Is SOX Discouraging Employee Whistleblowing?

In a prior post (here), I raised the question whether the whistleblower protection under Section 806 of the Sarbanes-Oxley Act is “more theoretical than real.” A February 2007 study by Alexander Dyck of the University of Toronto, Adair Morse of the University of Michigan Business School, and Luigi Zingales of the University of Chicago entitled “Who Blows the Whistle on Corporate Fraud?” (here, $ required) confirms statistically that SOX whistleblower protection is not encouraging employee whistleblowers and may be discouraging them.

The authors looked at a sample of 230 cases of corporate frauds that were alleged between 1996 and 2004 regarding companies with more than $700 million in assets, in order to determine who was involved in the revelation of fraud. The authors found that between 1996 and SOX’s enactment, employee whistleblowers represented 21 percent of the fraud detectors, but that after that, they represented only 16 percent.

The authors found that employee whistleblowers face significant discinventives. They found that in 82% of cases where the employee whistleblower's identity was revealed, the employee “quit under duress, or had significantly altered responsibilities.” In addition, may whistleblowers report having to move to another industry or to another town.

SOX attempted to create protections for employee whistleblowers. Section 301 requires public company audit committees to create procedures for “confidential anonymous submission" of questionable accounting or auditing matters. Section 806 provides protections for employees against being fired for coming forward with this kind of information. The authors found that the drop in the employee whistleblowers as a percentage of fraud detectors after the enactment of Sarbanes-Oxley suggests that “SOX’s modest incentives for whistleblowers has not been very effective.” They suggest that “protecting the whistleblower’s current job is a small reward given the extensive ostracism whistleblowers face.”

The D & O Diary would add to the authors' analysis that, as discussed in prior posts (most recently here), the protection that the SOX whistleblower provisions theoretically provide have proven cumbersome and procedurally challenging. The statutory protections, as implemented, arguably create affirmative disincentives for would-be employee whistleblowers.

The study's authors have an interesting observation about employee whistleblowers in industries (such as healthcare) that conduct significant business with the government, and where employees can receive substantial financial rewards for bringing a so-called qui tam action. The authors found that in the healthcare industry, where employees have these kinds of financial incentives to blow the whistle on fraud, employee whistleblowers account for 46.7% of fraud detectors, as opposed to only 16.3% in industries where employees cannot bring qui tam lawsuits. The authors also found that in the healthcare industry, fewer fraud lawsuits were dismissed or settled for less than $3 million than compared to all companies in all industries, leading the authors to conclude that there was no evidence that the availability of the qui tam lawsuits increased the level of frivolous litigation.

The authors conclude that the SOX whistleblower protection, offering only after-the-fact job protection, provides little incentive for employees to assist in fraud detection. The authors recommend “extending the qui tam statute to corporate frauds.”

Whether or not employee whistleblowers should have added fraud detection financial incentives, the authors’ point about the financial incentives for employee whistleblowers in the healthcare industry (and other industries that do substantial business with the government) is an important point for D & O insurance professionals. Clearly, with respect to companies in the healthcare industry and other industries that do substantial business with the government, it will be particularly important for the standard insured-versus-insured exclusion to be modified to carve back coverage for whistleblower suits, including in particular qui tam or False Claims Act lawsuits.

A February 13, 2007 CFO.com article entitled "Sarbox Curbs Fraud Whistleblowing" discussing the report referred to above can be found here.

Go Ask Alice: According to news reports (here), “a male lawyer who appeared in court in women’s clothes as a protest against what he said was New Zealand’s overly masculine judiciary was suspended Wednesday after being found in contempt of court.” The lawyer, who officially has changed his name to “Miss Alice,” was held in contempt for posting on the Internet certain documents pertaining to a bridge collapse, despite a court order that the documents not be distributed. The lawyer announced after the ruling that he would quit the law altogether, so that he would no longer appear “in a 19th century Alice in Wonderland environment that allows pomp, self-importance and deference to the court to eclipse the truth.” However, a subsequent news report (here) suggested that he had changed his mind about leaving the practice of law -- perhaps he felt his attire entitled him to that prerogative.

“Miss Alice,” this video is for you.