From Enron to Lehman Bros.: What Can We Learn From These Corporate Governance Failures? (PART III)
04/20/2013 | by Lipman, Frederick D.
Defects in Current Whistleblower SystemsAlthough Congress, when passing the Sarbanes-Oxley Act of 2002 (SOX), may have contemplated an active and effective whistleblower program, this goal has not been uniformly realized. The hotlines today are primarily a vehicle for employment discrimination, sexual harassment and other similar employment related complaints, rather than a pipeline for major fraud, illegality or enterprise risk of interest to the independent directors. The hotlines typically fail to create incentives for executives below the CEO and CFO level to reveal important information directly to the audit committee. Unfortunately, some independent directors are misled by the employment-related complaints on the hotline into believing the hotline is really effective.
There are seven major problems with the current whistleblower systems:
- The tone at the top tolerates but does not encourage whistleblowers, particularly executive whistleblowers.
- There is no meaningful reward or recognition for legitimate whistleblowers.
- The inability to communicate with anonymous whistleblowers results in failure to fully investigate anonymous information.
- The system does not guarantee anonymity.
- The system is not well advertised.
- The audit committee uses employee administrators and investigators who are not viewed as independent by whistleblowers and not even have forensic skills.
- Whistleblowers' motivations and personalities affect the investigation.
Many public companies have a “paper” whistleblower system. In such a system, the company has complied with the letter of the SOX requirements and exchange listing rules but has done nothing more. Management tolerates the whistleblower system but does not encourage whistleblowers. Whistleblowers are almost never recognized as employees of the month. As a result, potential whistleblowers (including executives whistleblowers), facing daunting disincentives, refuse to participate in the system.
Concerning the SOX whistleblower statute, the former general counsel of the Securities and Exchange Commission (SEC) has stated:
Not all corporate compliance programs work well. Some—no matter how elaborately conceived and extensively documented—exist only on paper. Some small numbers are shams. I once knew of an ostensibly anonymous employee hotline that actually rang on the desk of the CEO’s secretary. I’m not at all sure that Congress intended that a whistleblower at this company would have to avail himself of this hotline before coming to the Commission and getting an award.Very few, if any, whistleblower systems provide meaningful rewards or recognition for whistleblowers. Although some employees are driven by their moral compass to do the right thing and do not need rewards, the number of employees who are Mother Teresa is very limited. Given the real possibility that the employment of persons disclosing wrongful activity may be terminated and even if not terminated such person could be socially ostracized, employees have no reason to assume those risks without a meaningful incentive. Internal whistleblower systems do not have to compete economically with the size of awards available under the whistleblower statutes since there are many disincentives to external employee whistleblowing. However, the lack of any meaningful reward or other recognition for internal whistleblowers reflects an organizational attitude that is not conducive to whistleblowing.
Although the SOX whistleblower system allows for anonymous whistleblowers, that system does not work well because the audit committee or its counsel may need to further question the person whose identity has been hidden. Audit committees tend to provide fewer resources to investigating anonymous complaints.
Unfortunately, approximately half of whistleblower calls in 2010 were anonymous, a fact that suggests that many employees fear retaliation.
Moreover, many current whistleblower systems do not guarantee anonymity. Voice recognition techniques can be used to trace hotline calls. Private detectives can use handwriting analysis to trace anonymous letters. Anonymous e-mails can be traced back to the whistleblower’s computer. Best practices would provide greater guarantees of anonymity by permitting communication through the whistleblower’s personal counsel (at the company’s expense if the information is legitimate) and allowing the whistleblower to form an entity to further hide his or her identity.
Hotline service providers advertise their ability to ask further questions to the anonymous whistleblower. Although this service is useful, it is not a good substitute for direct communication between the whistleblower’s lawyer and the audit committee’s attorney, without the intervention of the hotline service provider. Hotline providers do not normally have the forensic skills necessary to ask follow-up questions. Sophisticated executive whistleblowers know that the information they reveal to the hotline, including their company position, is not protected from discovery by the attorney- client privilege. Moreover, executive whistleblowers, concerned about being blackballed and anxious about maintaining anonymity, will not necessarily be comfortable with an ongoing detailed dialogue with a hotline service provider selected by management and possibly even providing summaries of the conversation to management personnel. Yet, without this detail it is difficult for the audit committee to conduct a thorough investigation.
Many companies do not adequately communicate the whistleblower system except in a policy contained in an SEC filing or on their websites. As a result, average employees may not realize that the company even has an anonymous whistleblower system. A survey by the Institute of Internal Auditors indicates that employee familiarity with the organization’s hotline is a key factor in encouraging its use.
The administration and investigation of whistleblower complaints are typically performed initially by the internal auditor, director of compliance, human resources (HR) head, or general counsel. All of these individuals are company employees whose compensation is determined by management (with the possible exception of the internal auditor).
Potential whistleblowers do not have confidence in the independence or impartiality of those employees who would administer or investigate their complaints. Moreover, many of these individuals are not skilled forensic investigators.
An example of why whistleblower systems do not work can be found in the Enron case. Sherron Watkins sent a letter to Kenneth Lay, Enron’s chairman, stating, in part, that “I am incredibly nervous that we will implode in a wave of accounting scandals.” Kenneth Lay then gave the matter to inside counsel to administer and investigate Watkins’ complaint, rather than using completely independent counsel for that purpose. Inside counsel then employed Enron’s regular outside counsel, which received substantial legal fees from Enron, to perform the investigation. At the end of a very limited investigation, the regular outside law firm gave Enron a report that, in general, found no substance to Watkins’ complaint. A separate investigation completed shortly after Enron’s bankruptcy by an independent board committee, using completely independent counsel, found significant substance to Watkins’ complaint.
Whether a particular company’s hotline is effective can only be determined through employee surveys and exit interviews which are directed primarily at the executive group. Independent directors should consider conducting such surveys anonymously using third party service providers.
 David M. Becker, Esq., General Counsel, “Speech by SEC Staff: Remarks at the Practicing Law Institute’s Ninth Annual Institute on Securities Regulation in Europe.” U.S. Securities and Exchange Commission, January 25, 2011.
 James E. Hunton and Jacob M. Rose, “Effects of Anonymous Whistle-Blowing and Perceived Reputation Threats on Investigations of Whistle-Blowing Allegations by Audit Committee Members” Journal of Management Studies 1. No. 48 (2011): 75-98.
 “2011 Corporate Governance and Compliance Hotline Benchmarking Report” The Network, Inc.; Deloitte Forensic Center, “Whistleblowing and the New Race to Report: The Impact of the Dodd-Frank Act and 2010’s Changes to U .S. Federal Sentencing Guidelines.” 2010.
 Mary B. Curtis, “Whistleblower mechanisms: A Study of the Perceptions of ‘Users’ and “Responders.” Dallas Chapter of the Institute of Internal Auditors, April 2006.CATEGORY: Internal Whistleblowing