Employers Take Heed: The SEC Is Preparing for a Greatly Enhanced Reliance on Whistleblowers
By Anthony Pacheco, Sigal P. Mandelker, and Massiel Pedreira – July 5, 2011
Employers beware; the Securities and Exchange Commission (SEC) is intensifying its reliance on whistleblowers. Since the 2010 passage of the Dodd-Frank Act, which included key enhancements to the SEC’s whistleblower program, white-collar and compliance lawyers alike have been consumed by the potential consequences to companies of Congress’s decision to elevate the role of and empower whistleblowers. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 922, 124 Stat. 1841 (2010) (to be codified at 15 U.S.C. § 78u-6). Is all the hype warranted? Should employers fear that there will be an increase in the number of whistleblowers and that those whistleblowers will view the new whistleblower program solely as a means to cash in?
The answer is that the new changes could result in a sea change in the number of actions brought against companies by the SEC. Indeed, the program under the act effectively “deputizes” employees as agents for the SEC in the enforcement of purported securities violations.
Previously, the SEC’s whistleblower program, confined to insider-trading cases, capped awards at 10 percent of the collected penalties. See Press Release, Sec. & Exch. Comm’n, SEC Proposes New Whistleblower Program Under Dodd-Frank Act (Nov. 3, 2010), available at www.sec.gov/news/press/2010/2010-213.htm. Now, the commission is empowered to compensate whistleblowers with 10 to 30 percent of the total monetary sanctions resulting from the successful enforcement of a judicial or an administrative action based on the whistleblower’s information. See Dodd-Frank Act, supra (to be codified at 15 U.S.C. § 78u-6(b)). Those percentages can be enormous, particularly in Foreign Corrupt Practices Act matters, where fines and penalties have been in the hundreds of millions.
To qualify, a whistleblower must provide “original information.” This can be information derived from the independent knowledge or analysis of the whistleblower that is neither known to the SEC from any other source nor exclusively derived from an allegation made in a judicial or an administrative hearing or other public forum, unless the whistleblower was the source of information. Id. (to be codified at 15 U.S.C. § 78u-6(a)(3)).
And guess what? The SEC will have virtually unfettered discretion to determine the amount of the award within the 10 to 30 percent range. The SEC should, under the act, consider the significance of the original information to the success of the covered action; the degree of assistance provided by the whistleblower; the programmatic interest of the SEC in deterring violations of the securities laws by making such awards, and any additional relevant factors established by rule or regulation. Id.(to be codified at 15 U.S.C. § 78u-6(c)(1)).
The SEC Investor Protection Fund, which was created by the act, provides funding for the whistleblower program, including remuneration for whistleblowers and, as of September 30, 2010, had an ending balance of $451,909,854.07. Id. (to be codified at 15 U.S.C. § 78u-6(g)(2)(A)); see also Corruption Currents, SEC Whistleblower Fund is Juiced Up, Wall St. J., Nov. 1, 2010. The fund will also fund the operations of the SEC Office of the Inspector General’s suggestion program. Dodd-Frank Act supra (to be codified at 15 U.S.C. § 78u-6(g)(2)(B)). While the SEC apparently cannot consider the balance in the fund when making whistleblower awards, in practice it remains to be seen whether the SEC will turn a blind eye to its own financial interest when adjudicating whistleblower cases.
The act not only provides huge incentives for whistleblowers to report, but also there are now even stronger protections to prevent and punish retaliation against a whistleblower. See id. (to be codified at 15 U.S.C. § 78u-6(h)(1)(A) (listing prohibited retaliatory acts). The act creates a new private right of action that exposes employers to double back pay with interest; litigation costs including reasonable attorney fees and expert witness fees; and reinstatement of the whistleblower to the same seniority status. See id. (to be codified at 15 U.S.C. § 78u-6(h)(1)(C).
The SEC’s Proposed Rules Implementing the Dodd-Frank Act
In the fall of 2010, the SEC proposed rules, in over 180 pages, to implement the whistleblower program. Proposed Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, 75 Fed. Reg. 70,488 (proposed Nov. 3, 2010) (to be codified at 17 C.F.R. 240.21F). These rules intend to “explain the scope of the whistleblower program” and “outline the procedures for applying for awards.” Id. The SEC stated that it considered and weighed a number of competing interests resulting from the act’s implementation. Id.
The SEC curiously stated in the rules that it recognized that the monetary incentives provided to whistleblowers could reduce the effectiveness of a company’s existing compliance and internal-reporting procedures. But under the proposed rules, whistleblowers will not have to first report internally a suspected or an actual violation before going to the SEC. The SEC also considered the effect of whether the whistleblower rewards would incentivize attorneys, independent auditors, and compliance personnel to make whistleblower claims based on information they obtained through their positions. Id. at 70488; see also id. at 70,520–21 (to be codified at 17 C.F.R. 240.21F-4(b)(4)) (listing types of information ineligible for a whistleblower award). During the comment period, companies have expressed concern that employees will bypass compliance procedures, but it is unclear whether the SEC will take those concerns into account in the final rule, which will be released between May and July 2011, despite a mandated April 21, 2011, deadline.
The SEC has done little to remedy this problem that its proposed rules would embolden whistleblowers to report to the SEC and forego internal-compliance reporting. As a somewhat remedial measure, the SEC’s proposed rules protect a whistleblower’s “place in line” for 90 days if he or she chooses to first report internally before reporting to the SEC as a means to support the effective functioning of compliance and internal-reporting procedures. Id. at 70,495–96. This means the SEC will consider the date the whistleblower reported internally as the date reported to the SEC as long as it is submitted to the SEC within 90 days. 75 Fed. Reg. 70,495–96. However, in practice, this will do little to address the concern that whistleblowers will forego internal reporting, denying companies the opportunity to investigate and take appropriate remedial measures. An incentivized whistleblower will want to maximize recovery by reporting to the SEC and not giving the company the ability to take corrective measures. The SEC’s efforts to address this situation fall short of meaningfully addressing the issue.
Companies should be aware that both the act and the implementing regulations, once final, give the SEC unfettered discretion in setting whistleblower awards. There are no appropriate checks and balances over the SEC’s powers regarding the use of and financial incentives to whistleblowers. The SEC does set forth additional factors it will “consider” in making whistleblower awards, such as whether a whistleblower first reported the potential violation internally before reporting to the SEC. See id. at 70,500 (describing the additional factors). The SEC, however, falls short by not setting these so-called factors in the actual rules. In other words, these are factors that the SEC may, but does not have to, take into consideration.
What does this practically mean? As long as the SEC does not take into account the balance of the fund and makes an award between 10 and 30 percent of the total monetary sanctions imposed, a whistleblower award is entirely in the SEC’s discretion. Id.; see also Dodd-Frank Act, supra (to be codified at 15 U.S.C. § 78u-6(c)). The act prohibits the SEC from looking at the balance of the fund, but the proposed implementing rules are silent on this. The act itself, however, provides no relief if the SEC was to consider the balance of the fund prior to determining the whistleblower award amount.
And more troubling, there is no judicial review for an award under the act, as long as the whistleblower’s award is within the 10 to 30 percent range. Dodd-Frank Act, supra (to be codified at 15 U.S.C. § 78u-6(f)). The fund itself is financed by monetary sanctions collected by the SEC in judicial or administrative actions and from disgorgement funds not already distributed to victims. Id.(to be codified at 15 U.S.C. § 78u-6(g)(3)(A)). Furthermore, the Dodd-Frank Act dictates that a whistleblower’s interest in receiving an award outweighs a victim’s interest in recouping his or her losses as a result of the securities-law violations. Id.
The potential conflicts are evident. Id. (to be codified at 15 U.S.C. § 78u-6(g)(2)(B)). The SEC is incentivized to encourage whistleblowing, at the expense of critical policy concerns, to bring bigger cases and obtain larger sanctions and penalties. The sanctions and penalties against companies and employers are expected to increase significantly. The SEC will plainly be mindful that it has sufficient funds to pay victims of securities violations and maintain the fund to not only further incentivize whistleblowers to come forward but also to continue its own operations. With little, if any, meaningful judicial review, there are virtually no checks and balances on the SEC’s enhanced powers.
What This Means: Prepared Is Forewarned
Given the substantially increased risk that employees will now run to the SEC before reporting potential problems internally, employers need to review and perhaps revise their compliance programs so that they encourage would-be whistleblowers to report internally rather than report for the first time to the SEC. Indeed, the employer’s first line of defense is an effective compliance program.
Employers can do this in a number of ways, such as creating effective internal reporting procedures, ensuring those procedures are well publicized, encouraging reporting, and instituting strong anti-retaliation policies. Employers should also consider faster and more thorough self-reporting.
Employers should make sure that they have robust reporting procedures. A step in the right direction is to establish a 24-hour whistleblower hotline. The hotline should be made available on an anonymous basis and staffed by qualified compliance personnel. What not to do? An employer should not create a hotline that is ineffective. If employees are placed on hold for 20 minutes and required to follow a long series of prompts, employees will be less likely to use the company’s hotline. The hotline number should be provided to third parties such as an employer’s customers, suppliers, and business partners.
No matter how well crafted internal-reporting procedures are, if they are not well publicized, they are of limited use. Employers should provide employees with frequent training regarding their compliance programs and internal-reporting procedures. Employees need to not only know what policies and procedures are in place but also understand their underlying purpose. Frequent education of employees, managers, and human-resources personnel will demonstrate a company’s commitment to compliance and ethical conduct. It will also encourage employees to make use of the resources available and ensure that all complaints are treated properly. Creating a comfortable environment for employees to report within their chain of command can be critically important.
Employers should consider offering incentives that encourage internal reporting. For example, employers can make it mandatory to report violations in a timely manner. Employers can also restructure their policies to ensure employees may not launch their own investigation, without first reporting internally.
At the same time, employers must ensure that whistleblowers are not subject to any form of retaliatory conduct. Retaliation has been interpreted to be any form of employment action that tends to chill an employee’s exercise of his or her lawfully protected rights. Thus, employers should develop with the employee an overall plan for managing the employee’s terms during and after an investigation. The employer must carefully monitor the whistleblower’s employment conditions and thoroughly vet any changes, including both overt adverse employment actions and subtle versions, to ensure they are consistent with the agreed-upon plan and avoid creating facts that could later be construed as retaliatory.
Employers often have to balance between establishing appropriate protections for a whistleblower while maintaining the integrity of the investigatory process. Careful thought and planning is required to avoid unjustly isolating the whistleblower or undermining his or her career path, while concurrently avoiding causing unfair damage (prior to a final determination of wrongdoing) to the career and reputation of the alleged wrongdoer.
The manner and speed with which companies self-report will be affected in light of the whistleblower program. Self-reporting is often the most important way to obtain leniency from the SEC and other regulators or prosecutors. Prior to the whistleblower program, companies would conduct thorough internal investigations into often complex matters and then determine whether to self-report. Under the act, companies will have to perform internal investigations much quicker—all in an effort to report the violation prior to any potential whistleblower. Further complicating the self-reporting process, companies run the risk of not being as thorough and comprehensive in their internal investigations. A company could miss issues that could potentially be reported by a whistleblower, resulting in the appearance of inadequate self-reporting and in an incomplete evaluation of the company’s potential risk or actual exposure.
For example, on March 14, 2010, Renault issued an apology to three senior managers the company had fired after receiving a tip that the managers had negotiated a bribe. Subsequent investigations by Renault and the prosecutor’s office concluded that the tips were likely fraudulent. This highlights the very real and potentially embarrassing risks companies face if they hurry internal investigations in response to fears from whistleblowers. Sebastian Moffett & David Pearson, Renault Apologizes to Fired Employees, Wall St. J., Mar. 15, 2011.
With the implementation of the act, companies have fewer available options and greater risks of regulatory actions and civil lawsuits fueled by whistleblowers emboldened by the act. Being prepared is forewarned. An employer’s best defense is implementing an effective compliance and internal-reporting program and designing appropriate incentives. Responding quickly and effectively to internal reports of wrongdoing is all the more important in this constantly changing environment. The consequences of not doing so can be detrimental, particularly in this new era of the SEC’s heightened reliance on whistleblowers.
On May 25, 2011, a divided SEC (3–2 vote) approved the final rule for the Implementation of the Whistleblower Provisions of section 21F of the Securities Exchange Act of 1934. The final rule is set to take effect on August 12, 2011. The SEC’s final rule made a number of “revisions and refinements” to the proposed rule. Most significantly, for purposes of this article, the SEC decided not to require whistleblowers to report violations internally as a requirement to receiving an award. The final rules provide that a whistleblower’s participation in a company’s internal compliance and reporting mechanisms is a factor that may increase the whistleblower’s award, while a whistleblower’s interference with internal compliance and reporting mechanisms is a factor that can decrease the award. The final rules added a new provision that permits a whistleblower to receive an award when she first reports internally and the employer reports information obtained from its investigation to the SEC. The whistleblower would obtain full credit for all the information provided by the employer to the SEC as if the whistleblower itself had provided that information; the result being that the whistleblower would receive credit for more information and a potentially greater award (based on the factors the SEC uses to determine whistleblower awards). Under the final rules, therefore, a whistleblower could interfere with or disregard a company’s internal compliance procedures and nonetheless be eligible for an award.
Keywords: Litigation, criminal litigation, SEC, whistleblower, Dodd-Frank
Anthony Pacheco is a partner in Proskauer Rose’s Los Angeles, California, office and is a former assistant U.S. attorney. Sigal P. Mandelker is a senior counsel in Proskauer Rose’s New York, New York, office and is a former deputy assistant attorney general of the Department of Justice’s Criminal Division and a former assistant U.S. attorney. Massiel Pedreira is an associate in Proskauer Rose’s New York, New York, office.