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New SEC Whistleblower Rules

Client Advisory

June 6, 2011

On May 25, 2011, the SEC, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), adopted new rules which authorize the payment of significant bounties to corporate whistleblowers where the information provided by the whistleblower leads to the SEC’s prosecution of an enforcement action and collection of more than $1 million in sanctions. In such situations the SEC will pay the tipster between 10% and 30% of the amount collected.

The new rules, applicable to all publicly traded companies, will likely alter the actions of many employees who believe they have information about corporate malfeasance. The monetary incentive (potentially in the millions of dollars) to be a whistleblower, coupled with Dodd-Frank’s beefed-up protection of whistleblowers from employer retaliation, is likely to result in vastly increased disclosure and reporting of perceived corporate wrongdoing by corporate insiders. The new rules, which become effective 60 days after their publication in the Federal Register are summarized below:

Definition of Whistleblower – A whistleblower is defined as “an individual who, alone, or jointly with others, provides information to the [SEC] relating to a possible violation of the federal securities laws that has occurred, is ongoing, or is about to occur.”[1] This definition sets the bar quite low; as the commentary to the rule notes, a possible violation need not be “material,” “probable,” or even likely.

The Internal v. External Report Dichotomy – Regulations enacted pursuant to Sarbanes-Oxley encourage publicly traded companies to implement measures that facilitate and encourage the reporting of suspected misconduct, including the use of anonymous tiplines, anti-retaliation procedures and the like. After internal investigation and the addressing of problems, companies, where appropriate, would then self-report to the proper authorities.

The new rules incentivize, but do not mandate, internal reporting of violations before reporting to the SEC’s Office of Whistleblower. The SEC determined not to mandate internal reporting despite significant concerns raised during the comment period. Recognizing that concern, under the new rules an employee who reports misconduct internally that eventually is forwarded to the SEC reaps at least the same bounty as if he had reported directly to the SEC. Moreover, if the internally reported information leads to an investigation and eventual enforcement action (or settlement) of a scope wider than the original reporter disclosed, his bounty will include credit for everything that followed his or her original report.

For example, suppose the assistant to a mid-level manager internally reports his suspicion that his boss is padding her expense reports. An internal audit subsequently reveals rampant, widespread and material expense padding through an entire division of the company. The investigation of the expense padding scheme leads to the discovery an even more serious kickback arrangement between vendors and executives. Under the new SEC whistleblower rules, when everything is reported to the authorities, the assistant who made the original report will get credit for everything that was uncovered when his or her bounty is calculated. As an added incentive to report internally, the final rules permit the SEC to increase the award percentage for reporting internally.[2]

Finally, by excluding certain categories of individuals, such as lawyers and internal and external auditors, as whistleblowers who may share in the bounty, internal disclosure to those individuals is encouraged.[3]

Frivolous Reporting - To deter frivolous or bad-faith reporting, the anti-retaliation provisions for whistleblowers have been modified by establishing a requirement that the reporter possess a “reasonable belief” that the information reported relates to a securities law violation. The SEC’s commentary notes that “the ‘reasonable belief’ standard requires that the employee hold a subjectively genuine belief that the information demonstrates a possible violation, and that this belief be one that a similarly situated employee might reasonably possess.”

The SEC will be the arbiter of whether the reported information was original. Reporting stale or previously disclosed information will not qualify the reporter for the available monetary rewards and, if reported in bad faith, may subject the reporter to employment sanctions.

Managing the Risks – The new rules put in place a heretofore untested monetary incentive regime to encourage the reporting of “possible” securities law violations. The program bears certain similarities to the IRS bounty regime for the reporting of tax cheating. But the differences appear to be far greater. No one can be certain as to how these new rules will actually work in the real world. However, even under Dodd-Frank, before the SEC’s May 25th vote, whistleblower reporting had increased. With its enactment, the SEC has finished staffing its Office of the Whistleblower and fully funded the Investor Protection Fund. Public companies are well advised to be proactive to these developments. In that regard, they will want to revisit, and if necessary, revamp, best practices in areas such as management training, fraud detection and establishing a culture of good corporate citizenship. The new rules place a premium on fully formulated compliance and reporting policies that incentivize early internal reporting coupled with increased and rapid utilization of internal investigations undertaken by experienced outside counsel and voluntary disclosure of violations must become the new “business as usual.” No responsible board will want to first learn of problems from law enforcement or regulators following a whistleblower’s external report.


Questions regarding this advisory should be addressed to Michael Shapiro (212-238-8676, mshapiro@clm.com) and Alan S. Lewis (212-238-8647, lewis@clm.com).


 

Endnotes


[1] Rule 21F-2(a) under the Securities Exchange Act of 1934.

[2] Rule 21F-4(c) under the Securities Exchange Act of 1934.

[3] Rule 21F-6(a) under the Securities Exchange Act of 1934.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
© Copyright 2011


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