SEC's Whistleblower Proposal

By Cydney Posner

The SEC has posted its proposed new rules implementing the whistleblower provisions of the DFA (Section 922). The DFA directs the SEC to pay awards, subject to certain limitations and conditions, to whistleblowers who voluntarily provide the SEC with original information about a violation of the securities laws that leads to a successful enforcement of a covered judicial or administrative action or a related action that results in monetary sanctions exceeding $1,000,000. The awards will be between 10% and 30% of the total monetary sanctions collected, with the possibility that the awards may well be divvied up among multiple whistleblowers. The proposed implementing rules define various terms and set out procedures to be followed. While the program is designed to help the SEC obtain high-quality tips related to fraud and other serious securities law violations, we will have to wait to find out whether the SEC is instead inundated with spurious claims based on rumors. It will also be interesting to see if the proposed rules, if adopted, have any corollary effect in discouraging securities law violations, encouraging companies to beef up their internal compliance programs or to speed up their disclosures of wrongdoing to the SEC, or whether, notwithstanding the SEC's efforts to this result, they divert potential whistleblowers from complying with companies' internal compliance programs and reporting procedures (you know, the ones that companies spent so much time developing in response to SOX).

A few points from the proposed new rules may be of interest from the company perspective:

• Information does not need to be first hand. The release proposes to define "independent knowledge" very broadly: it does not require direct, first-hand knowledge of potential violations, but instead, the information may be obtained from the whistleblower's "experiences, observations, or communications" unless otherwise public. "Independent knowledge" can be derived from facts or other information that has been conveyed to the whistleblower by third parties, so long as the information leads the SEC to a successful enforcement action. Although the rules would require that information be submitted under penalty of perjury, this provision still has the potential to open the door for all kinds of investigations based on rumor and innuendo. 
• Information may be derived from analysis. "Original information" can include information that is derived from independent analysis. "Independent analysis" would mean the whistleblower's own analysis, alone or in collaboration with others, including academic or professional studies. An analysis under the proposed rules may involve "the examination and evaluation of information that may be generally available, but which reveals information that is not generally known or available to the public." This proposed rule offers a potential goldmine to academics who search out possible securities law violations -- think option backdating study.
• Exclusions for attorneys and accountants. Exclusions apply to attorneys (as well as those engaged to assist attorneys) when a would-be whistleblower obtains information as a result of the legal representation of a client. Similarly, accountants would be excluded when they obtain information in the performance of an engagement required under the securities laws. 
• Exclusions for others expected to address the violation unless the company fails to respond appropriately. Also excluded are officers, directors, employees and consultants "who learn of potential violations as part of their corporate responsibilities in the expectation that they will take steps to address the violations." Also excluded are persons who "gain knowledge about misconduct otherwise from or through the various processes that companies employ to identify problems and advance compliance with legal standards. In some cases, an entity's compliance program will fail to lead the entity to respond appropriately to violations. Under the proposed rule, if the entity did not disclose the information to the Commission within a reasonable time or proceeded in bad faith, these exclusions would no longer apply, thereby making an individual who knows this undisclosed information eligible to become a whistleblower by providing ‘independent knowledge' of the violations." The release states that this rule is intended to avoid undermining effective compliance programs by "creating incentives for company personnel to seek a personal financial benefit by ‘front running' internal investigations and similar processes that are important components of effective company compliance programs." However, where the company knows about material misconduct but has not taken appropriate steps to respond, those persons could qualify as whistleblowers.
  • Bad faith. In determining whether an entity acted in bad faith, the SEC will take into account "whether the entity or any personnel who were responsible for responding to allegations of misconduct took affirmative steps to hinder the preservation of evidence or a timely and appropriate investigation." Conduct such as destroying documents, interfering with witnesses or engaging in a sham investigation would constitute bad faith.
  • Reasonable time. The determination of a "reasonable time" will depend on all of the facts and circumstances. For example, an ongoing fraud that poses substantial risk of harm to investors would require "almost immediate" disclosure. Below is the SEC's definition of independent knowledge.

• Source of Employee's Knowledge
• Employee receives information because he/she is reasonably expected to take appropriate steps to respond to the violation because of his/her legal, compliance, audit or supervisory responsibilities
• Employee learns of information through company's legal, compliance, audit or similar functions or processes for identifying or addressing potential non-compliance with laws
• Employee otherwise lawfully learns of information through his/her work-related functions

• Does it Qualify as "Independent Knowledge"?
• Employee will not be deemed to have independent knowledge of the information unless (1) the entity did not disclose the violation to the Commission within a reasonable period of time, or (2) acts in bad faith
• Employee will generally be deemed to have independent knowledge of the information [Note: if employee elects to report internally first, he/she will receive the benefit of a "90-day look-back" for subsequent submission of information to SEC (See Proposed Rule 21F-4(b)(7))]

• Whistleblower's place in line. A whistleblower who provides information to another authority or to appropriate compliance persons at the company first, but submits the necessary forms for that claim to the SEC within 90 days thereafter will have the benefit of the earlier date for purposes of establishing priority. The objective is to incent whistleblowers to come forward by assuring them that they can provide information to other appropriate authorities without losing their "places in line" with respect to other whistleblowers who later provide the same information directly to the SEC.
• No requirement to comply with internal compliance and reporting programs. Although the SEC considered imposing a requirement that, before making a submission, a potential whistleblower must first follow internal company complaint and reporting procedures – thus allowing companies an opportunity to address misconduct –the SEC decided against that position: "Among our concerns was the fact 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." However, the SEC does not intend that internal processes will be bypassed: "We expect that in appropriate cases, consistent with the public interest and our obligation to preserve the confidentiality of a whistleblower, our staff will, upon receiving a whistleblower complaint, contact a company, describe the nature of the allegations, and give the company an opportunity to investigate the matter and report back. The company's actions in these circumstances will be considered in accordance with the Commission's Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions. This has been the approach of the Enforcement staff in the past, and the Commission expects that it will continue in the future. Thus, in this respect, we do not expect our receipt of whistleblower complaints to minimize the importance of effective company processes for addressing allegations of wrongful conduct."
• Anonymous whistleblowers. To prevent fraudulent submissions and to facilitate communication between the whistleblower and the SEC staff, the rules would require that anonymous whistleblowers be represented by an attorney whose contact information must be provided to the SEC at the time of the whistleblower's initial submission and who must certify to the SEC that he or she has verified the whistleblower's identity.
• No retaliation. The proposed rules would prohibit any person from impeding a whistleblower from communicating directly with the SEC staff about a potential securities law violation, including generally by enforcing, or threatening to enforce, a confidentiality agreement. The proposed rules would authorize the staff to communicate directly with whistleblowers who are directors, officers, members, agents or employees of an entity that has counsel, where they have initiated communication with the SEC related to a potential securities law violation, without first seeking the consent of the entity's counsel. A determination that a whistleblower is ineligible to receive an award for any reason does not deprive the individual of the anti-retaliation protections, for example, if the individual fails to satisfy all the procedures and conditions to qualify for an award under the program.
• Type of information. The proposed rules would distinguish between information that leads the staff to begin an investigation as compared with information about conduct that is already under investigation. In the latter case, "awards would be limited to the rare circumstances where the whistleblower provided essential information that the staff would not have otherwise obtained in the normal course of the investigation."
• Criteria for awards. There would be four criteria for determining awards, each involving "highly individualized review of the circumstances":
  • the significance of the information to the success of the action;

  • the degree of assistance provided by the whistleblower and any legal representative of the whistleblower;

  • the SEC's interest in deterring violations; and

  • whether an award otherwise enhances the SEC's ability to enforce the federal securities laws, protect investors and encourage the submission of high quality information from whistleblowers.

In evaluating these critera and determining the amount of awards, the SEC expects to weigh a multitude of considerations, such as the type and severity of the violation, the danger presented, any culpability of the whistleblower, whether the whistleblower encouraged others to assist the SEC in the investigation, any unique hardships experienced by the whistleblower as a result of the reporting, the whistleblower's efforts at prevention or remediation of the violation, and finally, "whether, and the extent to which, a whistleblower reported the potential violation through effective internal whistleblower, legal or compliance procedures before reporting the violation." The release notes again that this last consideration is not a requirement for an award above 10%, and "whistleblowers will not be penalized if they do not avail themselves of this opportunity for fear of retaliation or other legitimate reasons. The Commission will consider higher percentage awards for whistleblowers who first report violations through their compliance programs. Corporate compliance programs play a role in preventing and detecting securities violations that could harm investors. If these programs are not utilized or working, our system of securities regulation will be less effective. Accordingly, the Commission believes that encouraging whistleblowers to report securities violations to their corporate compliance programs is consistent with the Commission's investor protection mission."