On May 25, 2011, the Securities and Exchange Commission (“SEC”) adopted Final Rules1 implementing the closely watched whistleblower provisions of the Dodd-Frank financial reform legislation that Congress passed in July.2 As discussed in our previous alert,3 under the whistleblower provisions the SEC will pay a bounty to an eligible whistleblower who voluntarily provides the SEC with original information concerning a securities law violation that leads to an enforcement action that collects $1 million or more. The bounties would be not less than 10 and up to 30 percent of the monetary sanctions awarded. The Final Rules were adopted by a 3-2 vote, split along partisan lines.
In announcing the Final Rules, SEC Chairman Mary Schapiro emphasized the impact that the whistleblower provisions already were having, and noted that, in addition to the “high volume of tips and complaints,” the quality of the tips received by the SEC has improved.4 On the other hand, Republican SEC Commissioner Kathleen Casey, who voted against the Final Rules, characterized the Rules as favoring “a pound of cure over an ounce of prevention.”5 The SEC noted in its release that it has fully staffed its new Whistleblower Office in the Division of Enforcement and has funded its $450 million Investor Protection Fund to pay whistleblowers, positioning the SEC to pursue the Rules aggressively when they take effect on July 25, 2011.6
Like the Proposed Rules promulgated on Nov. 3, 2010,7 the Final Rules state that eligible individuals who voluntarily provide the SEC with original information about any possible violations of the federal securities laws that have occurred, are ongoing, or are about to occur, that leads to a successful enforcement action, are entitled to between 10 and 30 percent of the aggregate recovery, as long as the total recovery is at least $1 million.8 The Rules define “original information” as derived from the independent knowledge or analysis of the whistleblower; not already known to the SEC from any other sources; and not exclusively derived from allegations made in a judicial or administrative hearing, government report, audit or investigation, or from the news media.9 Additionally, the information must have been provided to the SEC after July 21, 2010.10 The Commission, stating that it is operating on the theory of “use a rogue to catch a rogue,” permits whistleblowers who engage in misconduct that is the subject of the SEC’s action or a related action to recover awards.11 Similarly, the Final Rules decline to make whistleblowers ineligible for an award if they obstruct or fail to cooperate in a company’s own investigation of the alleged misconduct.12 However, in response to comments, the Commission stated that such culpable whistleblowers only should be compensated at the lower end of the 10 to 30 percent range and that recoveries or penalties against the whistleblowers themselves would not count towards the $1 million eligibility threshold.13
Under the Final Rules, whistleblowers also are protected from retaliation regardless of whether or not they are eligible for a bounty, and companies may not hinder a whistleblower’s ability to communicate with the SEC.14 However, the Final Rules state that whistleblowers may be fired or sanctioned for conduct unrelated to their whistleblowing, leaving it to case-by-case determinations of whether adverse employment actions were in retaliation for whistleblowing.15 In addition, the Final Rules also provide that the whistleblower must have a “reasonable belief” that a violation had occurred (or was occurring or would occur), so that pretextual whistleblowing reports would not trigger protection against retaliation.16 The Final Rules also add a provision allowing the Commission itself (not merely the whistleblower) to enforce the anti-retaliation provisions of the rules.17
Reporting Through Internal Compliance Programs
Overall, while the Final Rules make some concessions that reflect the critical comments levied against the Proposed Rules, they do little to protect companies or to preserve the efficacy of internal compliance programs. Chairman Schapiro stated that the Final Rules attempted to strike a balance on the most contentious issue raised: whether to require employees to report possible wrongdoing to their employer before reporting to the government.18 While the Final Rules do provide expanded incentives for whistleblowers to report internally, they do not require whistleblowers to do so and thereby expose companies to several different risks.
First, if a company is not informed of wrongdoing, it cannot correct the situation and prevent further misconduct. As Commissioner Casey pointed out, “[b]y diverting a large portion of the flow of information, it impairs a company’s ability to step in.”19 Additionally, because SEC investigations proceed far more slowly than internal investigations, the Final Rules allow “violations to last longer and grow more serious.”20 A whistleblower therefore may benefit — in the form of an increased bounty — by declining to report to the company so that the violation continues for far longer than it otherwise might.
Second, a whistleblower is eligible to receive a bounty even if the whistleblower submits a tip to the SEC after having been contacted pursuant to an internal investigation.21 As such, whistleblowers are given an enormous financial incentive to bypass a company’s good faith attempts to identify and investigate alleged violations. Even more troubling, a whistleblower is still eligible to receive not less than 10 percent of any monetary recovery by the government even if that whistleblower actively interferes with a company’s internal investigation by, for example, lying to independent investigators.22 If as a result of the whistleblower intentionally undermining the company’s internal investigation, compliance, or remedial efforts the underlying violation is given the time to grow larger and more widespread, the increased size of the potential recovery easily may exceed the impact of any reduction in the percentage of the whistleblower’s recovery because the minimum recovery, even in the case of such intentional interference with the investigation, remains at not less than 10 percent of the total recovery. Frustratingly, all the information that the company voluntarily provides to the Commission will be attributed to the whistleblower,23 which means that the whistleblower will get credit — and potentially a greater award — even if the company whose internal investigation, compliance, or remediation the whistleblower deliberately disrupted nonetheless manages to conduct a thorough investigation and does everything it can to be cooperative with the SEC.
Third, the Final Rules provide only that a whistleblower’s bounty “may increase” if the whistleblower participated in the company’s internal reporting and compliance system.24 This uncertain promise is unlikely to convince whistleblowers to report problems internally before going to the SEC. This is especially true because anti-retaliation provisions in the rule, designed to prevent employees from losing their jobs or facing other repercussions from reporting potential violations, only apply once the tip has been given to the SEC.25 Further, whistleblower reports to the SEC relate back to the date the whistleblower reported a possible violation internally only if the whistleblower contacts the SEC within 120 days of the internal report.26 A whistleblower thus would be well-advised to report immediately to the SEC not only to preserve her bounty, but also to preserve her job.
Rules Relating to Eligibility for Awards
The Final Rules allow more whistleblowers to qualify for bounties than did the Proposed Rules. The Final Rules now consider various compliance and internal audit personnel to be eligible to receive a whistleblower bounty as long as there is a “reasonable basis to believe that disclosure of the information to the Commission is necessary to prevent the [company] from engaging in conduct that is likely to cause substantial injury to the financial interest or property of the entity or investors” or there is “a reasonable basis to believe that the [company] is engaging in conduct that will impede an investigation of the misconduct.”27 These exemptions are broad, and it would not be difficult for an individual to assert the reasonable belief required to fall within one or both of these exemptions. Moreover, an employee who is part of a compliance process or internal audit matter but whose “principal duties” do not involve compliance or internal audit responsibilities (and is not an officer, director, trustee, or partner of the entity), would be free to take any information she learned as part of the compliance or internal audit matter to the SEC. The Final Rules did not adopt language in the Proposed Rules that would have required supervisors to escalate issues internally before reporting out to the SEC.28
Under the Final Rules, whistleblowers also can collect a bounty for information provided to the SEC even after the government begins an investigation and requests information from the whistleblower’s employer. Only if the government requests information directly from the whistleblower will she be considered ineligible for a bounty.29 Further, whereas under the Proposed Rules virtually any state authority’s request for information would have disqualified a potential whistleblower from eligibility for a bounty, the Final Rules provide that only a request made in connection with an investigation by state attorneys general or securities regulators would serve as a disqualification.30
The Final Rules recognize that the SEC’s whistleblower program is considerably more permissive than the False Claims Act in terms of what kind of tip may give rise to a bounty.31 Under the Final Rules, a whistleblower is defined as one who provides information to the SEC that “relates to a possible violation of the federal securities laws.”32 False Claims Act whistleblowers, in order to be eligible for an award, “must file a federal court complaint alleging fraud with specificity as required by Rule 9(b) of the Federal Rules of Civil Procedure, whereas under [the SEC’s] program, a whistleblower only needs to complete a Form TCR, sworn under penalty of perjury.”33 A whistleblower therefore only must allege that a violation is “possible” on a government form in order to be eligible for a considerable bounty, making it likely that the SEC will receive numerous speculative “tips” from would-be whistleblowers. Instead of internal compliance departments separating the serious tips from the spurious and unfounded, the SEC likely will receive both.
The Final Rules implementing the Dodd-Frank whistleblower provisions are unlikely to ameliorate, and may well exacerbate, many of the concerns that companies raised about the impact that the Proposed Rules would have on their operations in general and their internal compliance programs in particular. Taken as a whole, the provisions adopted by the Commission are unlikely to persuade many whistleblowers to make their reports internally. Indeed, companies should anticipate an increase in the number of tips that bypass their internal reporting mechanisms entirely and instead go directly, or through plaintiffs’ lawyers, to the government. These tips may come from a wider variety of personnel, some of whom were tasked with ensuring the company’s compliance system in the first place, and need not be supported by actual evidence. Moreover, companies face the likelihood that some whistleblowers may obstruct internal investigations, and individuals asked to cooperate in internal investigations instead may take their knowledge of the internal investigation to the SEC. Companies already confronting increased regulatory and law enforcement scrutiny now may be hampered even further in their ability to identify and address potential wrongdoing.
It is unclear whether there will be a judicial challenge to the Final Rules. Although members of the House Financial Services Committee have discussed possible legislation designed to address the problems of culpable whistleblowers and failures to report to internal compliance processes,34 it is unlikely that any such legislation will move forward quickly. Public companies and SEC-registered entities should assume that the Final Rules will go into effect this summer and should review and amend their policies and procedures for dealing with whistleblowers accordingly.
Please direct questions to any of the listed lawyers or to any other Bingham lawyer with whom you ordinarily work on related matters.
Amy Kroll, Partner, Broker-Dealer Group
David Boch, Partner, Broker-Dealer Group
Jordan D. Hershman, Practice Group Leader, Securities and Financial Institutions Litigation
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
Jeffrey Q. Smith, Practice Group Leader, Securities and Financial Institutions Litigation
Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934 (“Final Rules” or “Rules”), 17 C.F.R. Parts 240 and 249, Release No. 34-64545 (May 25, 2011).
Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), Pub.L. 111-203, H.R. 4173 (July 21 2010).
Levy, Michael, SEC Reveals Proposed Dodd-Frank Whistleblower Rules
(Nov. 12, 2010) (available at: /Media.aspx?MediaID=11515
Statement by SEC Chairman Mary L. Schapiro, Opening Statement at SEC Open Meeting: Item 2 — Whistleblower Program, Washington, D.C., Open Meeting, May 25, 2011 (available at: http://www.sec.gov/news/speech/2011/spch052511mls-item2.htm
Statement by SEC Commissioner Kathleen L. Casey, Adoption of Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, Washington, D.C., Open Meeting, May 25, 2011 (available at: http://www.sec.gov/news/speech/2011/spch052511klc-item2.htm
SEC Press Release, SEC Adopts Rules to Establish Whistleblower Program, Release No. 2011-116 (May 25, 2011).
Exch. Act Rel. No. 63,237 (Nov. 3, 2010) (available at http://www.sec.gov/rules/proposed/2010/34-63237.pdf
) (“Proposed Rules”).
Final Rules at 3.
Final Rule 21F-4(b)(1)(i)-(iii).
Final Rule 21F-4(b)(1)(iv).
Final Rules at 194.
Final Rules at 139.
Final Rules at 195-96.
Final Rule 21F-2(b)(1)(iii).
Final Rules at 19.
Final Rule 21F-2(b)(1)(i).
Final Rule 21F-2(b)(2).
Statement by SEC Chairman Mary L. Schapiro, supra
Statement by SEC Commissioner Kathleen L. Casey, supra
Final Rules at 33.
Among the conduct the Release describes as consistent with a whistleblower winning an award (and as influencing not whether the award is granted but rather whether the amount of the award is closer to 10 than 30 percent) is “interfer[ing] with an entity’s established legal, compliance, or audit procedures to prevent or delay detection of the reported securities violation,” and making “material false, fictitious, or fraudulent statements or representations that hindered an entity’s efforts to detect, investigate, or remediate the reported securities violations.” Final Rule 21F-6(b)(3)(ii).
Final Rules at 6.
Final Rule 21F-6(a).
Final Rule 21F-2(a)(2). Section 21F(h)(1)(A) of the Exchange Act prohibits any form of retaliation by an employer against a whistleblower because of any lawful act done by the whistleblower in providing information to the Commission in accordance with Section 21F. 15 U.S.C. 78u-6(h)(1)(A)(i).
Final Rule 21F-4(b)(7). This period was 90 days under Proposed Rule 21F-4(b)(7).
Final Rules at 75.
Proposed Rule 21F-4(b)(4)(iv) with
Final Rule 21F-4(b)(4).
Final Rules at 30.
Proposed Rule 21F-4(a)(1) with
Final Rule 21F-4(a)(1)(iii).
Final Rules at 106 n.232 (“The barriers to participation as a False Claims Act whistleblower are appreciably higher than in our program…”).
Final Rule 21F-2(a)(1) (emphasis added).
Final Rules at 106 n.232.
34 Legislative Proposals to Address the Negative Consequences of the Dodd-Frank Whistleblower Provisions: Hearing Before the House Financial Services Committee
, 112th Cong. (May 11, 2011).