This content is from: Portfolio

SEC Whistleblower Rule: Good Intentions But Bad Consequences

A whistle-blowing train wreck is undoubtedly on the horizon for the SEC.

Michael Perlis and Wrenn Chais Last November, the Securities and Exchange Commission proposed rules to establish monetary awards for its whistleblower program.  It didn’t take long for these well-meaning rules to backfire.

The SEC has already announced that it expects in excess of 30,000 “tips” a year as a result of the whistleblower bounty, raising concerns that this provision of the Dodd-Frank Wall Street Reform and Consumer Act will lead to a flood of frivolous, ill-informed and unfounded claims.  Recent tipsters have included corporate competitors and even a “jilted spouse.”

These tips will undoubtedly require the devotion, at considerable expense, of expansive investigative resources by the SEC and, to an even greater extent, the companies implicated.  Given that the SEC may be in an extended period of flat budgets, and that many companies are still recovering from the financial crisis, it seems unlikely that the end result will benefit companies, their shareholders or the investing public.  Instead the likely beneficiaries are the throngs of plaintiff attorneys newly branding themselves as “Whistleblower” counsel and actively marketing the benefits of being first in line for a payday from the SEC.  A whistle-blowing train wreck is undoubtedly on the horizon for the Commission.

Section 922 of Dodd-Frank authorizes the SEC to pay awards to eligible whistleblowers who voluntarily provide the SEC with “original information” that leads to a successful enforcement action yielding monetary sanctions of over $1 million. The award amount is required to be between 10 percent and 30 percent of the total monetary sanctions collected in the SEC’s action or any related action such as in a criminal case.

The Act also expressly prohibits retaliation by employers against whistleblowers and provides them with a private cause of action in the event they are discharged or discriminated against by their employers in violation of the Act.  In considering the final rules for the whistleblower program, the SEC should be mindful of the potential for harm the currently proposed rules present.  Risks include rewarding and encouraging wrongdoers, creating incentives – through overbroad anti-retaliation provisions and substantial monetary rewards – to bypass or disrupt effective corporate compliance programs for the investigation of wrongdoing, and circumventing attorney-client protections.

Although enacted to prevent a recurrence of the Madoff Ponzi scheme embarrassment suffered by the SEC for ignoring repeated warnings by whistleblower Harry Markopolos (who first suggested the whistleblower bounty program be extended to all securities violations during his 2009 congressional testimony), the SEC’s failure with the Madoff scandal was not due to the lack of a whistleblower, but instead to a substandard SEC investigation.

Recognizing that the public outcry will be far worse if the SEC fails to properly investigate a submitted whistleblower tip, combined with the fact that the SEC has neither the budget nor the manpower to investigate the anticipated number of tips, the SEC will have no choice but to immediately notify the companies involved that they will need to commit significant corporate resources towards investigating the allegations.

As a result, the whistleblower program has incentivized – for a minimum of a $100,000 award - anyone with the slightest suspicion a company might be violating the securities laws to report to the SEC, but it will be the company, not the SEC that is to bear the burden of erroneous tips and malcontents.  The corporate financial burden alone is likely to be astronomical.  Assuming the SEC will refer 29,000 of the 30,000 anticipated “tips” back to the companies for investigation and assuming an extremely conservative average investigation cost of $50,000 (Avon Products, Inc. reportedly spent $18 million in FCPA investigative costs in the fourth quarter of 2009), the whistleblower program will collectively cost companies at least $1.45 billion in investigation costs.

Given that the SEC will not be able to adequately investigate the expected number of tips, one would think the SEC’s proposed rules would attempt to reduce the adverse impact a bounty program might otherwise inflict on internal compliance and reporting functions. However, this is not the case.  Simply put, the whistleblower program will wreck havoc on a company’s ability to investigate and remediate potential securities violations.

For example, under the proposed rules, an individual is not required to have “first-hand knowledge” of the violation and may bypass formal corporate compliance procedures and report directly to the SEC.  As a result, an employee who hears through water cooler discussion information that leads him to think the company may have committed a securities violation can run to a “whistleblower” attorney, and file an anonymous whistleblower claim, all without regard as to whether a comprehensive internal investigation may have already been commenced or whether the conversation may have violated certain attorney-client privileges. 

If the employee turns out to be correct, he (and his attorney) could stand to pockets hundreds of millions of dollars.  An added bonus for the employee is that the anti- retaliation provisions of Section 922, which provide a private right of action for double back pay, litigation cost and interest, will guarantee his employment for up to ten years.  An employee on the verge of termination could transform her job security by providing a whistleblower tip to the SEC.

The SEC still has time to consider the practical effects of the proposed rules, further refine and implement a more sensible approach to securities enforcement and place tighter parameters on what will be perceived as the whistleblower lottery. This “lottery” promises big winnings to a few at tremendous cost to shareholders and businesses.

Michael F. Perlis is a partner with Stroock & Stroock & Lavan in Los Angeles and a former assistant director of the Division Enforcement of the Securities and Exchange Commission. He assisted in the original drafting of the Federal Corrupt Practices Act.  Wrenn E. Chais is Of Counsel at Stroock & Stroock & Lavan in Los Angeles, where she practices securities-related litigation.

Related Content