Newly Enacted Whistleblower Provisions under Dodd-Frank and SEC Rules Mandate All Employers to Review their Compliance Procedures and Submit Comment to the SEC

The Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) has increased the need for all entities, including privately-held companies, to adopt: (I) anti-retaliation policies that encourage employees to make anonymous tips of suspected misappropriation or fraud; (ii) anonymous tip-lines that forward reports to the board; and (iii) a reward system for tips that improve operations to promote internal reporting habits.

The Securities Exchange Commission (“SEC” or “Commission”) issued proposed rules that describe the criteria whistleblowers must meet to be eligible for awards and which the SEC will consider in determining amount of the awards.

We encourage all organizations to review the full text of the proposed rules, and to submit comments to the SEC before December 17, 2010, on whether the proposed rules should be changed so that the SEC must also consider whether the whistleblower reported the potential violation through effective internal whistleblower, legal or compliance procedures before reporting the violation to the Commission.

Impact of the Dodd-Frank Act

Sections 922 to 924 of the Dodd-Frank Act enacted new Section 21F of the Securities Exchange Act of 1934, which may encourage employees of all organizations to ignore internal compliance systems and, instead, report their suspicions of fraud to the Securities Exchange Commission (“SEC” or “Commission”) to recover awards paid by the SEC to “whistleblowers.” The DFA increases the amount that “whistleblowers” may recover for retaliation over that which has been allowed under Section 806 of the Sarbanes-Oxley Act (SOX). Significant statutory changes include:

1. Pay whistleblowers who submit tips to the SEC an award in the amount of 10% to 30% of any penalty and disgorgement, with interest, that exceeds $1 million in any administrative or judicial action brought by the SEC, the Attorney General of the United States, appropriate regulatory authorities, self-regulatory organizations, or State attorney generals in connection with criminal investigations (§ 21F(a) and (b));
2. Allow whistleblowers to bring retaliation claims in the United States district courts (§ 21F(h)), without waiting 180 days after filing a complaint with the Department of Labor (18 U.S.C.§ 1514A(b)(1));
3. Allow whistleblowers to have their claims heard by a jury (DFA § 922©), rather than by a judge under SOX (18 U.S.C. § 1514A(b)(2)), or compelling arbitration when a pre-dispute arbitration agreement exists (see Schmidt v. Levi Strauss & Co., 621 F. Supp. 2d 796 (N.D. Cal. 2008));
4. Increase the amount of damages recoverable from 1 times lost earnings to 2 times lost earnings, plus costs (including attorney and expert fees) and interest (§ 21F(h)(1)(c);
5. Extend the statute of limitations from 180 days after a retaliatory event occurs or when the employee became aware of the violation (18 U.S.C. § 1514A(b)(2)(D)), to 6 years after the violation occurred or 3 years after discovery, but not to exceed 10 years from the event (§ 21F(h)); and
6. Create an Office within the SEC, separate from the Department of Labor, to enforce the whistleblower protection and award provisions stated in Section 21F.

The impact of removing the Department of Labor (“DoL”) from enforcing whistleblower retaliation claims brought under DFA, and allowing whistleblowers to demand jury trials, should increase employer liability substantially if written anti-retaliation policies do not exist. Only 1.4% of all retaliation claims reviewed by the DoL were found meritorious, with another 14% reported as settled. (See attached DoL States by FY though 2010.) Further, employers no longer may compel retaliation claims to be arbitrated.

Whistleblowers are defined in Section 21F(a)(6) as one or more persons who provide “information relating to a violation of the securities laws to the Commission, in a manner established by rule or regulation, by the Commission.” While this definition limits the direct impact of DFA whistleblower provisions to entities with publically traded securities, these provisions also impact the standards of care owed by directors of privately-held entities, as evidenced by recent pronouncements made by the heads of the SEC Enforcement Division and the Fraud Section of the Criminal Division of the U.S. Department of Justice. Each director has stated that the existence of effective internal compliance reporting systems will be considered in determining the amount of civil penalties assessed by SEC in enforcement proceedings, and whether the Department of Justice will decline to prosecute criminal charges, or reduce any penalties, fines and other sanctions at sentencing. See SEC Enforcement Manual at § 6.1.2, and U.S. Attorney’s Manual at § 9-27.230.

Proposed SEC Rules define Eligibility and Amount of Awards Paid to Whistleblowers

The Securities Exchange Commission issued SEC Release No. 34-63237 on November 3, 2010, to propose new regulations which describe the criteria that the SEC will use to determine eligibility and the amount of awards. SEC Rule 240.21F-4(b) states that whistleblowers are not eligible to collect any award if: their disclosures to the SEC are based on information that was the subject of attorney-client privilege; the information was received by the whistleblower while in the capacity of a government official, regulatory agency, auditing the entities financial statements, or were part of the company’s compliance department, unless the disclosure is otherwise authorized by regulation, were convicted of a criminal violation related to the events disclosed; or knowingly and wilfully gave false information to the Commission.

The SEC may increase the award from 10% to 30% of the total penalty based on: the significance of the information provided; the degree of assistance provided; programmatic interest of the Commission in deterring future violations by encouraging whistleblowers to provide information; and whether the award enhances the Commission’s ability to enforce the federal securities laws. See § 240.21F-6.

Employers have until December 17 to Submit Comment on whether to add Other Criteria

The Commission has asked the public to comment on whether the criteria for determining the amount of awards paid to whistleblowers should include:

whether, and the extent to which, the whistleblower reported the potential violation through effective internal whistleblower, legal or compliance procedures before reporting the violation to the Commission.

SEC Rel. 33-63237 (Corrected) at p. 52, Request for comment 27.

We encourage all entities to consider the impact of the proposed Rules on their internal compliance systems, and to submit comment to the SEC on whether adding the above provision will improve their internal compliance procedures and corporate governance. Comments are due on or before December 17, 2010, and may be submitted on-line at: http://www.sec.gov/rules/proposed.

Whistleblowers may submit their disclosures anonymously to the Commission

Section 21F(d) permits whistleblowers to submit information anonymously through an attorney, but the whistleblower must later disclose their identify after their tip has lead to a successful prosecution as a condition to claiming payment of their award.

The identify of whistleblowers who provide their identity to the Commission by proceeding without an attorney is protected by Section 21F(h)(2). This section prohibits the Commission from disclosing any information to the public that may identify the whistleblower until the person’s identify must be given under the rules in any SEC enforcement or other criminal proceeding, or as otherwise required by the FOIA. Proposed Rule 240.21F-7(a)(2) allows the Commission to require further assurances from any law enforcement or other agency to preserve confidentiality of the whistleblower’s identity.

Procedures for claiming awards

Whistleblowers are required to submit their disclosures to the SEC in compliance with the procedures stated in proposed Rule 240.21F-9 to 11.

Rule 240.21F-9 requires whistleblowers to: (1) submit their tips on-line through the SEC Electronic Data Collection System or in hard copy by submitting SEC Form TCR; and, within thirty (30) days of the tip; and (2) submit a Form WB-DEC [Declaration Concerning Original Information Provided Pursuant to § 21F of the Securities Exchange Act of 1934], signed under penalty of perjury.

Whistleblowers who elect to submit information anonymously through an attorney must give their attorney a signed Form WB-DEC. The attorney then submits a separate Form WB-DEC in their own name to the SEC verifying that they have reviewed and will retain the original tip information and Form WB-DEC submitted to the attorney by the whistleblower.

Whistleblowers have only sixty (60) days after the SEC Whistleblower Office posts a Notice of Covered Action to claim an award. Any claim made after the 60-day period will be barred. All claims must be made on SEC Form WB-APP, and when the initial tip was made anonymously, include the name of the whistleblower.

Administrative review procedures for the eligibility and amount of awards are stated in proposed Rules 240.21F-10 and 11, with judicial appeal procedures set forth in proposed Rule 240.21F-12.

Amnesty

Proposed Rule 240.21F-14 makes clear that making disclosures under the Whistleblower Provisions will not provide amnesty to those who have engaged in criminal conduct, but that cooperation with law enforcement and regulatory authorities may be considered at sentencing in any SEC Enforcement Action.

CONCLUSION:

Directors, officers, and managers of all organizations should review and reconsider how they may improve their internal compliance and governance systems. Auditing firms have reported that at least 5% of an entity’s revenue is lost through various forms of employee theft, whether that be in the form of taking paper and other office supplies home for personal use, overpaying vendors for soft dollar benefits, or straight embezzlement. Cable companies have reported that nearly 95% of all persons caught tapping into their systems are discovered by reports received from former girlfriends and spouses. These examples and the changing legal landscapes for retaliation claims with the SEC’s new bounty program make it harder to justify why those charged with oversight of an organization do not have strong anti-retaliation policies that are published frequently to their employees, and an anonymous tip-line with other measures that encourage employees to report all matters that may improve operations.

The size of your organization will determine the steps a jury will determine to have been “prudent” for your entity. Materials you should consider, and which effective attorneys will use as exhibits to demonstrate the effectiveness of your oversight, include Managing the Business Risk of Fraud: A Practical Guide (sponsored by IIA, AICPA, and ACFE), and SEC Release 33-8220. Once you have read these materials, larger entities may consider creating an office of ombudsman, who reports directly to the board, who forwards anonymous tips to the board and acts as a risk manager to investigate all anonymous or non-anonymous suggestions made to improve operations. Smaller entities may consider using more streamlined systems.

In either event, directors and management of all organizations should seek outside counsel to obtain an objective report of what juries will perceive to be “prudent” steps for the directors and management to have undertaken to improved operations and prevent fraud.