SEC Whistleblower Program: Compliance Nightmare or Missed Opportunity?

As part of Dodd-Frank Wall Street Reform and Consumer Protection Act passed last summer, the Securities and Exchange Commission was given the authority to establish a whistleblower program with monetary incentives as a way to entice individuals to come forward about corporate financial wrongdoings. Section 21F provides that whistleblowers who provide new information to the SEC about financial misconduct are able to collect monetary awards totaling between ten and thirty percent of the sanctions recovered through civil or criminal proceedings that total more than $1 million. The SEC characterizes “new information” as information that is original and “based on independent knowledge not already known to the Commission nor taken exclusively from public sources.”

According to the SEC, the new whistleblower authority will help the agency maximize its resources and effectiveness by increasing the number of high-quality tips that it might not otherwise receive without the incentives in place. SEC spokesman, John Nester, has already reported that that SEC has seen a “significant increase in high-quality tips.”

However, the whistleblower program is highly controversial. Many argue that such an incentive program pits employees against employers and creates a disincentive for employees to utilize internal compliance structures mandated by the 2002 Sarbanes-Oxley Act. According to Susan Hackett, senior vice president and general counsel for the Association of Corporate Counsel, the new program encourages “a lot of people who are being opportunistic or who are looking to actually help create problems they can then profit from.” She argues that compliance culture morphs from a “let’s fix it” attitude into a self-enterprising one, which creates clear compliance challenges. Tom Quaadman, vice president of the Capital Markets Competitiveness at the U.S. Chamber of Commerce takes a similar stance. Both advocate that whistleblowers should first be required to make use of internal reporting and investigative systems before submitting their complaints to the SEC. Further, these organizations call for a ban on monetary recovery for individuals who were engaged in the underlying misconduct before reporting. Quaadman asserts that whatever rules are finally implemented need to operate in such a way so as to promote good corporate behavior, not employee contrivance.

Another concern about the proposed Whistleblower Program is that there will be an increase in the number of frivolous allegations. This concern arises from acknowledgement that whistleblower complaints can act as a double-edged sword: they can be instrumental in identifying and correcting corporate misconduct but often, such complaints are made by underperforming employees in an attempt to advance personal grievances against their employer.

To counter these arguments, proponents of the whistleblower program cite to other successful programs with robust monetary rewards like that under the False Claims Act, which helped facilitate large settlements with pharmaceutical giants Pfizer and Eli Lilly for corporate misconduct. They take the stance that individuals who become aware of misdeeds are not eager to blow the whistle, but merely do so to keep their jobs or do what is right. Even among supporters, there is dissonance regarding the scope of the SEC’s proposed program. Some advocate for a broader definition of “whistleblower” and others are skeptical about the program’s potential for success because of limited resources and the program’s failure to address coordination of investigations between overlapping federal agencies.

In November 2010, the SEC released its proposed set of rules that will be used to implement the whistleblower program. The comment period for these rules expired on December 17, 2010, but the SEC has not issued final rules yet. Under the deadline set by Dodd-Frank, the SEC was supposed to have its final rules for the Whistleblower Incentives and Protection Program in place by April 21, 2011. In an April 26 interview, Mary Shapiro, chairman of the SEC, disclosed that the SEC is “now finalizing its whistleblower rules.” However, according to the SEC’s implementation calendar, the planned finalization of the rules is slated to be released between now and July. So far, the only completed installation of the program is the establishment of the new Whistleblower Office and appointment of Sean McKessy as the new director of that office.

Despite the delay in final rules and implementation, whistleblowers are currently protected from retaliation and entitled to applicable monetary rewards because Dodd-Frank provided temporary rules applicable for anyone who came forward after July 22, 2010. These temporary rules remain in effect until the SEC passes its final rules.

District Court Retroactively Applies Dodd-Frank Ban on Pre-dispute Arbitration in SOX Whistleblower Claims

The U.S. District Court for the District of Massachusetts applied the Dodd-Frank Act (“the Act” or “Dodd-Frank”) prohibition on pre-dispute arbitration agreements under the Sarbanes-Oxley (“SOX”) whistleblower protection retroactively. In a March 1 ruling, in Pezza v. Investors Capital, et al, Judge Douglas P. Woodlock, reasoned that retroactive application was appropriate due to the lack of clear Congressional intent to restrict the temporal scope and procedural nature of Section 922.

Section 922 of the Act, among other things, confers jurisdiction on the courts, rather than to a Financial Industry Regulatory Authority (FINRA) arbitration panel, by voiding arbitration provisions in employment agreements that purport to force an employee to arbitrate, rather than litigate disputes arising under Section 806 of SOX.

The suit arose from a claim of wrongful retaliation (in violation of SOX) against the plaintiff after he raised concerns about the defendant’s misconduct in connection with securities transactions. (The plaintiff had previously filed the requisite complaints with the Department of Labor.) The defendants, Investors Capital Corp., Investors Capital Holdings, Inc., and Timothy Murphy, argued that the plaintiff was required to submit his dispute to arbitration, not the courts, pursuant to a pre-dispute arbitration provision in his employment agreement. However, while the defendant’s motion to compel arbitration was under advisement, Congress enacted Dodd-Frank, which included the prohibition on pre-dispute arbitration agreements for whistleblower claims brought under SOX.

In determining whether to apply Section 922 retroactively, the court used the framework setup by the Supreme Court in Fernandez-Vargas v. Gonzales, which essentially instructs a court to first look to whether there is any Congressional intent allowing for retroactive application. If there is no clear indication by Congress, the court then must look to whether retroactive application would result in a disfavored consequence affecting a substantive right. If the court answers in the negative, retroactive application is appropriate.

Here, Section 922 did not include any express provisions or clear statements of Congressional intent regarding retroactivity. Further, after applying the standard rules of statutory construction, the court found nothing that indicated Congress intended for the provision to apply to existing arbitration agreements. The court also found it insufficient that Congress vested the authority to limit future pre-dispute arbitration provisions with the new Bureau of Consumer Financial Protection and the CFTC. Thus the court determined that the result regarding retroactivity under Fernandez-Vargas was inconclusive.

However, under Landgraf v. USI Film Prods, the Supreme Court recognized that jurisdictional statutes may be applied retroactively absent specific legislative authorization without raising retroactivity issues. As a result, the District Court construed Section 922 to be a jurisdictional statute and relied on the holding from Landgraf instead of the retroactivity test under Fernandez-Vargas. Accordingly, the court denied the defendants’ motion to compel arbitration and concluded that Section 922 should be applied retroactively to combat bad conduct arising prior to the enactment of Dodd-Frank.

SOX Section 307 and ABA Rule 1.13: Corporate Counsel Caught in the Crosshairs

While the duty of loyalty to corporations and the ethical standards of corporate counsel are not new ideas, a periodic reminder about what those standards are is welcome. Corporate counsel owes a duty of loyalty to the corporation, not its officers. Counsel also provides guidance and advice to employees of the organization about how to carry out their fiduciary duties. When counsel has evidence of a misdeed involving an officer or employee that might also have been a client, there are conflicting duties to the corporation and the officer or employee. This is a delicate relationship built on trust and the expectation that generally, communication between corporate employees and corporate attorneys will not be subject to disclosure.

Rule 1.13of the ABA Model Rules of Professional Conduct governs the disclosure standards for corporate counsel and has been adopted by every jurisdiction in some form. (Note that some states, like Missouri, have not adopted the updated version o f Rule 1.13, so reporting outside of the organization is not permissible.) The key elements of Rule 1.13 are the degree of knowledge that triggers attorney reporting of corporate misdeeds and the amount of discretion corporate counsel has in addressing this perceived knowledge. The degree of knowledge that triggers the reporting requirement occurs when the attorney “knows” of ongoing wrongful acts or future wrongful acts. Further, the trigger is only activated when those acts are a violation of law that “reasonably might be imputed to the organization” or that will likely “result in substantial injury to the organization.” Once the attorney learns of such conduct, the attorney is required “to proceed as is reasonably necessary in the best interest of the organization” and accordingly has the discretion to determine how to report: report up within the organization or report outside of the organization.

Reporting outside of the organization is only appropriate when reporting up the chain of command within the organization has been exhausted, no action has been taken by the officers, and when such a violation of law is reasonably certain to result in substantial injury to the organization. Only then may the attorney reveal information to the extent reasonably necessary to prevent substantial injury to the organization. Ultimately, the Model Rules require reporting, but the attorney remains empowered to exercise discretion in determining when to report violations by corporate employees and officers. Giving corporate counsel such discretion is necessary in order to maintain the relationship between corporate counsel and employees of the corporation and avoid discouraging counsel to take action when necessary. The ABA commentators were concerned that weakening the relationship of trust and openness between corporate counsel and corporate employees would lead to less communication and increased risk of corporate employees unintentionally engaging in wrongful behavior.

In addition to the Model Rules, the SEC implemented Section 307 of the Sarbanes-Oxley Act, which sets forth “standards of professional conduct for attorneys appearing and practicing before the [SEC] in any way in the representation of issuers.” The SEC broadly defines “appearing and practicing” to include attorneys that represent issuers and those that do not. Attorneys that have any communications with the SEC or participate in preparing any document that the attorney should anticipate will be submitted to the SEC falls under the scope of “appearing and practicing.” Also, attorneys that have no contact with the SEC may be included under the rule if they advise any party or organization that it is not required to make disclosures or submissions to the SEC or if attorneys represent private companies that do business with public companies and it benefits the public company in any way. This means that in some cases, attorneys may be obligated to report up within an organization that is not their client. For example, the SEC cites a case where a privately held company acts as an investment adviser to a public mutual fund. If the attorney for the private company assists in preparing the mutual fund’s SEC filings, the private company’s attorney will be obligated to report up any misconduct within the public mutual fund’s organization.

Under Section 307, when an attorney becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney must report up to the chief legal counsel or chief executive officer of the organization. (The SEC defines “material violations” as any material violation of federal securities laws, any material breach of fiduciary duty recognized by common law, or any “similar material violation”.) If the attorney does not receive an appropriate response, the attorney is required to report to the audit committee or the full board.

If the material violation is ongoing or regarding an SEC filing and there is still no appropriate response from the CEO or chief legal counsel, the attorney must notify the SEC that the attorney is disaffirming any “tainted” SEC filing that the attorney participated in preparing. Further, if the participating attorney is outside counsel, the attorney must notify the SEC of withdrawal from representation of the issuer based on “professional considerations,” which the SEC states will “virtually ensur[e]” an immediate SEC inquiry into the matter. Noisy withdrawal and disaffirmation is permitted under Section 307 for material violations that have occurred in the past; however, the SEC has taken the position that failure to disclose past violations may itself be an ongoing violation.

Section 307 also provides for an alternative reporting channel if the issuer’s board of directors establishes a “qualified legal compliance committee.” The QCLC would be comprised of at least one member of the issuer’s audit committee and two or more independent board members. The primary purpose of a QCLC would be to handle attorney reports of misconduct and advise the issuer on how to implement an appropriate response to a report of a material violation.

Further, Section 307 expressly states that it preempts any conflicting state laws unless those state laws impose more stringent requirements. Section 307 is inconsistent with most states’ rules of professional conduct, which are modeled after the ABA Model Rules, to the extent in which they require or permit attorneys to report conduct outside the organization.

When Section 307 was proposed, there was significant controversy. The rule came in the wake of Enron and WorldCom when there was public outcry for more regulation of corporate counsels. Several commentators argued that the rule would create a trap for the unwary because they can apply to attorneys that do not represent public companies. The rule has been criticized because it effectively requires attorneys to “tip” the SEC about misconduct by public companies when state attorney ethics rules would either prohibit disclosure or not require disclosure. Perhaps the biggest concern is that Section 307 would erode the relationship between corporate counsel and corporate employees, which is built on trust and openness, and actually cause more harm than good.

The ethical rules that apply to corporate counsel require attorneys to strike a delicate balance between the attorneys’ duty of loyalty to the corporation and the attorneys’ required conduct regulated by the state and the SEC.