanisms B. The Failure of the Media to Expose Corporate Fraud C. Whistleblowers' Failure to Communicate D. The Effects of These Failures on Whistleblowing: The Relative Payoffs of Whistleblowing and Insider Trading V. INSIDER TRADING, WHISTLEBLOWING, PROPERTY RIGHTS, AND LAW A. The Law of Insider Trading and Its Foundations in Property Rights B. Legal Lessons for Trading on Whistleblower Information: Creating Incentives C. What Kind of Information Qualifies as Whistleblower Information? VI. WHISTLEBLOWERS AND INSIDER TRADING: SOME DIFFERENCES A. The Need for Public Securities Markets B. The Timing Problem VII. WHO PAYS FOR WHISTLEBLOWING AND INSIDER TRADING: FAIRNESS WORRIES AND DISTRIBUTIONAL ISSUES A. Fairness B. Distributional Concerns VIII. WHISTLEBLOWING AND INSIDER TRADING: CORPORATE GOVERNANCE AND CONTRACTING ISSUES IX. WHISTLEBLOWING AND INSIDER TRADING ARE NOT BLACKMAIL CONCLUSION INTRODUCTION

Over the past five years, it appears that whistleblowing has become fashionable. Whistleblowers, who traditionally have been considered tattletales and otherwise viewed with suspicion, (1) have recently enjoyed a distinct rise in popularity. As Salon observed not long ago:

In recent years, aided in part by movies like "The Insider," whistle-blowers have attained the status of folk heroes. "It's become popular to protect whistle-blowers--that's never happened before," says Danielle Brian, executive director of the Project on Government Oversight, a nonprofit public interest group dedicated to exposing governmental corruption and mismanagement that works closely with whistle-blowers and that advocates for them. (2) Time magazine called 2002 "The Year of the Whistleblower," honoring "inside do-gooders who risked their careers" (3) to expose, among other things, how the FBI lost a key terrorism suspect before the terrorist attacks of September 11, 2001, and how Enron misled investors through phony accounting treatment of off-balance sheet transactions. There is even a National Whistleblower Center, a nonprofit group dedicated to helping whistleblowers in their efforts "to improve environmental protection, nuclear safety, and government and corporate accountability." (4)

It is still probably the case that whistleblowing is "a form of organizational dissent." (5) But the recent positive publicity for whistleblowers suggests that whistleblowing is now viewed with less suspicion--and whistleblowers as less politically motivated and more altruistic--than was true in the past. Whistleblowers are now thought of as an integral component of the recently re-regulated system of corporate governance that is supposed to result in better monitoring and control of managerial misconduct (agency costs) in large, publicly held corporations. (6) Tip-offs from insiders have been described as "by far the most common method of detecting fraud." (7)

The purpose of this Article is to suggest that whistleblowing and one particular kind of insider trading--namely insider trading on the basis of information about corporate corruption, corporate fraud or other illegal corporate conduct--are analytically and functionally indistinguishable as responses to corporate pathologies such as fraud and corruption. This, in turn, explains why whistleblowers are sometimes viewed with suspicion and distrust, not only by their colleagues but also by regulators and journalists.

When giant businesses like Enron, Adelphia, or WorldCom are brought to their knees by whistleblowers, innocent people are harmed. The innocent employees, small suppliers, local communities, and philanthropic organizations that depended on these firms suffer as much, if not more, than the firm's largely diversified investor base. These groups single out the whistleblower as the source of their trouble. Revelations by whistleblowers can be embarrassing to regulators, prosecutors, and others who are supposed to be alert for fraudulent corporate activity.

Conversely, it also is the case that inside traders sometimes have fared surprisingly well in the courts. In particular, in cases where insider trading leads to the same revelations about incipient fraud as whistleblowing would, courts can be remarkably accepting of such trading. (8)

In this Article, I advance the theory that both whistleblowing and insider trading are best analyzed as involving rights in the same inchoate intellectual property: valuable information. Whether one has the right to blow the whistle on somebody else and whether one has the right to trade on the basis of nonpublic information ultimately depends on whether the person engaging in the conduct has a rightful property interest in the information he or she is using. If so, then the conduct, whether characterized as whistleblowing or insider trading, should be not only legally permissible, but affirmatively encouraged. By contrast, in situations where the person doing the trading or the whistleblowing has no legitimate property interest in the information, the behavior should be illegal.

Part I offers a definition of whistleblowing and a history of the government's efforts to encourage the practice, including an analysis of perhaps the most famous case of whistleblowing: Sherron Watkins and Enron. Part II compares insider trading and whistleblowing. This comparison explains the traditional antipathy and suspicion toward whistleblowers. In Part III, I explore whistleblowing and insider trading as phenomena that often occur in tandem. Part IV demonstrates why whistleblowers lack credibility and explains that verifying the assertions of nontrading whistleblowers is likely to be very costly. In Part V, I discuss the implications of a property-rights regime for insider trading and whistleblowing, as well as the legal regimes dealing with each. I then show how insider trading on negative information, when properly regulated, is a superior substitute for whistleblowing. The argument here is not that insider trading should be generally permitted or that such trading is universally beneficial to shareholders, companies, or society. Rather, the argument is that the limited and tightly regulated ability to "sell short" can credibly signal to the market that the trader has negative information about a company. (9) Part VI considers why, in light of this analysis, we observe such radically different treatment of whistleblowers and inside traders. In Part VII, I look at the distributional concerns of insider trading and of whistleblowing for the investors of a company, exploring who actually pays for these practices and their effects on the company. Part VIII explains why the private contracting process within firms is not likely to permit the sort of trading advocated here, thereby making it necessary to accomplish the result by regulation rather than by intrafirm contracting. Part IX briefly discusses blackmail as a method for reacting to confidential or secretive information about corporate fraud and compares this reaction to that of whistleblowing and insider trading.

1. DEFINING WHISTLEBLOWING

   A whistleblower is an employee or other person in a contractual relationship with a company who reports misconduct to outside firms or institutions, which in turn have the authority to impose sanctions or take other corrective action against the wrongdoers. (10) While some definitions of whistleblowing require that the misconduct be reported to people outside the organization, other definitions also include reporting misconduct up the chain of command within an organization. (11) Where one is blowing the whistle against an entire way of doing business or against people at or near the very top of a company, as was the case with Enron, reporting the behavior up the chain of command is not actually whistleblowing. After all, it is hardly whistleblowing to report misconduct to the very people engaged in the misconduct. But where the misconduct...