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November 14, 2018
From: Harvard Business Review By Stephen Stubben and Kyle Welch

Some of the worst corporate disasters of the past two decades were heralded by whistleblowers: Sherron Watkins raised the red flag internally at Enron, Cynthia Cooper let management know of major accounting problems at WorldCom, and Matthew Lee brought problems to his management team at Lehman Brothers. The whistleblowers weren’t able to halt their companies’ declines and—in some cases—faced punishment for calling attention to internal misdeeds. Looking at these examples, it would be easy to say that whistleblowers have little impact on how companies both conduct themselves and weather corporate storms. But that’s not the case.

In 2018, NAVEX Global, the leading provider of whistleblower hotline and incident management systems, provided us secure, anonymized access to more than 1.2 million records of internal reports made by employees of public U.S. companies. Our analysis revealed that whistleblowers—and large numbers of them—are crucial to keeping firms healthy and that functioning internal hotlines are of paramount importance to business goals including profitability. The more employees use internal whistleblowing hotlines, the less lawsuits companies face, and the less money firms pay out in settlements.

Our conclusions are in many ways counterintuitive to how many executives manage complaints. Many companies continue to ignore—or misuse—whistleblower hotlines, and most don’t know what make of the information that is provided through them. Even when firms want to support whistleblowers, managers don’t know what to make of reported level of internal reports. Are more internal reports of problems a signal of widespread troubles within the firm? Research on external whistleblowing events, by Robert Bowen, Andrew Call, and Shiva Rajgopal finds that more external reporting events is associated with increased future lawsuits and negative performance. Does this finding on external reporting hold true for internal reporting events? Or do more reports instead reflect employees’ trust in management and a communication channel that allows management to more effectively prevent public disasters before they occur?

More whistles blown are a sign of health, not illness

We found that firms actively using their internal reporting systems face fewer material lawsuits and have lower settlement amounts than firms ignoring—or minimally using—similar information. While all firms are likely to have some frequency of issues, firms where these are reported early are more likely to address them before they become larger problems resulting in costly litigation.

We measured activity from the perspectives of employees and managers, assessing both the number of internal reports filed and the amount of information provided in each report. We also measured the number of times reports were accessed and reviewed by management. We found that a one standard deviation increase in the use of an internal reporting system is associated with 6.9% fewer pending lawsuits and 20.4% less in aggregate settlement amounts.

We also found that higher use of internal reporting systems is not associated with a greater volume of external reports to regulatory agencies or other authorities. This suggests that a higher volume of internal reports does not imply that problems at the company are more frequent or severe. Instead, internal reports indicate open communication channels between employees and management and a belief that issues raised will be addressed. At the same time, when employees do report externally, it reflects management’s failure to address issues internally.

Types of firms that actively use internal whistleblower hotlines

While the use of internal reporting systems, proxied by the number of reports filed, has increased over time, how those systems are used varies substantially across firms and industries.

What types of companies are actively using internal reporting systems? We saw a few common characteristics in our research. Using an index developed by Lucian Bebchuk, Alma Cohen, and Allen Ferrell in 2009, we found that firms with more powerful management—e.g., firms with governance protocols that limit shareholder power relative to firm leadership—are less likely to actively use their internal reporting systems. Fast-growing companies are also less likely to use their internal reporting systems, as are firms that show signs of potential earnings misstatements. Firms that are more active in using their systems tend to be more profitable (as measured by return on assets) than firms that are less active users of their systems.

We found that companies that more actively use their internal reporting systems can identify and address problems internally before litigation becomes likely. Significantly, our analysis shows that a one-standard-deviation increase in the use of an internal reporting system is associated with 3.9% fewer pending material lawsuits in the subsequent year and 8.9% lower aggregate legal settlement amounts. Over a three-year period, a one standard deviation increase was associated with 6.9% fewer lawsuits and 20.4% lower settlement amounts. Avoiding lawsuits is important for reasons beyond just the direct financial costs of legal defense and settlements. Although settlement costs can often be in the hundreds of millions of dollars, the hit to brand reputation and stock price can easily exceed all other out-of-pocket expenses. We found that in addition to reduced legal exposure, firms that more actively use their internal reporting systems are typically more profitable and have been in business longer.

What this means

In our discussions with compliance officers at firms, many executive leadership teams stated a “goal” to have zero reports. This is not hard to accomplish if you simply don’t make your employees aware of the system or comfortable using it. There is evidence that this is often the case: In 2014, Bruckhaus Deringer found that nearly 30% of managers in their survey reported that their company actively discourages whistleblowing.

Other executives seem to understand that having few or no reports signals a poorly used system, but they also seem to think that going beyond the industry average number reports is a sign that the firm has more problems than they should.

Our research provides strong evidence that neither of these assertions are true: high usage is more often a sign of a healthy culture of open communication between employees and management than a harbinger of real trouble. After all, all large organizations face a large amount of common, unavoidable, and unobserved problems. Internal reporting systems simply make those problems visible to management.

Managers should view hotlines as a critical component of traditional audit mechanisms and board of director meetings. The reports seem to be a valuable resource to identify and quickly address concerns arising within the firm. And regulators are on the hook, too. Given what we learned about how companies with strong internal reporting systems fair, regulators might rethink the recent prioritization of external over internal whistleblowing and provide greater incentives for companies to implement their own effective solutions.

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