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Private Investment Forum - Winter 2011


New Cash Incentives Increase Risk of Whistleblower Activity: Are You Prepared?



It certainly seems un-American but the Government is now paying employees to snitch on their employers in the financial services industry. Why, an employee might ask, should I report wrongdoing to a company hotline or compliance officer when the Government might pay me money for the information? In fact, according to newspaper reports, many people seem to be following this logic.

"New rewards for informants who help the Securities and Exchange Commission uncover fraud are already prompting a surge in tips [concerning alleged financial and white collar fraud]," according to a Wall Street Journal article published last fall. This flood of activity follows Congress's decision to enact an expanded whistle blower program as part of last year's new Dodd-Frank Financial Reform Act. The Dodd-Frank whistleblower provisions incentivize tipsters—by offering lucrative rewards of up to 30 percent of the funds collected by the U.S. Securities and Exchange Commission—to report "original information" about corporate fraud. The new program could result in millions of dollars in payments to employee informants who report on the activities of their employers and co-workers. Strengthened whistleblower protections shielding employees from workplace retaliation, coupled with the generous payouts to informants, may motivate employees to inform the SEC directly of potentially improper activities instead of reporting suspicions to a company's compliance department to allow it to investigate and address the matter.

The Dodd-Frank Act's bounty program rewards any individual who voluntarily gives "original information" to the SEC that leads to an enforcement action resulting in monetary sanctions in excess of $1 million. The reward will be between 10 and 30 percent of the total monetary sanctions collected by the enforcement action and any related actions. For example, an individual who discloses a $10 million insider trading ring to the SEC could be in line for payments of $1 million to $3 million. "Original information" is generally defined as information (i) derived from independent knowledge or analysis; and (ii) not known to the SEC from any other source. The bounty program applies to all securities violations, including breaches of the Foreign Corrupt Practices Act (FCPA), which bans companies from bribing foreign government officials to obtain or keep business.

We are concerned that the bounty program will motivate individuals to circumvent the normal corporate channels that encourage employees to report suspicious activities to their supervisors or compliance departments, and that it will lead to a higher volume of false or baseless allegations which will nevertheless result in heavy burdens to the subject companies. From the government's perspective, the program is already reaping dividends. A Wall Street Journal blog post reported that the SEC "has been receiving at least one tip a day about potential foreign bribery violations" since the whistleblower bounty program became law in July, although the quality of the tips was described as "mixed."

SEC Rule Making Process

Although the new whistleblower law is already in effect, the SEC is still working to promulgate implementing rules. The SEC issued proposed rules on the bounty provisions on November 3, 2010. Many comments were received during the comment period, which closed on December 17, 2010, including ones on the effect that the bounty program could have on public companies' existing internal reporting and whistleblower programs. The SEC is expected to issue final rules some time prior to its April 21, 2011 deadline.

In the background section to its proposed rules, the SEC acknowledged "the potential for the monetary incentives provided to whistleblowers… to reduce the effectiveness of a company's existing compliance, legal, audit and similar internal processes for investigating and responding to potential violations of the federal securities laws." To address this concern, the SEC "included provisions in the proposed rules intended not to discourage whistleblowers who work for companies that have robust compliance programs to first report the violation to appropriate company personnel, while at the same time preserving the whistleblower's status as an original source of the information and eligibility for an award."

Specifically, the SEC's proposed regulation allows a whistleblower to wait 90 days between providing information on potential violations internally and providing the information to the SEC without compromising his or her eligibility for a reward. The SEC hopes that this "grace period" will give corporations a sufficient amount of time to conduct an internal investigation and make an appropriate response to the whistleblower's information. Additionally, the SEC will consider the whistleblower's cooperation with his or her company's internal compliance program as a favorable factor in determining the percentage of recovery that the whistleblower will receive as reward.

The SEC also emphasized that, although the proposal does not require a whistleblower to utilize internal compliance processes, it does not mean that the receipt of a whistleblower complaint will necessarily lead to internal corporate processes being bypassed. In appropriate cases, the SEC 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.

Implementation of the New Provisions

While the SEC is eager to use the new whistleblower program to try to make up for its abysmal performance handling tips related to Bernard Madoff, its efforts have not proceeded smoothly.In December, the SEC announced that it would delay plans to set up its new whistleblower office, as well as other new offices created by the Dodd-Frank law, because SEC officials do not believe that they can do the work without increased funding from Congress.The SEC's funding has been frozen at fiscal 2010 levels, along with the rest of the federal government, while Congress has been unable to agree on new federal funding levels.In the meantime, the SEC says that the functions of the new whistleblower office have been temporarily assigned to existing staff within the SEC's Division of Enforcement.

What This Means to You

In the face of lucrative incentives for informants, it is more important than ever to ensure that your management company has a robust compliance program. Your program should include policies that encourage employees to report troublesome issues to the appropriate members of management, such as the Chief Compliance Officer or legal counsel, before contacting the SEC to prevent the potentially devastating effects of an SEC inquiry or formal investigation.

Your company's management must lead by example and handle each complaint seriously by conducting an internal investigation to see if it has merit. Do not avoid or cover up the problem. If your internal investigation uncovers improper activities, you should consider self-reporting to the SEC to minimize the (potentially) more damaging consequences of a full-blown SEC investigation down the road.

For more information on this issue and other white collar matters, please contact Steven D. Feldman at (212) 592-1420 or sfeldman@herrick.com.

Steven Feldman is a lead partner in Herrick, Feinstein LLP's White Collar Defense practice where he represents companies and individuals accused of securities law violations, business crimes and fraudulent practices by the U.S. Attorney's Office, State Attorney General, District Attorney and U.S. Securities and Exchange Commission. He also works with companies to conduct internal investigations and represents individual corporate officers in corporate internal investigations. Prior to joining Herrick, Steven spent more than six years as an Assistant U.S. Attorney for the Southern District of New York in Manhattan where he served on the Securities and Commodities Fraud Task Force.




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