Proposed Sec Rules Undermine Dodd-Frank’s Whistleblower Incentives

By: Marc Stephen Raspanti 

For years, the Securities and Exchange Commission (“SEC”) had a whistleblower program in place that would accept information about securities violations in exchange for the possibility of a financial reward if funds were recovered.  Nonetheless, over the years only five whistleblower claims were ever paid.  The reason appears clear.  The program was administered entirely at the discretion of the SEC.  One example of the failure of the prior program is Harry Markopolos, a former investment officer for a company that competed with Bernie Madoff’s investment firm.  Markopolos’s investment firm assigned him to analyze the basis for Madoff’s unbelievable returns to see if they could be duplicated.  His analysis concluded that Madoff was either involved in front running or a giant Ponzi scheme.  He tried in vain for years to persuade the SEC to investigate Madoff; but the SEC completely ignored Markopolos’s warnings, and Madoff’s fraud was only revealed when his own children learned the truth and turned him in.

In the summer of 2010, in response to the Madoff crisis, Congress enacted new whistleblower provisions for securities law violations as part of the Dodd-Frank Act.  The law addresses shortcoming in the SEC’s prior program and provides sweeping incentives for insiders to report securities law violations.  However, rules that the SEC has proposed threaten to gut the new law even before it has been fully implemented.

Before considering the effect of the regulations, it is important to understand the statutory framework for the current SEC whistleblower program.  Section 21F of Dodd-Frank establishes the SEC Investor Protection fund which is to be used to pay whistleblower claims. The Investor Protection Fund is to be funded with monetary sanctions that the Commission collects in a judicial or administrative action, or through certain disgorgements under the Sarbanes-Oxley Act of 2002.

Payments to Whistleblowers

Dodd-Frank Requires the SEC to Pay Whistleblowers Between 10 and 30 Percent of Amounts Recovered in Any Enforcement Action with Sanctions Exceeding $1 Million.

Section 21F(b) provides that the SEC “shall pay” a whistleblower who voluntarily provides original information to the SEC that leads to the successful enforcement of a covered judicial or administrative action and results in monetary sanctions exceeding $1 million.  Under the law, the whistleblower is entitled to an award of between 10 percent and 30 percent of what the SEC collects in monetary sanctions.  The amount of the award – between 10 and 30 percent—is determined subject to criteria set forth in subsection (c).  A whistleblower is defined as “any individual or two or more individuals acting together who provide ‘original information’ to the SEC relating to a violation of the securities law.

Original information” is further defined as information derived from the independent knowledge or analysis of the whistleblower; not known to the SEC from any other source unless the whistleblower is the original source of the information and the information is not derived exclusively from an allegation made in a judicial or administrative hearing, in a governmental report, hearing, audit or investigation, or from the news media, unless the whistleblower is a source of the allegation.

The concept of “original information” is derived in part from the public disclosure doctrine and original source exceptions found in the federal False Claims Act, and its purpose is to preclude opportunists from profiting from whistleblowing.

The definition of “original information” in Dodd Frank is fairly precise.  For example, the statute allows for a whistleblower to provide new information to supplement information already in the possession of the SEC.  It also expands on the concept of original source by allowing claims to be based in part on allegations already publicly available so long as they are not exclusively based upon such allegations.  On the other hand, a whistleblower may be barred under Dodd-Frank if he or she is not the source of independent knowledge concerning the non-public allegations.

An award may be denied only in limited circumstances if a whistleblower who is, or was at the time he acquired original information:  (1) a member, officer or employee of an appropriate regulatory agency, the Department of Justice, a self-regulatory organization, the Public Company Accounting Oversight Board, or a law enforcement organization; (2) convicted of a criminal violation related to the judicial or administrative action for which he is eligible for an award; (3) gains information through the performance of a required SEC audit; or (4) fails to submit information to the Commission in such form as the SEC may by rule require.

How to Make an SEC Whistleblower Claim

A whistleblower may make a claim anonymously; but may do so only through legal counsel.  His or her identity must be disclosed, however, prior to the payment of an award.  A whistleblower may appeal to the appropriate court of appeals whether an award was consistent with subsections (b) and (c).  Otherwise the SEC has discretion in determining the amount of the award.

Dodd-Frank provides similar whistleblower provisions for violations of commodity future laws, and also provides beefed-up protections against retaliation for whistleblowers.  Under prior law, whistleblowers who faced retaliation could pursue a claim through administrative procedures, and were entitled only to reinstatement. Under Dodd-Frank, whistleblowers are permitted to bring court claims directly and may seek double any lost wages, plus fees and costs.

Dodd-Frank provides for SEC rulemaking to implement and enforce the whistleblower provisions.  However, recently published proposed rules threaten to gut the essential provisions of section 21F.  Moreover, the SEC has recently deferred opening a whistleblower division to deal exclusively with whistleblower claims due to a lack of funding.  These events call into question the SEC’s commitment to the whistleblower program.

Most significant in the proposed rules is the SEC’s intent to require whistleblowers to report a violation of the securities laws internally prior to submitting a claim to the SEC.  The SEC’s rationale for this requirement is so that the whistleblower program does not circumvent internal reporting programs that companies developed under Sarbanes-Oxley and does not discourage companies from developing and maintaining such programs in the future.  While the SEC’s reasons are well-intentioned, in truth, the existence of internal reporting programs, to date, have failed to produce SEC whistleblower in large numbers.  And, rather than promote the concept of self-regulation, internal reporting programs have had the perverse effect of making whistleblowers targets for retaliation.

Many of the SEC’s proposed rules appear to be inconsistent with Dodd-Frank’s statutorily created whistleblower program.  The proposed regulations:

  • Provide grounds for denying awards additional to those set forth in the statute;
  • Attempt to limit statutory rights of appeal;
  • Limit recoveries for those with information critical to an SEC violation;
  • Place cumbersome procedures on whistleblowers to collect awards.

These proposed regulatory limitations are discussed below.

While Dodd-Frank restricts those reasons for which an award may be denied, proposed Rule 21F-4(b) attempts to broaden existing law by tinkering with the concept of “original information” defined in the statute.  Thus, while “original information” includes information derived from the independent knowledge or analysis of a whistleblower; the proposed rules attempt to limit what may be deemed independent knowledge if it is obtained through a communication subject to the attorney-client privilege.  Thus, the rules envision outright denial of a claim based on privileged information, rather than by taking into account the claim as a whole and whether the claim can survive without the use of privileged information.

Backtracking from Dodd-Frank

The proposed SEC rules appear to backtrack from the requirements of Dodd-Frank. The proposed rules also define the term “original source” inconsistently with Dodd-Frank.

Under Dodd-Frank a claim may be barred if based upon public information unless the whistleblower is a source of that information.  A whistleblower may also be a source of information derived from allegations made in a judicial or administrative hearing provided that he is an original source of that information.

Proposed Rule 21F-4(b)(5) provides that a whistleblower will be deemed the original source if the Commission initially received the information from a governmental organization and the whistleblower had voluntarily provided it to the organization.  This rule is too limiting, however, because Dodd-Frank’s original source language does not limit an original source to those instances when the SEC learns of the fraud through government agencies.  Instead, those sources may be other whistleblowers or private individuals.

Original information” also includes information “derived from the independent knowledge or analysis of the whistleblower.  Proposed Rule 21F-4(b)(2) defines “independent knowledge” to mean “factual information in [the whistleblower’s] possession that is not derived from publicly available sources.”  Such a definition is also too limiting because it excludes from consideration situations where the whistleblower is able to use public information to analyze the claims in a manner not previously disclosed or discovered.

Disqualifying Whistleblowers

The SEC’s proposed rules unduly expand grounds to disqualify a whistleblower from receiving an award.

The proposed rules disqualify a whistleblower with legal, compliance, audit, supervisory or governance responsibilities for an entity, and the information he provides is communicated with the reasonable expectation that the whistleblower would take steps to cause the entity to respond appropriately to the violation, unless the entity did not disclose the information to the SEC within a reasonable period of time.  This provision is substantially broader than any of the exclusions set forth in section 922 of Dodd-Frank and places an undue burden on whistleblowers.  Dodd Frank does not make a claim conditional upon internal reporting of claims, or even the self-reporting of the target company, and places no time limit on when the claim can be made (although the timing may affect whether an enforcement action may be brought).

Proposed rule 21F-4(b)(4)(vi) attempts to disqualify any whistleblower from an award if he obtains information by means or manner that violates applicable federal or state law.  Under Dodd-Frank, however, the whistleblower is only precluded from recovery if convicted of a crime related to the judicial or administrative action for which the whistleblower could otherwise receive an award.  Thus, the proposed rules seek to disqualify whistleblowers from recovery before any conviction has ever occurred.

Under Dodd-Frank, the SEC must pay an award to a whistleblower who voluntarily provides original information to the SEC that leads to a successful enforcement action.  Proposed Rule 21F-4(a) defines a “voluntary submission of information” more narrowly than the statutory language in Dodd-Frank.  That section provides that a submission is voluntary if the whistleblower provides the Commission with the information before the whistleblower or anyone representing the whistleblower receives any request, inquiry or demand from the SEC or other enumerated governmental entities about a matter to which the information in the submission is relevant.”  Under the proposed rule, the whistleblower is deemed to have received a request within the scope of the rule if the demand for documents was made to the whistleblower’s employer, unless the employer fails to respond to the request.  This particular rule then may bar a whistleblower claim even where a request for information is general and not focused on the conduct that is the subject of the whistleblower claim.  Thus, the claim might be barred even if the demand for information is not targeting the same violations of the securities laws as the whistleblower claims.

The proposed rules add an additional burden on the requirement that the whistleblower’s claim lead to a successful enforcement action.  Proposed Rule 21F-4(c)(1) requires that a successful enforcement action be one in which the whistleblower’s information “significantly contributed to the success of the action.”   The rule as proposed leaves the SEC with too much discretion in determining what constitutes a “significant contribution,” and, therefore, whether to make an award to a whistleblower.  This is contrary to the intent of Dodd-Frank, as embodied in section 922(b) and (c), which requires an award between 10 and 30 percent, and provides how the SEC should determine the amount of an award within those parameters based upon the whistleblower’s actual contributions to the success of the enforcement action.

Another proposed rule dealing with appellate rights provides that a whistleblower may only appeal a determination of whether or to whom to make an award without review of the determination of the amount at issue.  The rule runs contrary to the statutory language.  Dodd-Frank envisions appeals not only of whether and to whom an award should be made, but also provides for appellate review of whether the determination complied with subsection (b).  Subsection (b) requires an award to be between 10 and 30 percent of the amounts recovered.  Subsection (b), in turn incorporates those factors for the amount of an award under subsection (c).  Accordingly, Dodd-frank envisions appeals concerning whether the award was appropriate under the relevant statutory language.  The proposed rule seeks to exclude such consideration.

Finally, the proposed rules require a whistleblower to make a claim for an award once notice has been posted on the SEC website of a successful enforcement action.  Such a rule has no support in the language of Dodd-Frank and the intent to make a claim for an award should be fairly obvious from the whistleblower’s submission of information leading to a successful enforcement action.

What Does the Future Hold?

Dodd-Frank’s whistleblower provisions for securities laws were intended to be a game-changer in the regulation of securities by providing significant economic incentive for whistleblowers to report wrongdoing.

The Congress believes that only through whistleblowers can real fraud be detected.  The success of the False claims Act has been instrumental in demonstrating that.  The rules that the SEC has proposed to implement the whistleblower program, coupled with its deferral of establishing a whistleblower division, lead to the conclusion that most whistleblower claims will be dead on arrival.  It will be critical to see how the SEC modifies the rules in the coming months.

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