Incentivising Whistle-Blowers: Implications For Corporate Governance
The Companies Act (S.177(9)), requires every listed company to “establish a vigil mechanism for directors and employees to report genuine concerns in such manner as may be prescribed”, to the Audit Committee of a company. The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015 similarly requires such companies to institute a whistle-blower policy for their employees to report insider trading (Reg.9(6)).
A recent development in this area of Indian corporate law has been the notification of the SEBI (Prohibition of Insider Trading) Regulations Amendment 2019, which allows informants to directly approach SEBI to report insider trading. Reg.7D provides a monetary reward for the whistle-blower, amounting up to 10% of the proceeds collected, capped at Rs. 1 crore. This amendment, taking inspiration from the Dodd-Frank Act of 2010 from the United States, is a radical innovation in Indian Corporate regulation. This amendment came into effect 120 days after its notification, and the organisational set-up envisaged under the amendment was put into place by March 2020.
The introduction of the policy however introduces India to a broader debate on the desirability of such incentive mechanisms. Companies fear that incentivising external reporting will encourage employees to skirt internal reporting mechanisms and approach regulators at the first opportunity for monetary gain. Given that the amendment is still in its first year, coupled with the secrecy surrounding whistleblowing and pending SEBI investigations, it is difficult to pass an empirical judgement on the success of this mechanism. Existing literature on this development is thus limited to a textual and speculative outlook. This article seeks to contribute to this debate, through an interdisciplinary approach, by applying a law and economics perspective to test the various arguments advanced against the amendment.
This article argues that the ‘incentive’ mechanism for ‘external’ reporting as introduced by SEBI (Prohibition of Insider Trading) Regulations Amendment 2019, does not undermine the ‘internal’ vigil mechanism provided by Companies Act 2013 to the detriment of corporate governance. I first posit an economic model of whistleblowing, analyse the incentive mechanism introduced by the 2019 Amendment, and then address the common arguments against such incentives.
An Economic Model of Whistle-blowing
Whistle – blowers may be conceptualised as ‘rational’ agents, in the sense that they undertake a cost-benefit analysis before action. They report on their superiors/colleagues out of moral compulsion and concern for social welfare, gaining non-monetary ‘utility’ in this process. This is done after accounting for the transaction costs involved in reporting, probability of remedy and risk of censure/retaliation, and the personal cost for non-reporting (guilt). They have broadly 2 options available to them – external reporting (“ER”) and internal reporting (“IR”). ER involves reporting malpractices to the government regulatory authorities, while IR entails reporting to higher management, audit committees or independent directors, within the organisation.
For regulators, whistle-blowing acts as an efficient method of law enforcement, particularly for corporate crimes, where regulators are impaired by the information asymmetry that exists between an insider and an outsider to any given company. Compared to IR, ER has a higher deterrence effect on other corporations, as the resulting prosecution or sanction is public. This also contributes to social welfare.
For companies, IR presents less costs as compared to ER, in terms of allowing early detection, avoiding legal sanctions and reputational loss. Companies argue that IR mechanisms are more appropriate for timely interventions, prevention, self-reform, and are better suited to deal with frivolous complaints and avoid stock market distortions. However, IR’s underlying assumption is strong whistle-blower protection, that may not always hold true. In absence of specific standards and close monitoring, companies in India are lax in implementing strong reporting and audit mechanisms (Deloitte,2014), which make it necessary to rely on ER.
For employees, IR presents less transaction costs in terms of lower time, effort, evidentiary standard, and risk of censure. However, concurrent risks of inaction, identity exposure, retaliation and suppression may be present in some organisations. ER, on the other hand, involves higher transaction costs, in terms of time, effort, legal representation and evidentiary standards. However, it also affords better response and anonymity. This is reflected in the 2019 Amendment which stipulates requirements of submitting original information (Reg.7B) and identity protection (Reg.7H).
The 2019 Amendment
The amendment seeks to encourage whistle-blowing by increasing the ‘utility’ gained through monetary reward. In case of a weak IR culture and high ER costs, these rewards set-off the transaction costs of approaching regulators and increase probability of reporting. (This was empirically observed in the US, post 2010.) The increased reporting lowers investigation and prosecution costs for the state, and increases social welfare due to better enforcement of laws. The cost of monetary award on the state is offset by these benefits.
When reward is absent, employees do not have enough incentive to report externally, and thus the ER threat to companies is not credible. When the prospect of a reward incentivises employees to report externally, there is a credible ER threat. If employees first report internally, they lose the prospects of award, but are benefitted by low costs of IR, which compensates them for the ER reward lost.
1. Incentivising ER will lead to withholding of IR.
In the short-run, incentivising ER may lower IR. However, the marginal social benefit resulting from an increase in ER exceeds the marginal social loss from any short-term decrease in IR.
In the long run, since ER entails more costs for companies, incentivising ER will incentivise corporations to strengthen IR mechanisms to attract employees, creating a virtuous cycle, resulting in net increase in social welfare. As long as IR costs are kept lower than ER costs (minus potential reward), employees will continue to report internally.
Theoretically, a very high reward could cause employees to withhold IR, as now they would lose a higher net award compared to the non-monetary benefits of IR. However, the reporting requirements and Rs. 1 crore cap under Reg.7D in the 2019 Amendment pre-empts the same. It is thus a question of maintaining proper balance, the reward cap may be adjusted by SEBI in the future as necessitated by outcomes.
2. The law should adopt a facilitatory approach towards ER, instead of an incentive-based one.
It is argued that that rather than relying on monetary incentives to compensate whistle-blowers for likely ER cost (censure, career side-lining and dismissal etc.), the law should intervene to restrain the companies from inflicting these losses (costs). This approach involves granting private rights on whistle-blowing employees to sue their employers for these sanctions, such as an action for unfair dismissal under UK Law. However, enforcing such rights are a burden on the employee. Such ‘costs’ are not apparent, and are difficult to trace and prove in courts. Such remedy is more costly, prolonged and uncertain for employees.
A quicker, more efficient and credible remedy would be a monetary incentive. A guaranteed reward also ensures more certainty and facilitates decision making of potential whistle-blowers. It is perhaps in this spirit that Reg.7D also provides for grant of an interim reward, on the discretion of the board.
3. Incentives will encourage opportunistic whistle-blowers.
This argument is fallacious. Overwhelmingly, bona-fide whistle-blowers first report internally, in part due to higher transaction costs of ER. They approach regulators only when they fail to get a remedy internally, or in cases of systemic fraud where the integrity of the reporting authority of the company may also be compromised. This is because whistle-blowers are guided largely by non-pecuniary motives. A purely monetarily motivated employee may in fact choose to allow the activity or blackmail the company for higher gains, instead of reporting.
Moreover, the law itself has sufficient safeguards against mala-fide whistle-blowers in terms of defamation, malicious prosecution, perjury laws, etc. The 2019 Amendment empowers regulators to take action against frivolous complainants (Reg.7G). The risk of opportunistic claims can be reduced by strengthening these tools, rather than forego the potential of incentivising whistle-blowers.
A related argument made is that prior IR should be made conditional to any monetary award for ER, a requirement which is expressly excluded in the amendment (Reg.7E). Particularly in the Indian context, where there have been high-profile cases of systemic fraud with top-management involvement, such a condition is not appropriate and will only add to ER costs.
The ER-IR debate mirrors the broader relation between Public and Private Law enforcement. Ideally, both should play a complementary role. Incentivising ER will also encourage improving of IR systems. Thus, the incentive mechanism for ER under the 2019 Amendment is a step in the right direction, does not undermine IR, and results in net social welfare.
Such an incentive mechanism should also be extended to the reporting of other corporate offences, and be adopted in other regulatory contexts in the future.
† Devansh Kaushik is a III-year BA LLB Hons. student at the National Law School of India University
Image Credits: Fox School of Business