New research from Columbia Business School helps explain the low number of corporate whistle-blowers: company stock options are often given to rank-and-file employees to discourage them from publicly reporting financial reporting violations. Although the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 offers financial rewards to encourage whistle-blowing, the research shows that firms are giving employees far superior incentives to remain quiet about financial irregularities.

"Retribution against whistle blowing is a common problem, and not one that is likely to go away anytime soon," says Shivaram Rajgopal, co-author of the study and Roy Bernard Kester and T.W. Byrnes Professor of Accounting and Auditing at Columbia Business School. "Our research shows that even a small increase in stock-based incentives can reduce the probability that an employee will report wrongdoing they observe. In fact, the employees are more likely to cooperate in the wrongdoing if they also gain financially."

Additionally, the research shows that companies currently engaged in unethical and fraudulent behavior grant more stock options to employees than when they are not in violation. And among firms accused of committing violations, larger stock option grants to rank-and-file employees are associated with a reduced incidence of employee whistle-blowing. According to the research, these finding are consistent with managements' incentives to discourage employee whistle-blowing.

Finally, the research discerned that firms with a culture of egotism/arrogance are more likely to commit reporting violations and use stock-based compensation. Rajgopal noted that large sections of corporate America are grappling with issues related to their corporate culture, and where there is poor culture, there is lower probability of whistle-blowers coming forward.

"Although 5,300 employees were involved in the scandal at Wells Fargo, no one spoke up fearing loss of their jobs. Unless the firm fosters a culture of 'see something, say something,' more such behavior will go unreported because speaking up against authority is hard, "Rajgopal says.

The Research – In Depth
The study, Rank and File Employees and the Discovery of Misreporting: The Role of Stock Options, is coauthored by Rajgopal, Andrew C. Call of Arizona State University, and Simi Kedia of Rutgers Business School. The authors obtained information for the research from Stanford Securities Class Action Clearinghouse data to identify firms alleged to have engaged in financial misreporting and find class action lawsuits filed for the period 1996 to 2011.  The study closely looked at those firms who are subject to class action shareholder litigation for that time period. The studied sample had 784 cases which spanned 1,243 violation years for 663 unique firms, and the control sample contained all other firms on ExecuComp: The Executive Compensation Database without an alleged violation.