Does paying employees for blowing the whistle on corporate crime to regulators discourage internal reporting and undermine corporate governance? The answer is not as simple as it might seem. My research shows that, as the amount of reward increases, the probability of internal reporting rises at first but then falls.

The question has been discussed in countries that have introduced or contemplated the introduction of legislation to reward whistleblowers but has not yet been fully analyzed. One of the overlooked obstacles is that the standard of proof for external whistleblowing cases is higher than for cases of internal reporting, and thus collecting evidence for external whistleblowing takes more time. Since the harm caused by corporate crime may increase as time passes, many employees first report their concerns internally, based not on the possibility of a monetary reward but on the assumption that independent compliance departments will act. Then, if their concerns are not addressed, employees can blow the whistle to an outside enforcement agency.

The threat of external whistleblowing in the event that internal measures fail is an effective deterrent to corporate crime. Whistleblower rewards can strengthen that threat, but, if the expected reward is excessive, it can overshadow non-monetary incentives for internal reporting and prompt employees to seek monetary rewards and engage in external whistleblowing while refraining from reporting internally. In a recent paper, I provide an economic model and a new explanation for the relative roles that internal reporting and external whistleblowing play in the public and private enforcement of laws against corporate crimes.

Internal and External Reporting in Practice

Many surveys show that most whistleblowers first report internally before blowing the whistle externally, even if internal reporting is not a prerequisite for receiving rewards. According to one survey, nearly 90 percent of employees who filed a federal qui tam lawsuit in the U.S. between 2007 and 2010 (96 of 107) first reported their concerns internally either to their supervisors or to internal compliance departments.[1] Moreover, according to the U.S. Securities and Exchange Commission (SEC), in its whistleblower program under the Dodd-Frank Act, approximately 83 percent of reward recipients who were current or former employees first reported their concerns internally or understood that their supervisor or compliance department knew of potential violations before going to the SEC.[2]

There are several reasons why employees may report corporate crimes internally to a compliance department before turning to an outside enforcement agency. The first is that the standard of proof for external whistleblowing is higher than for internal reporting. This is because regulatory authorities must allocate their limited resources to the most credible cases. Employees often cannot collect evidence that meets the standard of proof for external whistleblowing until well after they have observed wrongdoing. Employees need stronger evidence to convince regulatory authorities to commence an investigation than they do to persuade a company’s compliance department. Second, employees are often motivated by factors other than money, such as a concern for social welfare or the satisfaction of doing the right thing. If the damage from crime grows as employees collect evidence sufficient to blow the whistle externally, they may choose first to report internally. These factors often persuade employees to report internally before going to outside regulators.

Relationship Between External Whistleblower Rewards and Internal Reporting

My paper develops an economic model by adopting realistic assumptions based on observations of past whistleblower cases. In the model, an employee observes an imminent or ongoing corporate crime in the workplace. The employee incurs a non-pecuniary loss if the employer commits the crime, which causes broader harm. The employee has two options: report to an honest and independent compliance department or to an enforcement agency. If the employee reports internally, the compliance department takes some preventive measures, which discourage the employer from committing further misconduct. Since collecting evidence that meets the standard of proof for external whistleblowing takes time, the employee can only report the misconduct externally much later. Reporting externally, the employee can receive a monetary reward, and the company gets penalized. However, the harm from the crime increases as time passes.

With these assumptions, the model shows that, as the reward increases, the probability of internal reporting increases and then decreases. The result can be explained as follows. When the reward is low, employees do not have enough incentive to report externally, which takes more time than internal reporting. Thus, the threat of external whistleblowing is not credible. Consequently, the employer will engage in misconduct regardless of whether employees report internally and employees have little incentive to report internally. When the reward is in an intermediate range, employees have enough incentive to report externally, despite the extra time it takes. Thus, the threat of external whistleblowing is credible. In this circumstance, if employees report internally to prevent the crime sooner, the probability that the employer will not commit the crime increases. If the employer does not commit the crime, employees will lose the opportunity to receive the reward, but they can also avoid any non-pecuniary loss. For employees whose costs of internal reporting are low, any avoidable non-pecuniary loss more than compensates for the net reward that they may lose plus the cost of internal reporting. However, if the reward rises beyond a certain amount, most employees will not report internally (the crowding-out effect), as they stand to lose too much reward relative to the size of the avoidable non-pecuniary loss.

Socially Optimal Rewards for External Whistleblowing

My paper also shows that the socially optimal amount of the external whistleblower reward is determined by the trade-offs between internal reporting and external whistleblowing. Crime can significantly harm social welfare, and rewards for external whistleblowing can affect the probability that crime will occur in two ways: through internal reporting and external whistleblowing. While an increase in the reward encourages external whistleblowing, thereby reducing the probability that a crime will occur, it can discourage internal reporting when the reward is sufficiently high. Therefore, at the social optimum, the additional harm that a decrease in the probability of internal reporting can do to social welfare equals the additional social benefit that can come from an increase in the probability of external whistleblowing.

ENDNOTES

[1] National Whistleblowers Center, 2010, Impact of Qui Tam Laws on Internal Compliance: A Report to the Securities Exchange Commission, at p.5, available at https://www.whistleblowers.org/storage/documents/DoddFrank/nwcreporttosecfinal.pdf.

[2] U.S. SEC, 2017, 2017 Annual Report to Congress on the Dodd-Frank Whistleblower Program, at p.17, available at https://www.sec.gov/files/sec-2017-annual-report-whistleblower-program.pdf.

This post comes to us from Masaki Iwasaki, a Terence M. Considine Fellow in Law and Economics and an S.J.D. candidate at Harvard Law School and an associate at the Tokyo-based law firm of Nishimura & Asahi. It is based on his recent paper, “Effects of External Whistleblower Rewards on Internal Reporting,” available here.