Worried About Whistleblowers? Try This.

By Adair Morse and Jo-Ellen Pozner

Forbes recently declared that  2014 would be “the Year of the Whistleblower,” while the Wall Street Journal essentially predicted that this would be the Year of the General Counsel  because corporations will face a lot of legal scrutiny.

These are related. Both the Internal Revenue Service and the Securities and Exchange Commission now have rules that offer potentially big bounties to individuals who expose corporate fraud. It’s a monetary incentive for employees and other insiders to blow the whistle, and it’s working. In both 2012 and 2013, the SEC recorded 3,000 whistleblower claims, many of which will be settled this year.

The pushback has already begun.  Corporate general counsels fear that the upcoming payouts will trigger a new wave of accusations. They also warn, and they may have a point, that an Orwellian cadre of snitches is likely to be bad for corporate culture.

On the other hand, it is also likely that those whistleblowers will expose and deter real fraud.   In a recent study with colleagues at the University of Toronto and the University of Chicago, we estimated that 14% of large public corporations are engaging in fraud and that the average exposed fraud costs investors about 20% of the firm’s value.   This is no trivial matter.

Let’s back up to the incentives for whistleblowing. A few years ago, we published a study in the Journal of Finance that documented how bad life becomes for employees who expose fraud.   Whistleblowers often become  unemployable and have to move to different cities, even if their accusations are proven correct,  because the fallout from their revelations often negatively impacts their communities. One of our main findings was that the fraud-deterrence system has to pay whistleblowers to go into retirement, a finding that Congress incorporated into the Dodd-Frank financial reform law of 2010.

In the SEC’s implementation of Dodd-Frank, whistleblowers remain protected by anonymity while their claims are being investigated.  Many corporate lawyers worry that this anonymity will make employees look at whistle-blowing as a risk-free free lottery ticket.  There is also a real possibility that the SEC will be overwhelmed by unsubstantiated or false allegations — 3,000 new cases per year is a large number, relative to 12,000 public companies and even to all 30,000 SEC registrants.

We could spend a lot of time debating the optimal formula for rewarding whistleblowers. Establishing more rigorous requirements or making the accusers’ names public would discourage informants who don’t have  evidence of substantial, prosecutable misconduct. But tinkering with the incentive structure is also likely to deter exposure of real misconduct, because the danger to a potential whistleblower’s reputation and career would be too high for all but a few people to justify.

A better approach would be for leaders in business and education to change corporate cultures on a larger scale.  It’s understandable that corporate general counsels worry about  employees becoming water-cooler Big Brothers. But leaders can use the opportunity of the SEC bounty program to reinforce healthy corporate values.  Companies can strengthen the norms  of honesty and fair play; encourage people to question assumptions and the status quo; facilitate beneficial task conflict; and reward openness and transparency. If they do that at every level of corporate life, business leaders (and those who educate future leaders) can do more than minimize the number of whistleblower accusations.  Strong corporate cultures can help deter fraud by avoiding the slippery slope of day-to-day malfeasance, which has been shown to lead to larger and more systemic deception.

We are not suggesting that whistleblowers will ever be celebrated within the companies they expose. But corporations should recognize that deterrence  means more than figuring out ways to inhibit fraud and snitching. Deterrence also requires  embracing the perhaps old-fashioned idea that employees should feel part of a culture of shared values, and that they will be rewarded for working together as well as for working in hierarchical competition.

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