Markopolous is the kind of guy who, as Felix Salmon puts it, “when reading public documents, can see ideas which are invisible to most people’s eyes.” Most famously, he correctly suspected that Bernie Madoff’s operations were fraudulent—and reported his suspicions to securities regulators, who brushed them aside.
What Markopolous noticed here was that pension funds using outside money managers for foreign exchange transactions reported slightly lower earnings than the managers themselves. This implied that the money managers weren’t giving the pension funds the best deals available.
After a little probing around, Markopolous began calling traders inside of banks and telling them, “I have a better job for you.”
That job was becoming a spy inside of the bank to help Markopolous and his team build a case for fraud. It was a better job, for the most part, because it had the potential to pay very, very well. New whistle-blower rules may allow Markopolous and his team to collect up to 25 percent of the amount the government recovers in the cases. All totaled, the various lawsuits against BoNY are seeking $2 billion.
In short, the whistle-blower rules may make Markopolous and his moles very wealthy men. This will allow him to recruit more spies. Stories like Mollenkamp’s in the Journal are great advertising for Markopolous’s private anti-fraud intelligence agency.
It’s likely that Markopolous won’t have this business to himself for very long. As whistle-blowing becomes more lucrative, more investigators will get into the business of actively recruiting human assets inside of corporations.
There will no doubt be some heavy backlash against the anti-fraud investigators. The profit-seeking nature of these operations will allow corporations and politicians to target them as having unclean motives. It may even make government regulators hesitant to bring these cases, worried that they are becoming tools of profiteers rather than honest servants of the public interest. (That Markopolous was seeking to profit from exposing Madoff apparently played some role in the SEC’s refusal to take his claims seriously.)
I think these complaints are largely misplaced. The desire for financial profit is no worse a motivation for investigating fraud than, say, the motives of a regulator inside a bureaucracy. In fact, they may be a good deal better. A regulator can advance not by bringing the most important cases or those most likely to succeed, but by bringing cases most likely to be held in high regard by his superiors. Focusing on, say, insider trading to the expense of less-showy types of securities law violations.
What’s more, many of those inside of government bureaucracies came out of the private sector and hope to eventually take a role in the private sector once again. This aligns their interests with the very firms they are seeking to regulate. A private investigator like Markopolous has no need to work for the firms he investigates—he can get rich without changing jobs.
One complaint against the whistle-blower reward rules is that they could create a perverse incentive for whistle-blowers and outside investigators to let fraud continue and grow, which would then push up the value of the eventual anti-fraud case. But in a robust anti-fraud market, this would be tempered by competition from other investigators. If one team of investigators decides to let a fraud fester, another might bring the case first.
Companies will need to find a way to respond to this developing market for fraud detection. Some will no doubt react stupidly, by attempting to prevent employees from being contacted by private investigators. Shareholders and customers of companies that go this route should take notice—the company would be essentially advertising itself as less well policed than its competitors. Strong anti-anti-fraud policies might be a good indicator for which companies short-sellers should target.
A far better response would be for companies to offer internal rewards that compete with those offered by the likes of Markopolous. If an employee detects fraud, he should be incentivized to immediately bring it to the attention of his employer’s internal anti-fraud squad. In return for reporting the fraud, he should be offered a handsome payout. The attraction of this would be the relative savings available to a company that can internally stop fraud and reach settlements with fraud victims—as opposed to having to fight government enforcement actions in court.
This too would likely cause some political backlash. You can easily imagine that companies could be accused of bribing employees to keep quiet about wrong-doing. That is why internal policing would have to be accompanied by public admissions and publicly reached settlements with victims.
One problem I can anticipate now is that as private anti-fraud enforcement becomes a bigger business, it will inevitably become a political force as well. The private anti-fraudsters will lobby for harsher fines and a bigger share of the pie. Their interests, in other words, will not be aligned with the public’s—which could result in a system in which we’ve over-incentivized anti-fraud investigations.
Our current securities law and corporate governance system really wasn’t set-up with such large whistle-blower rewards in mind. We may already be over-incentivizing anti-fraud activity, encouraging frivolous cases and fines that don’t reflect the seriousness of the wrong-doing. We don’t want to replicate the problems with created in other areas of the economy—such as health care’s malpractice burden—with our whistle-blower laws.
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