Whistle-Blowing: Target Firm Characteristics and Economic Consequences

In our paper, Whistle-Blowing: Target Firm Characteristics and Economic Consequences, which is forthcoming in The Accounting Review, we document the first systematic evidence on the characteristics and economic consequences of firms subject to employee allegations of corporate financial misdeeds. Whistle-blowing has received considerable attention in recent years after (1) whistleblowers were responsible, in part, for revealing the accounting scandals at Enron and WorldCom, and (2) provisions in SOX were enacted to protect employee whistle-blowers. Still, little is known about the nature of firms that are subject to whistle-blowing and whether such allegations are economically significant events with meaningful consequences for the targeted firms. Unlike other research to date, our focus is on (1) characteristics of firms targeted by employee whistleblowers, (2) the economic consequences of such whistle-blowing revelations and (3) firm responses to such allegations via subsequent governance changes.

Specifically, we report new empirical evidence on 218 employee whistle-blowing events between 1989 and 2004. Our paper adds to the literature on corporate governance in four ways. First, we conduct a cross-sectional analysis of the characteristics of firms subject to whistle-blowing. Our evidence is broadly consistent with whistle-blowers targeting firms that were large, growing, successful and highly regarded. Whistle-blowing tended to be more prevalent in firms that had downsized and in firms with worse governance. Finally and not surprisingly, when the potential benefits to the whistle-blower increased (via the potential to share in any fraud-related settlement), employees were more likely to make public allegations of wrongdoing.

Second, we present evidence that, on average, whistle-blowing allegations had an immediate negative economic consequence for target firms. The average market-adjusted return in the five days around the day the allegation became public was -2.8%. Further, the stock market reaction was substantially more negative when the whistle-blower alleged earnings management (-7.3%).

Third, we find that whistle-blowing targets had more earnings restatements (Press sample), more shareholder lawsuits (Press sample), and relatively poor operating and stock return performance (press and OSHA samples) compared to a sample of propensity-score matched firms with similar characteristics. Whistle-blower allegations appear to be an early indicator of future negative economic consequences for targeted firms.

Fourth, we find that, 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. Interestingly, these governance improvements were not apparent for firms subject to whistle-blowing allegations that were not widely disseminated (OSHA sample). In sum, whistle-blowing is far from a trivial nuisance for firms targeted by allegations of corporate misconduct.

Our research represents early work on the role of financial whistle-blowing and provides indirect evidence on the effectiveness of Sarbanes-Oxley (SOX) Section 806 as a mechanism to expose agency problems at firms. We find that public whistle-blowing events are relatively infrequent, and a majority of the whistle-blowing allegations we identify are not directly related to the types of fraudulent behavior that precipitated the SOX legislation.

The full paper is available for download here.