by Cydney Posner

A new academic study, “Rank and File Employees and the Discovery of Misreporting: The Role of Stock Options,” finds that companies that flout financial reporting rules tend to grant more stock options than their peers that adhere to those rules. Moreover, the study found that violators that granted more options to rank-and-file employees during periods when violations were ongoing were more likely to avoid whistleblowing allegations.  Although it may sound cynical, the authors of the study posit the theory, as reported in this article in the WSJ, that violators may be using option grants in “an attempt to discourage whistleblowing.”

The study, which is expected to be published in the Journal of Accounting and Economics, analyzed 784 cases of class action shareholder litigation at 663 companies from 1996 to 2011. The WSJ reports that, during the period from commencement of the financial reporting violation until discovery, these companies granted stock options to rank-and-file employees covering an average of 2.49% of total shares outstanding, compared with a control group that granted only 1.62% of total shares outstanding. The numbers were also lower both before the violation and after discovery: prior to the commencement of the violation, these companies granted stock options to employees to purchase an average of  2.17% of the shares outstanding and, after violations were publicly reported, grants represented only 1.67% of the outstanding.

According to this article in, the study looked at stock options in part “because financial misreporting usually involves overstating performance to boost the price of a company’s shares, directly tying an employee’s expected gain from a portfolio of options to the continuation of the misconduct.”  In the study, there appeared to be a greater incidence of whistleblowing (either to regulators, such as in qui tam cases, or to the media) where options representing a lower percentage of the outstanding were granted:  “violating companies that experienced an employee whistleblowing event granted options averaging 1.37% of total shares outstanding during the violation period, compared to 2.44% for companies that avoid whistleblowing events.” According to the study, the “78% higher usage of rank and file options in misreporting firms without whistleblowing is both statistically and economically significant.” In addition, the study reported that “employees of misreporting firms that experienced a whistle-blowing event held in their portfolio stock options averaging 3.47% of shares outstanding. This is significantly lower than the 6.14% held by employees of misreporting firms that did not experience an employee whistle-blowing event.” concluded about the study results that  “[e]mployees are less likely to blow the whistle about corporate misconduct if they benefit from it…. [W]hen a higher share of their compensation is tied to firm performance, employees are more likely to facilitate (either directly or indirectly) wrongdoing.”

According to the study, whistleblowing may ultimately not pay off financially and  “involves huge personal risks such as the temporary or permanent loss of employment, personal trauma, and social stigma. Motives for blowing the whistle include maintaining personal integrity, avoiding complicity in the wrongdoing, and the need to remove the public harm caused by the misconduct…. Along with these moral and ethical concerns, financial considerations likely impact the whistleblowing decision. We argue that, on the margin, employees are more likely to cooperate in wrongdoing if they gain financially from it.” According to the study’s co-author, as reported in the WSJ, the options function as an “incentive to keep quiet”: “‘It’s a straightforward story….Companies compensate you for not speaking up.’ Companies can use the stock options as a counterweight to any bounty whistleblowers could potentially receive….” As a caveat, however, the study acknowledges that the evidence is “circumstantial” because the authors “cannot observe the underlying motivation for employees’ whistle-blowing decisions and are therefore unable to completely rule out alternative explanations for our findings.”

SideBar: Under the SEC’s whistleblower program, implemented under Dodd-Frank, eligible whistleblowers who report securities law violations to the SEC can receive between 10% and 30% of the monetary sanctions collected. Note, however, that the SEC’s whistleblower program did not become effective until August 2011, so there is not much overlap in time between the cases examined in the study sample and the availability of bounties under that program. The SEC indicates that, prior to the enactment of Dodd-Frank, “the SEC only had authority to reward whistleblowers in insider trading cases,” and the study itself notes that very little has been paid to whistleblowers under that earlier program. As proudly announced on the SEC’s website, so far the SEC has paid over $100 million in whistleblower bounties under the Dodd-Frank whistleblower program.  With the largest whistleblower bounty to date being over $30 million, the question remains whether that just might be a big enough incentive to shift the balance of a rank-and-file employee’s calculation.

Posted by Cydney Posner