by Stephen Stubben and Kyle Welch
With limited time, corporate directors are accustomed to monitoring firms by using aggregated information that is supplied by firms’ management. Nearly every task conducted by a board of directors involves data curated by employees working for a firm’s CEO. A critical challenge for directors is to be informed of important situations that may have been lost in data aggregation or that may have been selectively not reported. Indeed, this is why firms with stellar directors and high-quality external auditors still have major public debacles. One way a corporate director can obtain unfiltered information regarding a firm’s operations and potential problems within a firm is by reviewing reports made by employees through internal reporting systems (also known as internal whistleblowing systems). The problem with this solution is that there have been differing views and understandings as to how to appropriately manage these systems and interpret these submitted reports—until now.
The Examiner’s Report in the Lehman Brothers Chapter 11 Proceedings provides insight into the firm’s key governance failure—information being withheld from the board. While Monday morning quarterbacks provide convenient commentary on governance incompetence, the directors’ resumes suggest otherwise.[1] Instead, Lehman Brothers’ governance failure involved management omitting accurate stress tests of risky portfolios in reports to the board, management withholding information regarding reports of accounting manipulations, and auditors failing to report key issues to audit committee members.[2] Directors’ primary role is to provide oversight, which is nearly impossible when management filters critical information. As a result, directors need to refocus their attention to systems that can provide unfiltered insight into a firm’s operations—internal reporting systems.
Internal reporting systems allow employees to anonymously report potential problems to third party providers (e.g. NAVEX Global), which are then made available for management, directors, internal auditors, and others to review. Using an external provider allows the employees to remain anonymous while ensuring that the reports can be accessed by the appropriate parties at the firm. While this arrangement with an external service provider is certainly helpful for accessing difficult information, we have found that there has been some confusion among directors and managers about how to interpret the volume of reports submitted. Does a higher number of reports reflect a “healthy” reporting system with more communication from employees, or does it instead indicate that there are severe problems within a firm?
The confusion in evaluating whistleblowing lies in two competing views of these systems. The first view treats each report negatively, as an indication of severe troubles within the firm. The second view acknowledges that in large organizations, some degree of problems is bound to exist. Reports from employees are a positive, not a negative, signal. The number of reported events is not a pulse on the volume of problems, but a pulse on how much your firm is discovering those problems.
In our recent paper, we evaluate these competing views of internal reporting and find the latter to be generally true; firms with more engagement with employees (e.g. more employee whistleblowing reports) tend to have better corporate governance, to be targeted by fewer material lawsuits with smaller eventual settlement amounts, to have less evidence of improper earnings management, and to be more profitable. Our findings suggest that internal reporting is not associated with more severe problems within a firm but rather with more communication from employees that allows management to address issues early, before they become more severe and costly.
We expect these findings to be useful to directors who are interested in gaining insight into potential issues within their firms. Internal reports are a key resource for discovering material problems that have potentially been omitted from the board packs typically provided to directors. In our research, we have learned of cases where boards have actively sought to push the number of reports toward zero, as if cutting off communication about problems would somehow make those problems disappear. Instead, directors should look to internal reporting systems as a source of valuable information that supports their monitoring activities. Directors may benefit from (1) regularly reviewing employee reports and identifying any trends in reporting activity; (2) ensuring that reports are reviewed by management, internal auditors, corporate counsel, and human resource personnel, as appropriate; (3) and questioning management on their responses to important concerns.
Footnotes
[1] The directors included former CEOs and/or chairs from the American Red Cross (also a retired admiral from the U.S. Navy), GlaxoSmithKline, Halliburton, IBM, Sotheby’s, Telemundo Group, U.S. Bancorp, and Vodafone.
[2] The report noted that Lehman Brothers’ executives excluded critical information from the Finance and Risk Committee regarding stress testing the firm’s commercial real estate exposure (Valukas 2010 p.77 & 155). In particular, the report notes, “Management did not inform the Committee of a new ‘Credit Crunch’ scenario that was added to Lehman’s portfolio of stress testing scenarios in October 2007 that predicted the worst loss of all the scenarios, $3.99 billion (although early drafts of the presentation did include the scenario)” (Valukas 2010 p.155). Moreover, the examiner noted that the board received no information regarding the use of Repo 105 as an accounting manipulation (Valukas 2010 p.1036), despite the Audit Committee’s direct request to Ernst & Young to investigate a tip regarding the Repo 105 problem. Ernst & Young’s role in the follow up led to a malpractice claim and over $100 million in legal settlements. See Valukas, Anton R., 2010, Examiners Report. United States Bankruptcy Court, Southern District of New York. Case No. 08‐13555. VOLUME 3 OF 9 (PDF: 2.8 MB).
Stephen Stubben is the David Eccles Faculty Fellow & Associate Professor at David Eccles School of Business, The University of Utah and Kyle Welch is an Assistant Professor of Accountancy at GW School of Business, The George Washington University.
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