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Companies commonly question the sanity of accusers, but investors disagree, study of financial whistle-blowing suggests

Lagging stock performance of firms after whistle-blower news stories testifies to power of press

Whistle-blowers are likely to take on a new prominence in the battle against corporate fraud under major finance legislation now making its way through Congress. Both the House and Senate drafts of financial reform bills include provisions to increase awards to employees for making company wrongdoing public and to expand the range of fraudulent practices for which bounties can be claimed.

Beyond the concern such measures may inspire among corporate executives, a new study may give then further cause for anxiety about financial whistle-blowing. The research in the July issue of The Accounting Review, a bimonthly journal of the American Accounting Association, suggests that media reports of  such allegations lead to multiple woes for targeted companies, including a significant depression of their stocks not just for days but years.

"While it is common for companies to question the sanity of whistle-blowers, it would appear from our findings that the stockmarket disagrees," comments Shiva Rajgopal of the Goizueta Business School at Emory University, who carried out the study with Robert M. Bowen of the Foster School of Business of the University of Washington and Andrew C. Call of the Terry College of Business at the University of Georgia.

"There has been surprisingly little research," Prof. Rajgopal continues, "on whether whistle-blower allegations are economically significant events with meaningful consequences for targeted firms. Our findings suggest strongly they are.

"And what seems equally plain," he adds, "is the power of the press in all this."

The study's most striking findings are based on an analysis of the stock performance of 81 companies   after whistle-blower allegations of financial misconduct were reported in the media. The professors found that in the five days surrounding such press reports, stocks of accused companies experienced a 2.84% average drop in price compared to the market as a whole. The relative drop was 7.3% when the allegations concerned earnings management.

As impressive as these short-term declines, if not more so, were long-term weaknesses in stocks subsequent to press accounts of whistle-blowing. The professors found the median stock performance of accused companies to be significantly lower over the course of the next two years than that of similar firms that were not beset by whistle-blowing.

"There was even some evidence of continued weak stock performance for a third year," comments Prof. Rajgopal. "And this was in comparison with companies we selected because they were similar to the  whistle-blower firms in essential ways -- what we call propensity-score matched controls."

For example, he explains, fast-growing firms are at increased risk of whistle-blowing, as operational responsibilities spread rapidly to more and more people. Very bureaucratic firms  also tend to be subject to whistle-blowing, particularly when they are highly diversified or widely dispersed geographically. These and other relevant factors dictated selection of firms for the propensity-score matched group.

"The fact that the 81 firms in our press sample did significantly worse on average than these controls in terms of stock performance suggests the power of whistle-blowing, especially when amplified by the media," comments Prof. Rajgopal. "Equally suggestive is the fact that within three years from the time that whistle-blower stories appeared in the media, 17.9% of the firms involved had to restate their financial results, compared to 7.5% in the propensity-matched controls, and 26.9% were sued for financial misconduct compared to only 11.9% of the controls.  In both cases, the differences were highly significant statistically, meaning that the chances were more than 95% that they were not due to chance."

Further reinforcing the impression of media impact is the relative lack of significant results from a second sample of 137 companies that were reported to the Occupational Safety and Health Administration (OSHA), the federal agency responsible for handling complaints of alleged discrimination against whistle-blowers. In these cases, which did not attract media coverage, there was not a statistically significant difference in the incidence of restatements and lawsuits between the accused companies and a control group. In terms of stock performance, the differences between the OSHA companies and the control group were either not statistically significant or only marginally so.

In yet a further indication of the power of the press, companies that suffered media exposure related to whistle-blowing were more apt to take subsequent steps to improve corporate governance than comparably-sized other firms in the same business or a similar business. They were significantly more likely to replace their CEOs, to reduce the size of their boards, and to lower the proportion of insider directors and directors with three or more additional board memberships. As the professors put it, "On average, whistle-blowing targets exposed via the press appeared to change governance on four dimensions that exceeded the level of market-wide governance improvements in the post-SOX era, while firms targeted by whistle-blowers via OSHA (a less public venue) did not."

The 81 firms in the press sample (generated via an electronic search for the period 1989-2004 that employed terms akin to "whistle" or ''whistle-blowing" and others akin to "financial" or "fraud") included such notorious corporate names as Enron, Tyco, HealthSouth, and Qwest Communications, as well as such eminently respectable names as General Electric, Intel, and Medtronic.

The study, entitled "Whistle-Blowing: Target Firm Characteristics and Economic Consequences," is in the July/August issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include Accounting Horizons, Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation Association, and The Journal of Management Accounting Research.

 

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