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Investors respond negatively to whistle-blower allegations

Firms accused publicly of financial fraud by whistle-blowers may deny the charges vehemently, but investors take them very seriously.

This according to new research developed at the University of Washington Foster School of Business and published in this month’s issue of The Accounting Review. The study demonstrates that media reports of such allegations lead to multiple woes for targeted companies, including a significant depression of their stock prices not just for days, but for years.

Attention to whistle-blowing has heightened dramatically in the decade since insiders helped reveal accounting scandals at Enron and WorldCom. The subsequent Sarbanes-Oxley Act of 2002 included provisions to protect employee informants. But critics have downplayed the impact of whistle-blowers, suggesting they often misjudge a situation or lodge frivolous charges in an attempt to exact revenge.

Whether accurate or not, whistle-blower charges should not be taken lightly, according to study co-author Robert Bowen, the PricewaterhouseCoopers Professor of Accounting at the Foster School of Business, who carried out the study with Shiva Rajgopal of the Goizueta Business School at Emory University, and Andrew Call, a former Foster School doctoral student now at the Terry College of Business at the University of Georgia.

“Our results suggest that whistle-blowing is far from a trivial nuisance for targeted firms,” Bowen says.

Truth or economic consequences

The authors analyzed 218 employee whistle-blowing events between 1989 and 2004, initially focusing on the stock performance of 81 companies whose whistle-blower allegations of financial misconduct were reported in the media. They found that, in the five days after the allegations became public, share prices of the accused companies fell 2.8 percent on average, compared to the market as a whole. Relative prices dropped even more steeply—7.3 percent—when the allegations concerned earnings management.

In the two years following media accounts of whistle-blower accusations, the accused firms issued more earnings restatements, fought more shareholder lawsuits and produced poorer operating and stock performance than similar firms during the same period.

“Whistle-blower allegations appear to be an early indicator of future negative economic consequences for targeted firms,” Bowen says.

Power of the press

Analysis of a second sample—137 firms that were the targets of complaints relating to financial misconduct registered privately with the Occupational Safety and Health Administration (OSHA)—suggests that whistle-blower cases exposed in the media weigh more significant costs and repercussions than do cases not reported in the media.

Companies that were the object of media-reported, whistle-blower scandals were significantly more likely to subsequently improve corporate governance than other comparably-sized firms in the same business or a similar business. They also were much more likely to replace their CEOs, to reduce the size of their boards, and to lower the proportion of insider directors and directors with three or more additional board memberships.

“These governance improvements were not apparent for firms subject to whistle-blowing allegations that were not widely disseminated,” Bowen says.

Characteristics of whistle-blown firms

The researchers also learned a good deal about the type of company vulnerable to fraud charges by employees.

Whistle-blowers tend to target firms that are large, growing, successful and highly regarded. Recently downsized firms, and those with slack governance are more likely targets as well. And, perhaps not surprisingly, employees are more likely to go public with allegations of corporate malfeasance when they potentially benefit from a share in any fraud-related settlement.

The study, “Whistle-Blowing: Target Firm Characteristics and Economic Consequences,” appears in the July issue of The Accounting Review. The paper received the 2008 Glen McLaughlin Award from the University of Oklahoma for the best unpublished research in accounting ethics.