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Whistleblower Provisions of the Dodd-Frank Act Clarified by the SEC's Proposed Rules

Client Alert

Authors: Russell E. Adler and Ivan B. Knauer

11/12/2010

The recently passed Dodd-Frank Wall Street Reform Consumer Protection Act (Dodd-Frank or the Act) includes amendments to the Securities Exchange Act of 1934 that provide significant monetary awards to whistleblowers who disclose violations of securities laws to the SEC or CFTC. Whistleblowers are also afforded protection from retaliation as a result of their exercise of rights afforded under Dodd-Frank. On November 3, 2010, the Securities and Exchange Commission (SEC) issued proposed rules implementing Dodd-Frank’s whistleblower provisions; the proposed rules are now subject to public comment until December 17, 2010. The proposed rules, including the SEC’s extensive commentary, are available at: www.sec.gov/rules/proposed/2010/34-63237.pdf.

Monetary Awards for Whistleblowers

Perhaps the most well-publicized component of Dodd-Frank are the provisions regarding financial awards to whistleblowers who report securities law violations. Companies are clearly concerned that such bounties will discourage internal disclosures and encourage reporting to the SEC without first affording companies the opportunity for internal investigation and remediation. In issuing the proposed rules, the SEC repeatedly states that it is aware of this concern and notes: “With this possible tension in mind, we have included provisions in the proposed rules intended not to discourage whistleblowers who work for companies that have robust compliance programs to first report the violation to appropriate company personnel, while at the same time preserving the whistleblower’s status as an original source of the information and eligibility for an award.” It is unlikely that this statement or the proposed rules will quell the debate about whether the SEC achieved this balance, and this tension is expected to be the subject of extensive public comment.

Indeed, in recognition of the need to handle an expected surge in tips, complaints and referrals (TCRs), the SEC has created an Office of Market Intelligence (OMI). One of the main functions of OMI is to create a systematic and organized mechanism for the SEC staff to handle TCRs from whistleblowers. By enhancing its ability to respond to TCRs, the SEC is hoping to avoid a repeat of some of the recent market scandals, which were exacerbated by the SEC’s failure to recognize and respond to relevant complaints (such as in the Madoff matter). See Pepper Hamilton’s November 2, 2010 Client Alert, “OCIE Director Discusses Recent Changes at the Commission and Current Exam Priorities.”

The proposed rules define “whistleblowers” as individuals who provide the SEC with “information relating to a potential violation of the securities laws.” To provide whistleblowers with an incentive to report securities law violations, whistleblowers are protected from retaliation and are eligible for an award of between 10 percent and 30 percent of the total monetary award recovered by the SEC if it imposes a sanction exceeding $1 million. To be eligible for an award, the individual must voluntarily provide original information that leads to a successful enforcement action and monetary sanctions. The proposed rules define, among other key terms, “voluntarily,” “original information” and “leads to successful enforcement action.”

Information is submitted “voluntarily” if it is made before the individual or anyone representing the individual receives any “request, inquiry, or demand” from the SEC, Congress, any federal, state or local authority, any self-regulatory organization or the Public Company Accounting Oversight Board “about a matter to which the information in [the individual’s] submission is relevant.” An individual will be considered to have received a request if the documents or information the individual has provided the SEC are within the scope of a request to the individual’s employer, unless the employer fails to provide the documents or information in a “timely manner.” Furthermore, information is not provided “voluntarily” if the individual is under a pre-existing legal or contractual duty to report the securities violation revealed by such information.

“Original information” is information derived from independent knowledge (which under the proposed rules can come from “experiences, communications and observations in your business or social interactions”) or independent analysis (“examination and evaluation of information that may be generally available, but which reveals information that is not generally known to the public”) that is not already known to the SEC and not exclusively derived from an allegation in a judicial or administrative hearing, government report, hearing, audit, investigation or news media (unless the individual is the source). The acknowledgement that an individual may qualify for an award as a result of his or her independent analysis calls to mind the repeatedly ignored reports by Harry Markopolos to the SEC identifying the Madoff fraud.

The proposed rules further provide that information is not obtained through independent knowledge or analysis if, among other things, it was derived:

  • from communication subject to attorney-client privilege
  • as a result of an independent public accountant’s engagement as required by the securities laws
  • because the person had legal, compliance, audit, supervisory or governance responsibilities for the entity and the information was communicated with the reasonable expectation that the person would take steps to remedy the violation, or
  • from or through an entity’s legal, compliance, audit or similar functions or processes for identifying, reporting and addressing non-compliance.

In the latter two cases, an exception is drawn if the entity failed to disclose the information to the SEC “within a reasonable time or proceeded in bad faith.”

Information will be deemed to have “[led] to successful enforcement action” if it caused the SEC to commence an examination, open or re-open an investigation, or to inquire concerning new or different conduct as part of a pending investigation, and if the information “significantly contributed” to the success of the action.

Except in limited circumstances, the SEC is required to keep the identity of a whistleblower confidential and whistleblowers are permitted to report potential violations anonymously, in which case they must be represented by counsel. The proposed rules also provide detailed reporting requirements and proposed forms, both for reporting alleged violations and for claiming monetary awards.

No ‘Free Pass’ for Whistleblowers

Whistleblowers are not given amnesty for their actions. Although a whistleblower’s cooperation will be taken into account, the proposed rules provide that “the fact that [an individual] may become a whistleblower and assist in SEC investigations and enforcement actions does not preclude the SEC from bringing an action against [the individual] based upon [his/her] own conduct in connection with violations of the federal securities laws.” Similarly, when determining whether the $1 million sanction threshold has been satisfied, the SEC will not count any sanction the whistleblower is ordered to pay or any sanction against an entity whose liability is based substantially on the conduct the whistleblower “directed, planned or initiated.”

Whistleblower Protections from Retaliation

Under the proposed rules, whistleblowers are protected from retaliation if they report a potential violation of the securities laws. A final adjudication that securities laws were violated is not necessary for retaliation protection, nor is it necessary that the whistleblower ultimately qualify for a financial award in order to be protected. Affording protection for reports of potential violations is clearly intended to increase reports to the SEC and is in contrast to some whistleblower laws, like New York’s, which has been interpreted to afford protection for whistleblowers only if they report actual violations of law that present substantial and specific dangers to the public health or safety.

The proposed rules also prohibit any action that impedes a whistleblower from communicating directly with the SEC about potential securities violations, including enforcing, or threatening to enforce, a confidentiality agreement. Likewise, the proposed rules provide that a whistleblower who is a director, officer, member, agent or employee of an entity that has counsel may continue to communicate with the SEC without the SEC seeking consent of the entity’s counsel. Further, although not addressed in the proposed rules, employees claiming retaliation may do so in court despite a pre-dispute arbitration agreement, such as those required of registered representatives; in fact, the Act expressly invalidates such pre-dispute arbitration provisions, which means that registered representatives’ agreement under FINRA to resolve all disputes with their employer will not be applicable to whistleblower retaliation claims.

Whistleblower Protection Is Not Limited to Public Companies

Non-public companies must also be aware that the whistleblower provisions apply to any potential securities violation. This would apply, for example, to potential securities law violations by entities regulated by the SEC, such as registered broker-dealers or investment advisers, whether or not they are public companies (or subsidiaries of public companies). For example, if an individual employed at a broker-dealer or investment adviser reported an alleged front-running scheme to the SEC, he or she would be protected from retaliation and potentially eligible for a monetary award. The whistleblower provisions would also apply, for example, to a report by an employee of a non-registered hedge fund that the fund’s principals were engaged in insider trading.

What Should Companies Do Now?

Companies should review their compliance policies and procedures to make sure they have a robust and meaningful procedure that encourages internal communication and escalation if an employee becomes aware of any possible violations of the securities laws. Such policies should also explicitly state that employees are not subject to retaliation for reporting potential violations. Management must support such policies so employees feel empowered and are not afraid to report matters up the chain. As the SEC reminds companies frequently, “tone at the top” is extremely important.

Companies should also take steps to prevent retaliation claims by, for example, training managers to immediately involve both the compliance and human resources departments in cases in which an employee inquires about or complains of any action or omission that implicates a potential securities violation. Similarly, before any personnel action involving an individual who has inquired about or complained of a potential securities violation, human resources and, if necessary, outside counsel should be consulted to ensure that such action is not retaliatory.

Russell E. Adler and Ivan B. Knauer

More Resources on the Dodd-Frank Act

For additional information, please visit Pepper's Financial Services Reform Resource Center.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.