When people hear the word “whistle-blower,” they think of a lone person doing the right thing in a company, firm or institution where there’s some sort of rampant corruption going on that only a sheriff in a white hat can fix.

But it doesn’t have to be that way. What if whistle-blowers were embraced as part of a prudent compliance culture in a company that is actually well run?

That’s the kind of company studied by researchers at George Washington University.

Their effor resulted in a report called “Evidence on the Use and Efficacy of Internal Whistle-blowing Systems,” which details a positive relationship between internal reporting and business performance.

According to Kyle Welch, the lead researcher on the study and an assistant professor of accountancy at George Washington University, companies that have systems in place to let individuals raise red flags have more responsive managements and are better at dealing with problems that may arise.

On the contrary, when the whistle-blowers are reaching outside the company for help, said Welch, it’s a sign that a company has more problems coming down the pike.

“Internal whistle-blowing is a completely different concept,” Welch says, in which “reports are made directly to people most capable of fixing the problem—and, instead of indicating future problems, it really means that management is more actively seeking feedback from employees.”

Welch pointed to the collapse of Lehman Brothers at the onset of the global financial crisis in 2008 as an example of a failed internal reporting system.

“They had a whistle-blower system, but material was being withheld from the board of directors,” said Welch. “They had a source of exogenous information in their Ernst & Young audits, but there were issues with the way those audits were conducted. The person who reported the issues was fired and the directors weren’t able to respond to the issues he had raised.”

The study suggests that there’s more at stake than running afoul of regulators. Companies with more active whistle-blower hotlines can reap competitive benefits as well: greater productivity and profitability in return on assets. It may be that strong, successful companies encourage their internal dissenters. Well-run companies, especially larger ones, likely already have a process in place encouraging employees to speak up more, Welch said.

“Larger and more profitable firms have more resources to throw at better governance,” he said, including hotlines for employees who can help companies prevent lawsuits and regulatory entanglements.

The more internal reporting activity there was at a company, the greater the increase in return on assets over the study period.

Company boards should be demanding data on internal reporting, he said, and compliance personnel should be putting this information in front of their directors alongside other measures of business performance.

Investors can’t typically get at that reporting data, Welch said, but they can take some lessons from the study, nonetheless.

“The ideal situation would be that whistle-blowing reports were made available to the public, but I don’t know if that will ever happen,” said Welch. “As stakeholders, investors benefit as a whole as companies become more informed about these systems and engage in better compliance and auditing.”

Are We Bad?

Of course, it might look to outsiders that a company has whistle-blowers only because it needs them—that it has more problems, in other words. So there’s a stigma people need to get past.

“There’s cultures where whistle-blowing is associated with really bad things and there are serious stigmas against whistle-blowing,” said Welch. “Your background has a lot to do with how you think about whistle-blowing. Then there’s this idea that somehow there’s a silver bullet manager who can solve all of a company’s problems and eliminate all reporting and complaints—but if you’re managing humans, you’re going to have problems. Whistle-blowing allows you to identify problems that you might not see otherwise.”

Welch and his fellow researchers used NAVEX Global’s database of internal reporting systems—the world’s largest—to study businesses with higher levels of internal reporting. NAVEX made available 3 million internal report records from 5,000 public companies covering a 14-year period from 2004 to 2017.

The study looked at firms actively using their internal reporting systems, at firms with more employees participating and at firms where staff was providing more information in their reports. The study also considered whether management regularly followed up on the reporting.

It's A Governance Issue

According to the study, firms with rapid growth, weaker corporate governance and weaker internal controls “were less likely to use their internal whistle-blowing system.”

If a company’s governance practices included staggered terms for board directors, limited shareholder rights and golden parachute payments for senior executives, these traits correlated with lower firm valuations.

“It’s somewhat easy to distinguish which firms are less concerned about whistle-blowing because their management is more ‘entrenched,’” Welch said, referring to companies with those poorer governance traits. “Thus, entrenchment can probably be used by investors as a proxy for the volume of internal reporting.”

According to Welch, firms with weak corporate governance are more likely to have executives powerful enough to stifle dissenting voices and internal reporting.

Firms with less reporting also tended to engage in more earnings techniques that inflate financial performance. For example, the lower the measured hotline usage within a company, the more likely a company was to use discretionary accruals to make judgments on cash flows, behavior associated with earnings management and manipulation.

Companies that more actively used the internal reporting system, however, saw fewer lawsuits filed against them and smaller awards and settlements.

“The average settlement is actually approximately 20 percent less for firms that were more engaged in internal reporting,” said Welch. “The relationship is pretty strong.”

Firms that don’t have robust and active whistle-blowing systems may instead pay the price other ways—by having their internal issues exposed in a negative news story or in the filing of a claim, said Welch.

“For most managers and directors right now, receiving zero internal reports isn’t a problem—but it’s easy to get zero reports by not telling anyone about the system,” said Welch. “The data we have says that the more reports you get, the more active your system, the better.

“Managers and directors need to do everything they can to capture these reports,” he added. “They need to solicit whistle-blowing. Put information about the system in the footnote of their e-mails. Start engaging directly with these systems much more than they have in the past.”