Study Finds Whistleblowers are the Fraud-Finding Pros

Back in the fear-infused days of fall 2001, when it seemed that a plane full of terrorists and Anthrax-wielding snipers was lurking around every corner, a whistleblower was helping to uncover the Enron scandal–just before the company imploded. Sherron Watkins was Vice President of Corporate Development at Enron, and she identified serious problems at the company and brought these issues to the attention of CEO Kenneth Lay (who of course proceeded to do his own thing). Watkins later testified before Congress and the Senate in the aftermath of Enron’s meltdown.

Enron and other corporate frauds piqued the interest of academia, and now a new study in The Journal of Finance has found the best fraud “sniffer dogs” in the corporate world are not regulators but whistleblowers–specifically employees. The study is entitled “Who Blows the Whistle on Corporate Fraud?”. The authors, finance professors Alexander Dyck, Adair Morse, and Luigi Zingales, were intrigued by the fact that the legislature acted quickly to fight corporate fraud by enacting the Sarbanes-Oxley Act (SOX), but no substantive research was ever conducted on who was actually identifying fraud.

The researchers analyzed 216 cases of alleged corporate fraud between 1996 and 2004, including Enron and its loathsome brethren in fraud, WorldCom and HealthSouth. Their most important conclusion was that employees were the whistleblowers in 17 percent of the cases–more than any other actors. Employees were far more effective in identifying fraud than the SEC–the government agency responsible for regulating the securities industry. In fact, the SEC detected only 6.6 of the fraud cases, ranking behind analysts (13.8%) and short sellers (14.5%).

The second major conclusion of the study is that there is little incentive for most whistleblowers to uncover fraud. One researcher notes that

Auditors, analysts, and employees do not seem to gain much and, in the cases of employees, seem to lose outright from whistleblowing.

The only actors who seem to benefit outright from being whistleblowers are journalists involved in major cases and (drumroll) employees who have access to a qui tam suit. The researchers conclude that there should be more financial compensation structures for whistleblowers who come forward, which they describe as “sharpening the incentives of those who are endowed with information.”

This study provides important empirical evidence regarding the essential role qui tam whistleblowers  play in today’s regulatory environment. Hopefully legislators will pay attention and expand the system of monetary incentives to reward more corporate fraud finders. Employees who blow the whistle on corporate fraud have the most to lose from their actions, so they deserve to be compensated for doing the right thing.