A New World for Whistleblowers

Wayne Carlin is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Carlin, Theodore A. Levine and John F. Savarese. An earlier post by Mr. Carlin discussing securities enforcement under the Dodd-Frank Act was posted here; other posts on the Dodd-Frank Act are available here.

Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama on July 21, creates an elaborate new regime of financial incentives to encourage whistleblowers to come forward to the SEC with information about securities law violations. An unfortunate likely effect of this new regime, however, may be to undermine the effectiveness of corporate compliance programs.

The principal new incentive offered to whistleblowers is the opportunity to obtain a substantial cash bounty in the event that information they provide leads to an enforcement action in which the SEC obtains a monetary sanction (defined to include penalties, disgorgement and interest) totaling at least $1 million. In such cases, Section 922 provides that the SEC “shall pay an award” to the whistleblower of between 10 and 30 percent of the monetary sanctions imposed in the SEC enforcement action and in any related actions brought by the Attorney General of the United States, an appropriate regulatory authority, a self-regulatory organization or a state attorney general in a criminal proceeding.

Bounty payments are to be made from a newly created “Securities and Exchange Commission Investor Protection Fund.” The Fund is to be built up (to a ceiling of $300 million) by depositing monetary sanctions obtained by the Commission in its enforcement actions generally, to the extent that those funds are not distributed to victims. In addition to paying awards to whistleblowers, this $300 million will also be available to fund the activities of the SEC’s Inspector General.

Section 922 also provides significantly enhanced remedies for whistleblowers who believe they have suffered retaliation by their employers, including expanded private rights of action and the ability to obtain awards of double back pay. In view of these provisions, companies will need to be vigilant in taking steps to prevent any mistreatment of known whistleblowers. But the biggest problem raised by Section 922 is the extent to which whistleblowers are now incentivized not to make their concerns known to their employers.

In many cases, a 10-30% bounty may translate into the prospect of millions of dollars. A whistleblower will not collect one cent, however, unless he or she provides “original information” – information that is not already known to the SEC from another source. Accordingly, voicing concerns internally through the employer’s compliance system or ethics hotline will run the risk that corporate management may determine to report the matter to the SEC – thus depriving the whistleblower of the ability to obtain a bounty, by making the whistleblower’s information no longer “original.”

Section 922 thus creates a major financial incentive for employees with knowledge of wrongdoing to bypass corporate compliance systems and ethics mechanisms. Companies devote extensive resources to developing these systems, publicizing them internally and sending the message that employees should surface their concerns about any questionable activities. Corporations undertake these efforts so as to be able to bring any misconduct by employees to a halt and to be in a position to implement remedial measures promptly. Section 922 threatens to undermine these efforts by dangling the prospect of multi-million dollar bounties that can be secured only by employees who fail to use these internal mechanisms in the face of corporate policies that urge them to do so. Section 922 may thus have the perverse effect of making it more difficult for companies to take prompt corrective action.

Tying the funding of the “Investor Protection Fund” to the SEC’s general monetary recoveries in enforcement actions raises additional concerns. The SEC’s enforcement program is most effective and respected when it is perceived that the SEC is handling each case on its individual merits, without extraneous considerations affecting the result. It is no service to the SEC or its staff to create a system in which the SEC may be seen as having its own agenda in determining the monetary recovery in a case, or in determining whether recovered money will be distributed to victims. This problem is compounded by a system that ties the SEC’s decisions about monetary relief to a funding mechanism for its Inspector General. The current Inspector General has devoted substantial time and resources to sensationalized investigations of the SEC’s own staff, with the results then released publicly. It is difficult to find the wisdom in creating a system that could be portrayed as giving the enforcement staff and the Inspector General a shared interest in higher penalties, so as to generate funding for the Investor Protection Fund.

Notwithstanding these serious flaws, Section 922 has become part of the enforcement landscape. The SEC will now write regulations to govern the process of awarding bounties in more detail. Companies should consider participating in the comment process associated with this rule-making in order to communicate to the SEC concerns about the potential impact on corporate compliance programs. The enactment of Dodd-Frank is also an occasion to review the overall structure of the compliance and ethics function and its role within the corporation, with an eye to finding more effective ways to embed a compliance component in day-to-day business operations.

Strong protections for known whistleblowers will be more important than ever, in light of the anti-retaliation provisions of Section 922. Even more significant, however, will be the need to think creatively about the most effective ways to communicate to employees the importance of surfacing their concerns internally. Management should seek to develop meaningful incentives for employees to make use of corporate compliance and ethics reporting mechanisms. Maintaining a corporate culture in which all personnel understand that conducting business ethically is a shared and important value will be a cornerstone of this effort.

Section 922 unquestionably creates an environment in which it will be more challenging for companies – despite their best efforts – to detect and remediate misconduct, or even to investigate internally. Companies that take the opportunity now to consult with their expert advisers and consider carefully how best to adapt their programs, controls and crisis response plans will be best positioned to operate successfully in the new environment. In the event that a significant episode of misconduct is uncovered, it will be essential to have a response team with the necessary expertise ready to navigate what will now be more dangerous waters.

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  1. Dr. Dirk A. Zetzsche
    Posted Tuesday, July 27, 2010 at 11:13 am | Permalink

    Dear Mr. Carlin,

    With all due respect I do not share your concerns. Regulators are well advised to strive for an equilibrium in which compliance is the norm rather than the exception. Where there are no defectors, there is no bounty to whistle blowers and thus no incentives to game the system.

    Sincerely yours,
    Dirk Zetzsche

    PS: In a recent paper of mine (please see SSRN link above) I suggested to let whistle blowers participate in the bounty for one specific type of violations of securities laws and worked out the details. I am delighted to see that regulators picked up the idea.

  2. Francisco Benzoni
    Posted Monday, August 30, 2010 at 3:56 pm | Permalink

    It seems that Sec. 922 does not apply to private companies because Sec. 922(b) – concerning the payment of awards – is limited to “covered judicial or administrative actions” which is a defined term to mean “any judicial or administrative action brought by the Commission.” The SEC does not have authority to bring an FCPA enforcement action against a non-public company. While Sec. 922(b) also applies to a “related action,” that defined term is tied to the “successful enforcement of the Commission action.” Is that analysis correct?

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