This article was originally published by the Fiscal Times on Monday, Feb. 7, 2011.
The SEC will soon issue a rule giving corporate whistleblowers the chance to collect big money for reporting securities violations, but the business community fears a wave of frivolous claims.
By Katherine Reynolds Lewis
In his continuing outreach to business leaders, President Obama spoke at the U.S. Chamber of Commerce this morning about global competition, technological innovation and the outdated or unnecessary government regulations. But a major concern of many corporate leaders is a proposed federal rule giving corporate whistleblowers an opportunity to collect hundreds of thousands of dollars for reporting securities law violations. The rule has alarmed the business community, which argues that the plan would encourage frivolous claims and undermine a decade of work to provide safe reporting channels for whistleblowers.
By April 17, the Securities and Exchange Commission must give final approval to the rule, which Congress ordered as part of the Dodd-Frank financial overhaul law aiming to prevent a repeat of the 2008 financial crisis.
Corporate lawyers and lobbyists have asked the SEC to require whistleblowers to report problems internally before going to the government, to limit the people eligible to collect a bounty and to extend the time a company has to correct violations. On the other side, lawyers who represent whistleblowers say the provisions the SEC proposed are needed to protect tipsters from retaliation and prevent corporate cover-ups.
The rulemaking is the latest in a series of government attempts to encourage corporate employees with knowledge of fraud or other violations to come forward. The Sarbanes-Oxley Act of 2002 — which Congress passed in response to accounting fraud at Enron, WorldCom and other corporate giants — required companies to establish internal reporting programs and made boards of directors and top executives personally liable for neglecting to investigate fraud complaints. In both 2001 and 2008, scandals over the activities of publicly traded companies quickly spread from the stock market to the broader economy, affecting everyday Americans as well as shareholders.
"This is one of the most explosive issues that has come up in a while for such a broad group of companies," said Alice Joe, a senior director at the U.S. Chamber of Commerce, which represents more than three million businesses. "Our companies have spent millions of dollars over the past 10 years trying to build up these compliance programs. Now you've got a rule that the SEC has proposed that is going to incentivize whistleblowers to completely bypass these systems."
Under the proposal, a corporate employee who voluntarily provides new information about securities law violations to the SEC that results in a successful enforcement action would be eligible to collect between 10 and 30 percent of any fines surpassing $1 million. Previously, the bounty was capped at 10 percent and only applied to insider trading cases. The SEC had only awarded $159,537 in the 70-plus years of the prior program, until it made a $1 million award in July 2010. Bounties couldn't be collected by individuals who learn about fraud because they're part of the internal reporting system, or whose professional ethics require them to report violations.
A key point of contention is whether the whistleblower should be required to report internally first. The SEC proposal would give the employee the choice of going directly to the government, and would protect the tipster's "place in line" for the bonus by using the date of any internal reporting in determining whether the information qualified for a payout.
Whistleblowers almost always attempt to report internally and face retaliation while their concerns are squashed, said Jason Zuckerman, a principal at The Employment Law Group, which represents corporate whistleblowers.
"While some companies have established robust compliance programs, there are also corporate compliance programs that are just window dressing, especially in organizations where senior management is condoning or orchestrating fraud to increase profits," Zuckerman said. "When a corporation has an opportunity to deal with an issue before the issue is provided to the SEC, that can be an opportunity for the corporation to destroy evidence and to influence what the key witnesses are likely to say to the SEC."
A study involving Fortune 500 audit committee members found that the majority of anonymous complaints were not investigated, in a hypothetical experiment. When the allegation would have hurt the director's reputation, there was zero investigation, said Jake Rose, an associate professor at the University of New Hampshire's business school and co-author of the paper published in the Journal of Management Studies.
"This anonymous reporting is supposed to be the cure, the primary mechanism that firms can use to prevent financial fraud," Rose said. "Given the fragile state of the financial markets and economy, a few more big financial frauds coming out could have a big effect on recovery and what's happening in the market. We would see improving this as being very critical."
The majority of publicly traded companies understand that robust fraud-detection systems are a business necessity, according to their representatives. "The cost of a fraudulent scheme is going to eclipse the cost of defending against a whistleblower," said Steven Pearlman, a partner at the law firm of Seyfarth Shaw and co-chair of the firm's national Sarbanes-Oxley whistleblower team.
Corporate management is concerned that employees motivated by the promise of riches might delay reporting any concerns — either internally or externally — in order to maximize the award they would eventually receive. Moreover, the 90 days that the SEC proposal would give companies to remedy violations is far too short for the complexity of the issues involved, Pearlman said.
"The SEC needs to condition the receipt of any bounties on certification that an employee has made an internal complaint and exhausted internal reporting avenues first," he said. "Why would somebody ever complain internally if they can make some very serious money by running to the SEC right away?"
Another major concern is how the SEC will grapple with the flood of tips the proposed rule is expected to generate — as many as 30,000 a year. "Sometimes it's the training and the perceptiveness of the folks who actually receive the tips that's the problem, not necessarily the tips themselves. How to separate the wheat from the chaff is going to be a big problem for the SEC," said Paul S. Atkins, a former SEC commissioner, who spoke on January 28 at an event held by the New York State Society of Certified Public Accountants. "There are all sorts of crackpots out there, people who are aggrieved because they didn't get their promotion. They have one little piece of the picture ... It will lead to a lot of needless investigations."
Already, plaintiff's lawyers have started to set up Web sites and offer conferences to encourage whistleblowers to come to them with reports, he said. It's conceivable that private lawyers may end up doing the bulk of investigating and building a case, on a contingency basis, if the SEC doesn't have the resources. The cost of defending against specious complaints ultimately falls to the investors in public companies.
"We think the managerial and funding issues regarding the SEC are significant issues. We have advocated for the last three years for managerial reforms," said Tom Quaadman, a vice president at the chamber. "We need to have a well-run, well-managed, effective regulator."
The chamber wants the SEC to exclude certain corporate employees from receiving rewards, such as those who are part of the fraud and effectively report on themselves. Under the proposed rule, "wrongdoers can also profit from whistle blowing," Quaadman said.
Possibly the most famous tipster, former Enron vice president Sherron Watkins, expressed concern that the SEC proposal doesn't go far enough to protect whistleblowers. Watkins wouldn't have been eligible to collect part of the $316 million in Enron-related SEC fines under the proposed rule, because she didn't technically provide information voluntarily — her lawyer asked the SEC to serve her a subpoena to protect Watkins from violating confidentiality obligations to Enron when she shared information about the company.
"I meet whistleblowers who try to get things corrected through their own company. There are a number of tactics the company uses to oppress the truth teller," Watkins said at the NYSSCPA event. "The SEC's going to have to develop mechanisms by which they can listen through the paranoia and get to the bottom of things."
Note: This story was updated on Feb. 8, 2011, to include the fact that a $1 million award was granted by the SEC in July 2010.
Whistleblower Rule: Business Leaders Want it Changed
This article was originally published by the Fiscal Times on Monday, Feb. 7, 2011.