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.