The federal bureaucracies are hard at work churning out rules to implement the Dodd-Frank financial “reform” act. In May the Securities and Exchange Commission announced rules for its new whistleblower program, which rewards individuals who provide the agency with “high-quality tips that lead to successful enforcement acts.”

The minimum amount of recovered funds that can earn a reward is $1 million, but the sky’s the limit on the upside. The whistleblower gets to keep 10 to 30 percent of the amount collected, including fines, interest, and disgorgement of ill-gotten gains. We’re talking about big game here, with awards conceivably topping $100 million.

Eric Havian, an attorney with a law firm that represents whistleblowers, noted in an interview with the San Francisco Chronicle’s Kathleen Pender that the securities laws cover a “huge category of bad conduct,” such as illegal insider trading, cooking the books, market manipulation, stock option back-dating, false or misleading disclosures, and the deceptive sales of securities. Almost anything potentially can be illegal, and these vaguely defined offenses leave much room for government mischief. As for insider trading, this is a practice that does little harm and may actually provide benefits to small investors. (See my January/February 2011 Freeman article, “Inside Insider Trading.”)

If corporations felt they needed limits on insider trading or other conduct to attract shareholders, they could write prohibitions into their bylaws so that violations, if not settled internally, could be remedied under civil law.

The mind boggles at the incentives the whistleblower program establishes. Law firms must be gearing up already to coach whistleblowers in the fine art of identifying and documenting actions that can be gussied up into plausible cases. It would make sense for law firms to take cases on a contingency basis because this sort of lawyering could be very lucrative. The SEC staff, concerned primarily with covering its collective rear end, will shy away from dismissing all but the most frivolous cases.

The road to riches will not be short or direct. Many years could elapse, if only because of bureaucratic inertia, between the time of filing and the bestowal of an award. “There will be more people struck by lightning in a given year than will get a check from the SEC in the next five to ten years,” cautioned Tim Mazur of the Ethics and Compliance Officers’ Association. But once the first awards hit the headlines, “a lot of people will start paying attention,” he added (San Francisco Chronicle).

All whistleblowers run the risk of retaliation from their employers, but in today’s climate this risk seems minimal. Besides, complaints may be filed anonymously.

Whistleblowers will lose their incentive to pursue complaints through their companies’ internal review process, an avenue that could correct any genuine wrongdoing relatively quickly. With such a massive potential pot of gold beckoning, why not wait and let the supposed wrongdoing fester for a while?

To be sure, the SEC rulemakers are aware of at least some perverse incentives. The website announcement contains a section headed, “Avoiding Unintended Consequences,” which excludes certain people from eligibility. The SEC also says information presented must be the whistleblower’s independent knowledge or analysis. But these limits seem to leave enough space to drive a truck through, and the truck drivers are revving their engines.

New Uncertainty

Of course corporate officers will be aware of the new incentives for whistle-blowing, which may well make them more cautious about taking on the risks of new or expanded production. Too bad. Investment is exactly what the country needs to get out of its economic funk. New uncertainty will further delay recovery.

Meanwhile, government whistleblowers aren’t doing nearly so well. Thomas Drake, a National Security Agency employee, found hundreds of millions of dollars being squandered on failed programs and tried to expose them. He did not leak any classified information, and he tried informing his bosses, the NSA inspector general, the Defense Department inspector general, and congressional intelligence committees before taking his findings to the Baltimore Sun. Rather than a pile of cash, Drake’s reward was an indictment on ten felony charges that could have gotten him many years in prison. But earlier this month, following a New York Times article on his situation and a judge’s ruling that certain classified information which prosecutors wanted to use against him could not be kept under wraps, all charges were dropped in a deal in which he pleaded guilty to one misdemeanor.

A recent petition signed by 20 noted whistleblowers calls for rescinding a “Transparency Award” given to President Obama recently. The President “has invoked baseless and unconstitutional executive secrecy to quash legal inquiries into secret illegalities more often than any predecessor,” the complaint noted. “Ignoring his campaign promise to protect government whistleblowers, Obama’s presidency has amassed the worst record in U.S. history for persecuting, prosecuting and jailing government whistleblowers and truth-tellers.”

But hey, we should just be glad the feds are protecting us from those nasty corporate insiders.

[Editor’s note: this essay first appeared in the Freeman on Sept 21 2011]