by Michael Connor

Whistle-Blower_iS_000007907470Whistle-blowing by employees and insiders is a “useful mechanism” for uncovering corporate misbehavior, with clear economic and governance impact on the companies involved, according to a new academic study.

“Whistle-blowing allegations had an immediate negative economic consequence for target firms,” the study found.  On average, the stock price of a target company fell 2.8 percent in the five days around the day an allegation became public and even more severely – an average of 7.3 percent – when the whistle-blower alleged “earnings management.”

The paper – Whistle-Blowing: Target Firm Characteristics and Economic Consequences – was written by Robert Bowen and Shiva Rajgopal, Professors of Accounting at University of Washington, and Andrew Call, Assistant Professor of Accounting at the University of Georgia.  Highlights of the paper were first posted on the Harvard Law School Forum for Corporate Governance and Financial Regulation.

In the wake of scandals at Enron, WorldCom and other companies, the Sarbanes-Oxley Act of 2002 incorporated provisions to encourage and protect whistle-blowers, including requirements for whistle-blowing “hotlines” that facilitate employee reporting.  The paper addresses critics who have argued that whistle-blowers often misjudge a situation and “indulge in trivial or frivolous complaints.”

“Our results suggest whistle-blowing is far from a trivial nuisance for targeted firms,” the paper reports, and provide “indirect evidence on the efficacy” of whistle-blowing protections in the Sarbanes-Oxley Act.

The researchers found that whistle-blowing generally led to more earnings restatements, more shareholder lawsuits, and “relatively poor operating and stock return performance” compared to other firms.  “Whistle-blower allegations appear to be an early indicator of future negative economic consequences for targeted firms,” the study found.

On average, whistle-blowing targets exposed in the press “improved several dimensions of governance relative to the year before the whistle-blowing event” and relative to a matched sample of control firms.   Those governance improvements were not apparent for firms subject to whistle-blowing allegations that were not widely disseminated, the researchers said.

High-growth companies and those with strong stock market performance are more likely to encounter whistle-blowing, according to the study, as are those that have recently made reductions in work force.  “Employees, especially former employees who have been let go, are more likely to make public allegations following layoffs,” the paper says. “Further, layoffs can increase the animosity between the firm and existing employees, and if existing employees perceive their job as being less secure, the potential cost of blowing the whistle decreases.”