The Securities and Exchange Commission (SEC) recently proposed rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) to reward whistleblowers who provide the SEC with information that leads to successful enforcement actions. Section 922 of the Dodd-Frank Act, which authorizes the whistleblower program under new Section 21F of the Securities Exchange Act of 1934 (Exchange Act), substantially expands the SEC's authority to compensate individuals who provide information about violations of the federal securities laws. The comment period for the proposed rules expired on December 17, 2010.
Who Can Participate
To be considered for an award, a whistleblower must voluntarily provide the SEC with original information that leads to a successful enforcement action by the SEC in a federal court or administrative action in which the SEC obtains monetary sanctions in excess of $1 million. Under proposed Rule 21F-2, a "whistleblower" is defined as "an individual who, alone or jointly with others, provides information to the [SEC] relating to a violation of the securities laws." The whistleblower must provide "original information." Under proposed Rule 21F-4(b)(1), "original information" is information derived from the whistleblower's independent knowledge or analysis and not already known to the SEC. Information is derived from "independent knowledge" if not obtained from publicly available sources. Original information need not be obtained first-hand, and may have been conveyed to the whistleblower by third parties. A whistleblower that provides information already known to the SEC has not provided original information, unless the whistleblower is the original source of that information. Under proposed Rule 21F-4(b)(6), a whistleblower will be considered the "original source" of any information derived from his or her independent knowledge or analysis that materially adds to information already possessed by the SEC.
Additionally, the information must be provided "voluntarily." Under proposed Rule 21F-4(a)(1), information would be provided voluntarily if provided before the whistleblower receives any formal or informal request, inquiry or demand from the SEC, Congress, any federal, state or local authority, any self-regulatory organization, or the Public Company Accounting Oversight Board. Information would not be provided voluntarily if the informant has an existing legal or contractual duty to report violations of the type at issue. In order to be eligible for a reward, the whistleblower's information must lead to successful enforcement of the SEC's action.
Under proposed Rule 21F-4(c)(1), information must: (1) have caused the SEC staff to commence an examination, open an investigation, reopen a closed investigation, or inquire about new and different conduct as part of an open investigation or examination; and (2) have significantly contributed to the success of an enforcement action. Proposed Rule 21F-4(d) defines an "action" as a single captioned civil or administrative proceeding.
If all of the above criteria are satisfied, the whistleblower would be eligible for an award of 10 percent to 30 percent of the monetary sanctions collected in the action.
Proposed Rule 21F-4(b)(4) defines seven circumstances in which information will not be considered to be derived from "independent knowledge." For example, attorneys and persons who assist attorneys on client matters, such as accountants and experts, are not eligible for a whistleblower award for reporting information obtained through communications subject to the attorney-client privilege. Also, persons who obtain information under engagements by an independent public accountant are not eligible for a reward relating to a violation by the engaging client or its directors, officers or employees. Additionally, persons who learn of violations within the scope of their corporate responsibilities—with the expectation that they will address the violations— generally would be precluded from eligibility as a whistleblower (subject to an exception, described below). This can include officers, directors, employees and consultants, or those who learn information through legal, audit, compliance or similar functions.
Procedure to Claim Award
A whistleblower must follow certain procedures in order to perfect his or her status as a "whistleblower" under the SEC's whistleblower program. First, the whistleblower must submit information on a standard form or via the SEC's online referral database. Second, the whistleblower must complete a form regarding the truthfulness of the information provided and his or her eligibility to receive a reward. Information may be submitted anonymously and through an attorney.
Once an action results in the imposition of monetary sanctions exceeding $1 million, the whistleblower would be required to make a claim for an award within 60 days of publication of the notice of the eligible action. Eligible whistleblowers may also receive rewards based on monetary sanctions collected in related actions that are based on the same original information in the first action.
Under the proposed rules, a Whistleblower Office and SEC staff would evaluate the claim and assess whether to allow the claim and at what amount. The SEC recently announced it would delay plans to set up the Whistleblower Office due to a lack of funding, but presumably the claims analysis would be handled by others within the SEC until the Whistleblower Office is operational. The Whistleblower Office or SEC staff would then send the claimant a preliminary determination of the award that, if not contested, would subsequently become a proposed final determination. The determination would then become a final order within 30 days, so long as a commissioner does not request a review of the determination.
Implications for Companies
Many observers have expressed the concern that the monetary incentive under the SEC's whistleblower program may hinder companies' ability to first investigate and handle reported violations internally. The proposed rules include provisions that are intended to encourage individuals to first report violations through their companies' internal compliance framework, however, the rules do not require – and arguably do not go far enough to incentivize – use of companies' internal compliance programs.
Proposed Rule 21F-4(b)(7) allows a potential whistleblower to first provide information to legal or compliance personnel at his or her company and preserve his or her status as a whistleblower, so long as information is then provided to the SEC within 90 days. While this 90-day look back period affords companies the opportunity to first conduct their own internal investigations, it is questionable whether employees would proceed first through corporate channels and risk losing the high monetary incentives present in the SEC's whistleblower program. Additionally, even if employees do report potential violations through corporate compliance programs, the proposed rules seem to preserve the opportunity for the whistleblower to disclose potential violations to the SEC if the employee is not subjectively satisfied with the results of the investigation. This incentive to thereafter "tattle" to the SEC may effectively undermine companies' ability to conduct investigations and appropriately resolve allegations. Finally, if allegations are of widespread misconduct or involve complex facts requiring further investigation, this 90-day period may be insufficient for companies to conduct a thorough and conclusive investigation.
While the proposed rules generally exclude from the class of potential whistleblowers persons performing compliance functions who are responsible for addressing potential violations of the securities laws, this exclusion ceases to apply—and such persons become eligible whistleblowers—if a corporate compliance program fails to lead to an appropriate response to violations. For example, the proposed rules contemplate that if a company does not disclose the potential violation to the SEC within a reasonable time or proceeds in bad faith, an individual performing a compliance function who knows of the undisclosed information may report the potential violations to the SEC and thereafter be eligible for a monetary reward. The SEC's proposing release explains that this approach is intended to strike a balance between facilitating effective internal compliance and permitting persons to act as whistleblowers when a company knows of potential violations but has not responded appropriately. Despite this intended balance, the opportunity for persons performing compliance functions to participate in the whistleblower program and to potentially reap a monetary reward creates an incentive for individuals to second-guess the efficacy and results of corporate investigations, which are often collaborative endeavors, if that person is subjectively unsatisfied with the result.
Recommended Next Steps
All of these incentives to report potential violations of the securities laws pose a challenge for effectively enforcing internal corporate policies and adequately managing internal investigations. In order to address this challenge, we recommend regular training for all directors, officers, and employees about corporate ethics policies and codes of conduct, as well as internal compliance programs and processes. This training may be accomplished through presentations by legal or compliance personnel, internal memoranda or posters in the workplace, disclosure of applicable policies on internal and external company websites, and reinforcement by senior management or supervisory personnel. Companies should also review their internal communication policies and practices to ensure that they are effectively communicating the results of internal investigations to interested parties. Regularly reminding employees about a company's culture of compliance should decrease the risk that potential violations of securities or other laws may occur. Moreover, if employees understand that a corporate compliance program, such as an anonymous hotline or complaint system, is in place and consistently and effectively administered, they may be more likely to report potential violations through internal channels before looking to the SEC. Companies should consider reviewing their internal compliance program and code of conduct to ensure that employees may effectively voice their concerns to compliance personnel.
Overall, the SEC's proposed whistleblower program creates a strong monetary incentive for employees to bypass corporate compliance programs in favor of direct reporting to the SEC. While this incentive may be difficult to overcome, employees who are educated about, and believe in, the effectiveness of corporate compliance programs may be more likely to participate in internal corporate reporting about potential violations of securities laws.
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