The Welch Case: Focusing On "Protected Activity" Under Sarbanes-Oxley

Thursday, November 1, 2007 - 01:00

Editor: Ms. Hoey, would you tell our readers something about your professional experience?

Hoey: I graduated from Fordham Law School in 1984 and after practicing for two years at a medium-sized labor firm, I joined Kelley Drye. I have been practicing labor and employment law since then. I became a partner in 1996 and co-chair of the department in 2000.

During the early years of my career I was engaged in a more or less traditional labor practice, meaning that we represented employers in their dealings with labor unions. That included collective bargaining negotiations and responding to charges before the NLRB. Following the amendments to the Civil Rights Act in 1991, however, employment litigation really exploded. The Act allowed for jury trials and expanded damages, and litigation-counseling clients on the avoidance of litigation and defending them in court-has now become the most important aspect of my practice.

Editor: You have been following the case of Welch v. Cardinal Bankshares Corp. on what constitutes "protected activity" under Sarbanes-Oxley. Would you give us the background on this matter? For starters, what does Sarbanes-Oxley say about whistleblower protection?

Hoey: Sarbanes-Oxley was enacted in 2002 in the wake of Enron, WorldCom and the other corporate scandals. The Act contains a whistleblower provision which was broadly-worded. It basically states that anyone who reports what they "reasonably believe" to be unlawful activity under the federal securities laws, the federal banking laws, and the mail and wire fraud statutes, has engaged in "protected activity" and cannot be retaliated against for having engaged in that activity. The statute did not really define what constituted protected activity with any specificity, however. During the initial years following the statute's enactment there was considerable litigation over what type of a complaint actually fell under its purview. Plaintiffs would argue that if they had blown the whistle on virtually anything affecting the company's bottom line-overspent accounts, misplaced airplane parts, and so on-they were engaged in protected activity.

Most of this litigation took place at the OSHA Division of the Department of Labor, where the administrative law judges attempted to define what constituted Sarbanes-protected activity. Some ALJs took a very broad approach to the definition, while others tried to narrow the scope of what constituted protected activity.

Editor: Who was David Welch and what were his claims?

Hoey: Mr. Welch was chief financial officer of Cardinal Bankshares, a bank in Virginia. According to reports on the case, he claimed to have first discovered errors in the bank's financial reports. Welch claimed that the proceeds from certain types of loans had been misclassified as income-in violation of GAAP, the generally accepted accounting standards-and he got into a dispute with his executive team over this issue. He went on to make a complaint, both internally and with the outside auditors, about insider trading on the part of the bank's CEO. In 2002 he brought the latter complaint to the SEC. That resulted in an internal investigation by the bank and, ultimately, to Welch's termination in October of 2002. This occurred just shortly after the passage of Sarbanes-Oxley, and so his case became one of the first filed under the statute.

Editor: How did the case get to the OSHA Administrative Review Board?

Hoey: The Welch case is really a saga. Initially Welch filed a complaint with OSHA, which is required under Sarbanes-Oxley. After the initial investigation, OSHA found no merit to his allegations. He then requested a hearing before the ALJ, to which he is entitled. At the hearing-and we are now up to 2006-the ALJ found that Welch was terminated because he participated in a Sarbanes-protected activity and recommended he be reinstated. The bank then filed in federal court over the reinstatement issue-whether immediate or only on completion of the resolution of the dispute-and followed with an appeal to the next level within OSHA, the Administrative Review Board or ARB. In May of 2007, almost five years after Welch's termination, the ARB issued a decision reversing the 2006 decision of the ALJ and holding that that termination was lawful.

Editor: Would you take us through the reasoning of the ARB?

Hoey: The first principle the ARB defined in May 2007 was what constituted a "reasonable belief" of unlawful activity under Sarbanes-Oxley, and stated that Welch was required to show that he "definitively and specifically" complained to his employer regarding an issue that he believed constituted securities fraud or some other violation under the securities laws.

The second thing the ARB found that Welch would be required to prove was that this belief was reasonable, considering his expertise, knowledge and position at the company. This is a difficult standard, and it indicates that the more expertise and information a person has, the higher the standard to which he or she is going to be held. That is, a secretary in the company's accounting department-a person normally lacking extensive expertise and without access to all of the company's books and records-might be able to file a complaint of shareholder fraud and make it stick, while the CFO, with much greater familiarity with all of the issues, might fail in filing a complaint.

The ARB then went on to address, utilizing the new standard, each of Welch's claims. With respect to the accounting entries, for example-which the bank acknowledged were wrong-the ARB found that they constituted such a minor error that there was no impact on the company's bottom line. The ARB then stated that, since Welch was the CFO, he should have been aware of the error and that even as an error, it did not result in an overstatement of the company's income. On the basis of that finding, the ARB determined that Welch did not have a reasonable belief that the accounting entries would mislead a potential investor.

Editor: You can actually make waves to a much greater extent as a whistleblower if you do not have access to the company's books and records?

Hoey: That is correct, at least potentially. A lower level employee, under this standard, can have a reasonable belief that a misstatement or overstatement of income has occurred which an experienced CPA and the company's CFO-which Welch was-is not entitled to claim. The ARB was quite clear in stating that Welch could not have reasonably believed that the bank's third quarter SEC report presented potential investors with a misleading picture of the bank's financial condition.

Welch also argued that a violation of GAAP accounting standards was itself a violation of the securities laws. The ARB rejected this argument and stated that had Congress intended to extend Sarbanes-Oxley protection to people who reported such violations it would have said so in the statute. This is very helpful in defining what is not protected activity.

Finally, Welch argued that his complaints to senior management to the effect that the bank did not have sufficient internal accounting controls in place amounted to protected activity and, in addition, a violation of GAAP. The ARB ruled that insufficient accounting controls might well be a violation of GAAP accounting standards, but such a state of affairs was not a violation of the securities laws and, accordingly, not a fraud on the shareholders or a protected activity under Sarbanes-Oxley.

In summary, the Welch case has given us a clearer roadmap on how a company must conduct its affairs under Sarbanes-Oxley, and that is a good thing.

Editor: What are the implications of Welch going forward?

Hoey: Welch , together with other cases decided over the last year or two, has served to provide us with a much better definition of what is meant by protected activity under Sarbanes-Oxley than we have had to date. As a result, I think we will see fewer of the silly cases-the discarded airplanes parts, for example-that seek to take advantage of a broad definition of the term. That said, the plaintiffs' bar is very sophisticated, and I believe we will see a greater number of cases on what a company can and cannot do. If Sarbanes-Oxley is not available, they will certainly turn to OSHA or some of the discrimination statutes to bring their actions. I do not see any diminution in their interest here even if a particular avenue has been closed down or at least restricted.

Editor: Please share with us your thoughts as to whether this case means that complaints about discrimination, sexual harassment, workplace harassment, safety issues and other non-securities fraud issues should not be entitled to Sarbanes-Oxley protection.

Hoey: I think that is correct. I do not think any of these things are entitled to Sarbanes-Oxley protection. Welch has provided us with a signal degree of guidance on what is covered by a Sarbanes complaint and, more importantly, what is not.

Editor: What happens next? Presumably Welch has exhausted his administrative remedies. Any thoughts on a court action?

Hoey: Not that I know of. I find it interesting to note, however, that Sarbanes-Oxley created an administrative mechanism in an attempt to have quick and expeditious resolution of these cases. In point of fact, this case would have been decided much more quickly in federal court in New York-or in federal court in Virginia, where the bank is located-than was the case with the very lengthy OSHA proceeding. That entailed five years of litigation, and I believe that a court proceeding, from summons and complaint to trial, would have taken no more than 18 months. Can he now take his case to court? I believe that Sarbanes-Oxley gives him that option, although I have not read anything in the commentaries on the case concerning his options.

Editor: Is there anything you would like to add?

Hoey: I think Sarbanes-Oxley is certainly a challenge for employers, but it has not turned out to be the boon for the plaintiffs' bar that it was thought to be when enacted in 2002. If a company understands the law and understands what it can and cannot do, I believe it has a good chance to successfully navigate the waters.

Please email the interviewee at bhoey@kelleydrye.com with questions about this interview.