When Employees Speak Up: The Role of Confidential Witnesses in Shareholder Litigation of Financial Disclosure Fraud

Establishing managers' intent to defraud and providing particulars of misstatements are major hurdles for shareholders in securities class action lawsuits. A common practice to overcome these hurdles is to recruit former employees as confidential witnesses. We study the determinants and consequences of involving employee confidential witnesses (ECWs) in securities lawsuits alleging financial disclosure fraud. We find that shareholders are more likely to engage ECWs when public information about misstatements is limited, when soft signals such as credit rating downgrades hint at potential fraud, and when misstating firms have higher labor intensity. ECW involvement is also more likely in firms with higher employee growth and lower employee satisfaction, reflecting weaker employee loyalty and greater disapproval of management behavior. Additional analysis reveals that ECWs’ job positions align with specific allegations at issue. The presence of ECWs increases both settlement likelihood and lawsuit duration. Our study sheds new light on the role of rank-and-file employees in disciplining corporate financial disclosure fraud.