SEC Proposes Rules To Implement Dodd-Frank Whistleblower Program

Monday, December 6, 2010 - 00:00

On November 3, 2010, by a unanimous vote, the Securities and Exchange Commission proposed rules to implement the whistleblower incentives and protection provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank"). Set forth in Section 922 of Dodd-Frank and incorporated into the Securities Exchange Act of 1934 in a new Section 21F, Dodd-Frank created a whistleblower bounty program that allows persons who provide information that leads to a successful SEC enforcement to receive 10 to 30 percent of the monetary sanctions over $1 million.1 Though the SEC has described its proposed rules as mapping out "a simple, straightforward procedure for would-be whistleblowers to provide critical information to the agency,"2 the actual rule proposal is more than 150 pages long and contemplates the addition of more than a dozen new sections to the Code of Federal Regulations.3

Among the most controversial aspects of the SEC's proposal is the decision not to require individuals to utilize in-house reporting procedures before making an award-eligible report to the SEC. Those in-house compliance procedures were Congressionally mandated by the Sarbanes-Oxley Act of 2002, and much of the recent criticism of the SEC's proposed rule has focused on whether Dodd-Frank's whistleblower bounty program, as implemented, may undercut compliance efforts by incentivizing individuals to blow the whistle rather than to report wrongdoing internally.

We set out below a summary and discussion of the key provisions of the SEC's proposed rule.

Whistleblower Defined

Like Dodd-Frank itself, the proposed rule defines a whistleblower as an individual or two or more individuals acting jointly who provides the SEC with information relating to a violation of the securities laws. Anonymous whistleblowers must be represented by an attorney who must certify that he or she has verified the whistleblower's identity and reviewed the whistleblower's submission for completeness and accuracy. Companies and other entities are not eligible to be whistleblowers or to collect awards through the SEC whistleblower bounty program.

To receive an award through the program, a whistleblower must (i) voluntarily provide the SEC with (ii) "original information" that (iii) "leads to the successful enforcement by the Commission of a federal court or administrative action" resulting in (iv) "monetary sanctions totaling more than $1,000,000." Additionally, the SEC will pay a whistleblower a further award based on amounts collected in actions brought by the U.S. Department of Justice, "appropriate regulatory agencies" ( e.g. , Federal Deposit Insurance Corporation), self-regulatory organizations ( e.g. , NASD, FINRA), and state attorneys general in a criminal case if the action is based on the same original information that the whistleblower voluntarily provided to the SEC and that led the SEC to obtain monetary sanctions in excess of $1 million.

Voluntary Submission Required

Individuals who do not provide information to the SEC voluntarily will be ineligible to receive an award through the bounty program. Submission of information is involuntary if it is made subsequent to receipt of a request, inquiry, or demand from the government, a self-regulatory organization, or the Public Company Accounting Oversight Board. An individual is considered to have received such a request, inquiry, or demand if it is received by the individual himself or herself, by someone representing that individual (such as an attorney), or by the individual's employer (unless the employer fails to respond to the requesting authority in a timely manner).

Whistleblowers Must Provide Original Information

The SEC will not reward individuals for reporting information derived exclusively from publicly available sources. As SEC Chairman Mary Schapiro has explained, whistleblower tips are "high-quality leads" because they "come from those closest to an ongoing fraud" and provide "valuable firsthand information that may otherwise not come to light."4 Similarly, the legislative history of Dodd-Frank reveals Congress' intent "to motivate those with inside knowledge to come forward and assist the Government to identify and prosecute persons who have violated securities laws and recover money for victims of financial fraud."5 Nonetheless, according to the proposed rule, award-eligible submissions are not limited to such inside knowledge, but may also be premised on provision of non-inside independent knowledge, even including secondhand knowledge. Thus, an individual who has heard secondhand of an alleged violation or who has no connection at all with the issuer accused of wrongdoing may receive an award if he or she provides "original information" to the SEC. Indeed, even competitors may attain whistleblower status if the reported information is based on personal experience, communication, observation, or analysis. However, the SEC will not award whistleblowers for reporting information already known to the Commission.

Acknowledging that the prospect of a monetary award could encourage ethically questionable behavior on the part of potential whistleblowers, the proposed rule does not credit information based on communications subject to the attorney-client privilege, obtained through a company's internal compliance program, or procured through criminal means.

Furthermore, the proposed rule recognizes that a participant in a securities fraud scheme may become a whistleblower. However, it seeks to limit the ability of significantly culpable individuals to collect full awards in cases where they have effectively blown the whistle on themselves. In determining whether the $1 million threshold has been satisfied and the amount of total sanctions for purposes of making an award, the SEC will exclude any monetary sanctions that either the whistleblower or an entity whose liability is the result of conduct directed, planned, or initiated by the whistleblower is ordered to pay.

Additionally, the proposed rule emphasizes that Dodd-Frank does not provide amnesty to individuals who provide information to the SEC. The fact that a whistleblower may assist the Commission in an investigation and enforcement action does not preclude the Commission from bringing an action against the whistleblower based on his or her own conduct.

Success As An Indicator Of Materiality

Though the proposed rule recites that the SEC will award individuals for providing original information that leads to "the successful enforcement of a judicial or administrative action," it effectively establishes a materiality standard that must be satisfied before a whistleblower's information is deemed award worthy. The Commission will award tips that cause the SEC staff to commence an examination, to open (or reopen) an investigation, or to inquire into new or different conduct. Where the government, an SRO, or PCAOB was already examining or investigating a company's conduct when a whistleblower sought to provide the SEC with original information, an award may be given if the information would not have been obtained otherwise and was "essential" to the success of the resultant enforcement proceeding.

Criteria For Determining Amount Of Award

Under Dodd-Frank, whistleblower awards will be 10 to 30 percent of collected monetary sanctions over $1 million. This is a significant departure from the preexisting statutory scheme, which authorized the SEC to pay a bounty of no more than 10 percent of civil penalties collected in insider trading cases.6 Assuming that the $1,000,000 threshold is met, what was once the ceiling is now the floor, and the SEC's incentive program is no longer limited to insider trading matters.

The proposed rules articulate the criteria that the SEC will use in determining where an award should fall in the range between 10 and 30 percent. The SEC will take into consideration the significance of the whistleblower's information to the success of the enforcement action, the degree of assistance provided by the whistleblower, and the Commission's interest in deterring violations of the securities laws by making awards to whistleblowers. Though the Commission's decision to withhold an award is directly appealable to the Court of Appeals for the D.C. Circuit or to the circuit where the aggrieved whistleblower resides or has his or her principal place of business, the SEC's determination regarding the amount of an award is not appealable.

No Requirement To Report Up Before Blowing the Whistle

With its proposed rule, the SEC has sought to respond to criticism from the private sector7 that Dodd-Frank's whistleblower bounty program is in tension with the internal reporting mechanisms mandated by the Sarbanes-Oxley Act of 2002, which required companies to establish a way for boards of directors to receive, retain and treat anonymous complaints regarding accounting, internal accounting controls or auditing matters.8 In an effort to discourage employees from bypassing their companies' costly and Congressionally mandated internal compliance programs, the proposed rule would not disqualify an individual who reports wrongdoing internally, as long as that individual provides the same information to the SEC within 90 days. The commentary to the proposed rule does not explain the rationale behind the 90-day window, and the SEC has requested comments specifically on the question of whether 90 days is an appropriate timeframe.

Notably, the proposed rule does not require potential whistleblowers to utilize in-house reporting procedures before making an award-eligible report to the SEC. In its proposed rule, the SEC did not accept the suggestion made by some practitioners that following internal procedures should be "a required prerequisite" to seeking a whistleblower reward.9 In rejecting that approach, the SEC cited the concern that "while many employers have compliance processes that are well-documented, thorough, and robust, and offer whistleblowers appropriate assurances of confidentiality, others lack such established procedures and protections."10 However, according to the supplementary information accompanying the proposed rule, the extent to which a whistleblower reported a potential violation through internal procedures before reporting the violation to the SEC will be among the considerations to be considered in determining the amount of a whistleblower award.11

The SEC has expressed its belief that internal compliance processes will remain relevant and has articulated its expectation that, in appropriate cases, the SEC staff, upon receiving a whistleblower complaint, will contact a company, describe the nature of the allegations, and give the company an opportunity to conduct an internal investigation and report back to the Commission,12 but the concern remains that the SEC's proposal does not do enough to preserve the role of corporate compliance programs. In particular, SEC Commissioner Troy Paredes invited public comment on the question of the net impact on corporate compliance if individuals bypass a corporation's internal procedures in favor of reporting alleged violations to the SEC to earn sizable bounties.13 The U.S. Chamber of Commerce has already voiced its opposition to the proposed rule, which it claims creates a lottery "[i]nstead of allowing companies to identify and fix problems."14 Indeed, given that a whistleblower's award is a proportion of the sanctions collected by the SEC in excess of $1 million, potential whistleblowers may well be reluctant to provide companies with an occasion to mitigate wrongdoing if such ameliorative conduct could soften penalties and adversely affect the SEC's ultimate payout.

Public comments on the proposed rule should be submitted to the SEC by December 17, 2010. A final rule is expected by mid-April 2011.

1 See David S. Frankel, Alan R. Friedman & Melissa J. Prober, Dodd-Frank's Impact on Securities Enforcement and Litigation , Metro. Corp. Counsel, Oct. 2010, at 12.

2 Press Release, Sec. & Exch. Comm'n, SEC Proposes New Whistleblower Program Under Dodd-Frank Act (Nov. 3, 2010), available at http://www.sec.gov/news/press/2010/2010-213.htm.

3 Proposed Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, 75 Fed. Reg. 70,488 (Nov. 17, 2010) (to be codified at 17 C.F.R. pts. 240, 249).

4 Press Release, supra note 2.

5 S. Rep. No. 111-176 at 110 (2010).

6 15 U.S.C. § 78u-1(e) (2006).

7 See, e.g. , Ashby Jones & Joann S. Lublin, Critics Blow Whistle on Law , Wall St. J., Nov. 1, 2010, at B1.

8 Sarbanes-Oxley Act of 2002 § 301, 15 U.S.C. § 78j-1(m)(4) (2006).

9 Kaja Whitehouse, Big Firms Seek Shield Against Whistleblowers , N.Y. Post, Nov. 1, 2010, at 32.

10 Proposed Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, 75 Fed. Reg. at 70,496.

11 Id. at 70,500.

12 Id. at 70,496.

13 Jenna Greene, SEC Proposes New Whistleblower Rules , The Blog of Legal Times (Nov. 3, 2010, 4:25 PM), http://legaltimes.typepad.com/blt/2010/11/sec-proposes-new-whistleblower-rules.html.

14 Press Release, U.S. Chamber of Commerce, U.S. Chamber Urges SEC To Consider Potential Consequences of Whistleblower Bounty Program (Nov. 3, 2010), available at http://www.uschamber.com/press/releases/2010/november/us-chamber-urges-sec-consider-potential-consequences-whistleblower-boun.

Arthur H. Aufses III, Partner, is a commercial litigator who defends securities and class action lawsuits, conducts internal corporate investigations and counsels corporate officers, directors and financial advisors on securities and other potential liabilities. David S. Frankel, Partner, focuses his practice on defense of white collar prosecutions, SEC, CFTC, and FINRA enforcement actions and arbitrations. Alan R. Friedman, Partner, focuses on the litigation and defense of complex civil and criminal cases. Theodore S. Hertzberg, Associate, focuses on white collar criminal defense, complex civil litigation and condemnation matters.

Please email the authors at aaufses@kramerlevin.com, dfrankel@kramerlevin.com, afriedman@kramerlevin.com or thertzberg@kramerlevin.com with questions about this article.