While external whistleblowing—reporting misconduct to regulators or members of the media— has captured much attention, the impact of reporting misconduct anonymously to management, known as internal whistleblowing, is relatively unknown. Our new study, Evidence on the Use and Efficacy of Internal Whistleblowing Systems, reveals the impact of these systems.

Due to the sensitivity of individual internal whistleblowing reports, we received only limited data on each whistleblowing event. No names or specific text were shared. We did have access to over 900 public company internal feedback systems, including reports about financial reporting issues, harassment or other HR issues, business integrity, workplace safety, and misuse or theft of corporate assets.

The study finds substantial variation in how different companies use their internal whistleblowing systems (activity is measured by three proxies including the number of reports from employees). Firms that actively use such systems tend to be more profitable (as measured by return on assets) and older and to have fewer employees (when measured on a per-employee basis). Companies with more discretionary accruals (a proxy for financial reporting earnings management) tend to use their systems less, which could reflect that the types of firms that manage earnings also choose not to promote or use their internal whistleblowing systems, or such systems help prevent earnings management. Finally, using a subsample of the S&P 1500, the study finds companies with weaker corporate governance, as captured by the Bebchuk, Cohen, and Ferrell (2009) entrenchment index, are less likely to be active users of their internal whistleblowing systems.

The study also finds that active use of those systems is negatively associated with the number of material lawsuits filed against the firm and the size of related legal settlement. A one standard deviation increase in the use of an internal whistleblowing system is associated with 3.9 percent fewer pending lawsuits in the subsequent year and 8.9 percent less in aggregate legal settlement amounts. The associations are even larger when examining material lawsuits and settlements over the subsequent three years. A one standard deviation increase in the use of an internal whistleblowing system is associated with 6.9 percent fewer pending lawsuits and 20.4 percent less in aggregate settlement amounts. Finally, the study does not find evidence that active use of internal whistleblowing systems is associated with a greater number of external whistleblowing reports to regulators.

Positive associations could result from both internal whistleblowing activity and litigation being driven by the severity of issues at the firm. Yet these negative associations with lawsuits and settlements, along with no association with external whistleblowing events, are consistent with the theory that internal whistleblowing systems provide relevant and actionable information to management about issues arising within the organization, enabling management to get ahead of problems.

This research will affect boards and managers who have been confused about how to manage internal feedback. Two conflicting theories dominate corporate governance and management approaches to internal whistleblowing systems. The first assumes that any increase in reporting levels at the firm is a negative sign that there are even more problems at the firm. The second assumes that all firms have problems and that the level of reports simply captures the firm’s ability to notice events that won’t show up in operational or financial reports. It appears, from this research, that the latter most accurately reflects managements’ approach.

Consider the same dynamic in terms of parenting and raising teenagers. In Family A, everyone keeps his or her problems private and tries to solve them alone: The teen is stressed about academic performance, has a porn addiction, or is depressed. In Family B, the parents realize that due to puberty, most problems a teen faces are common among teens and that troubling events and stress aren’t indications that the parents have failed but signs of how much respect the teen has for getting help to solve the problem. In Family B, the teen brings those issues to the dinner table to discuss with his or her  parents in hopes of helping to find answers. Which teen and family is likely to handle problems better?

The big counter-intuitive takeaway is that a greater number of internal whistleblowing reports about asset theft, harassment, or financial manipulation does not necessarily indicate more problems at a firm. Instead, it indicates an effort by management to get ahead of problems like lawsuits and workplace-regulation violations.

This post comes to us from professors Stephen Stubben at the University of Utah and Kyle T. Welch at George Washington University. It is based on their recent article, “Evidence on the Use and Efficacy of Internal Whistleblowing Systems,” available here.