The whistleblower rules and insider trading

Larry Ribstein —  25 May 2011

The SEC has adopted Dodd-Frank whistleblower rules (see Law Blog story) which have sparked controversy because they award bounties without requiring use of internal corporate reporting mechanisms. Whistleblower organizations are happy, corporations not so much.

It’s a good time to remember my proposal last year to let the whistleblowers trade:

The beauty of the insider trading approach to uncovering fraud is that it reduces the need for a lot of the Dodd-Frank whistle-blowing apparatus. The market decides through its price movements how important or original the information is and computes the insider’s compensation for disclosing it. While the insider might still worry about protecting his job, rewards from selling the information could make the disclosure worth the risk.

Another advantage of the insider trading approach is that it does not necessarily bypass the corporation as a first line of defense against employee fraud. The selling-induced stock drop could motivate honest executives to look into the cause of the decline and take action. The Dodd-Frank procedure always bypasses the corporation by rewarding only whistleblowers who bring new information to the SEC. * * *

This idea would not sit well with the SEC, which seemingly has made insider trading rather than Madoff-scale fraud its main target. There is a separate and broader issue whether the SEC’s and Congress’s obsessions with insider trading and short-selling perversely reduce the amount of information in the market and divert it from its main task. But whatever the SEC and Congress do about insider trading generally, they should at least consider using it as a weapon in the war against corporate fraud.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

2 responses to The whistleblower rules and insider trading

  1. 
    north fork investor 25 May 2011 at 3:00 pm

    This is not a terrible idea. Differentiating itself from the usual efficiency argument for insider trading, in this concept it is not the putting on of the trade that creates market efficiency; rather it is the incentives such trades give the inside trader to publically disclose once his inside trades are on.

    Unfortunately, the numbers probably do not work to provide an appropriate incentive to the party with the information to disclose.

    Only the big guys in the big corporations have the capital to put on positions large enough to profit from inside trading in the amounts the SEC rule visualizes for frauds causing substantial investor losses. The average middle manager in the trenches that sees the fraud simply cannot profit that much from inside trading and subsequent disclosures. Even using listed options if they exist on the securities subject to fraud. (Believe me the middle manager isn’t going to be trading otc derivitives, swaps or bonds.) So how can he take the risk that he will never work as a manager again.

    Nice effort at original thinking Professor. But a little abstract from the real world of trading

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