ON Securities : Securities Lawyer & Attorney for Corporate Governance & Executive Compensation Matters

Under the SEC’s whistleblower rules (302-page PDF), adopted in May under the Dodd-Frank Act and described in this prior post, whistleblowers are not required to report perceived misconduct internally before going to the SEC. However, the SEC intended the rules to encourage internal reporting. There is evidence that most companies are still considering whether, and how, to maximize the chances that an employee will report internally first.

Broc Romanek, in TheCorporateCounsel.net Blog, recently published the results of a survey on whistleblower policies, with 33 companies responding. A majority of the respondents reported that they either intend to change their policies in response to the rules or have not yet decided. Further, a majority have not yet decided whether to provide incentives to report internally first, and a majority have not yet decided whether to create a system to alert employees of the benefits of reporting internally.

Obviously, the jury is out on the best way to incentivize internal reporting. Last month, RAND Corporation released “For Whom the Whistle Blows: Advancing Corporate Integrity and Compliance Efforts in the Era of Dodd-Frank” (free download available here), a report summarizing the conclusions and discussions of a recent symposium. The symposium featured speakers with widely varying views, and the 78-page report makes interesting reading. Some of the key points:

• The speakers emphasized the important roles of the chief ethics and compliance officer and boards of directors.
• It is critical to create a culture in which internal reporting is valued, whistleblowers are clearly and obviously protected, and employees have trust in the internal reporting system.
• Companies can consider financial and non-financial incentives to make internal corporate reporting mechanisms more effective.

On the last point, some companies have considered paying their own bounties to whistleblowers to report internally first, as a way to combat the bounty to be paid by the SEC in successful external reporting cases. This is a controversial practice, and I have not yet heard of companies implementing such direct payments. The participants in the symposium also discussed providing non-financial incentives, such as acknowledgement by the CEO or recognition by the company. Others believe internal reporting can be enhanced through the management compensation system:

One suggestion offered to help reinforce internal reporting was that corporate compensation schemes could be tweaked to include a set of ethical leadership criteria for management, thereby supporting a culture in which internal whistleblowers are supported and valued. . . . [O]ne participant noted that the CEO and key senior executives could receive contingent compensation based on a range of performance metrics tied to ethical leadership, support of the compliance function, and successful efforts to contribute to ethical culture.

Another frequently discussed method of encouraging internal reporting, not discussed in the Report, is based on a compliance certification. Employees would be required to certify periodically to the effect that they have reported, or will report, any instances of certain types of wrongdoing to the company. In a recent webcast on TheCorporateCounsel.net (available by subscription), Sean McKessy, the Chief of the SEC’s Office of the Whistleblower, Division of Enforcement, engaged in a discussion of such certifications with several practitioners. McKessy expressed the concern that such a certification, if not properly worded, could conflict with an employee’s statutory right to report to regulators.

The bottom line is that there are a lot of methods to consider in encouraging internal reporting by whistleblowers. And most companies are still doing just that – considering what is the best approach among the alternatives.
 

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Last Friday, the SEC’s whistleblower rules (PDF) went fully into effect, and the Office of the Whistleblower web page went live. The Office’s Chief, Sean McKessy, spoke forcefully about why companies should not be overly alarmed. But the proof will be in the results.

The SEC web page now includes links to the necessary forms for submitting tips or claiming bounty awards under the rules, as well as FAQs for tipsters. The page also includes a link to a speech by McKessy, explaining that the rules are still misunderstood and should in fact be considered a positive factor for companies. In particular, he tries to counter the perception that the rules will undermine internal compliance systems by giving whistleblowers incentives to go directly to the SEC:

. . . The rules specify that employees who report wrongdoing internally first and, within 120 days, then report the wrongdoing to the SEC, benefit in two significant ways. First, those employees will be deemed to have reported the information to the SEC on the date they reported internally. This preserves their place in line in terms of when information was provided to the SEC. Second, the employees who report internally first receive the benefit of all the information uncovered by the company in connection with its own internal investigation of the alleged wrongdoing. . . .

McKessy goes on to explain how this latter factor will allow the whistleblowers who first report internally to share in the potential for a percentage share in a much greater ultimate recovery. Further, a whistleblower who first reports internally will likely receive a higher percentage bounty within the 10% to 30% range established by the rules. The rules “. . . require that cooperation with internal compliance programs be considered as a positive factor that could increase a whistleblower award, and interference with such programs as a negative factor that could decrease an award.” He concludes that these incentives built into the SEC program will actually improve the strength and effectiveness of internal compliance programs.

These statements won’t alleviate fears that the rules will lead to a flood of whistleblower complaints that bypass internal compliance programs. For example, in “W-Day is Here: The SEC’s Whistleblower Rules Are Now Effective” in TheCorporateCounsel.net Blog, Broc Romanek points out that “The opportunities [for Foreign Corrupt Practices Act violations claims] are so great that U.S.-based plaintiffs' lawyers are ramping up their advertising throughout Europe, Asia and Africa in order to bring SEC whistleblowers out of the woodwork.” These sorts of reports don’t make corporate compliance personnel rest any easier.

However, according to a Reuters report, the SEC promises to make changes in the whistleblower program in the event of unintended consequences. In “US SEC says will fix whistleblower rule if any problems” by Andrea Shalal-Esa, McKessy is quoted as stating, “If our program is not doing what it’s intended to do, then we’ll look at it and figure out ways to fix it.”

In the meantime, McKessy, a former compliance officer with AOL and Altria, recognizes that siding with whistleblowers is not exactly going to win him any popularity contests in corporate America. The Reuters article quotes him as saying:

Look in a thesaurus under 'whistleblower' and see what kind of words you get out. I'm either the head of the office of the rats, or the rat finks, or rat bastards . . . .

[But] if even one fraud is stopped before it gets to a Madoff-type situation, then all the effort has been worth it.
 

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The SEC yesterday issued proposed rules (PDF) under Section 21F of the Securities Exchange Act of 1934 (Section 922 of the Dodd-Frank Act), which provides a bounty to whistleblowers who disclose securities law violations leading to large monetary sanctions. This press release issued by the SEC summarizes the new rules. In order to qualify for a bounty under Section 21F, the whistleblower must “voluntarily” provide the SEC with “original information” that “leads to” successful enforcement in which the SEC obtains monetary sanctions totaling more than $1 million. The proposed rules clarify these concepts. The rules also define a number of types of individuals who are not entitled to the bounty, including the wrongdoers, persons with a pre-existing duty to report the information or attorneys or accountants in certain cases.

My main concern about Section 21F is that the bounty program will encourage employees and other potential whistleblowers to bypass the internal reporting systems public companies have carefully set up in the past decade to comply with the provisions of the Sarbanes-Oxley Act of 2002. The SEC has tried to address this concern in the proposed rules, which would facilitate and encourage internal reporting in the following ways:

• The rules allow an employee to report information internally as a whistleblower and still get credit for original reporting to the SEC as of the same date – as long as the employee provides that same information to the SEC within 90 days of that date. According to the SEC, “ . . . employees will be able to report their information internally first while preserving their ‘place in line’ for a possible award from the SEC.”
• The rules provide that the SEC may consider higher percentage awards for whistleblowers who report internally first, as long as the company has an effective compliance program.

Comment. The proposed SEC rules are an improvement over the provisions of the Dodd-Frank Act. However, there are still concerns that the bounty program will encourage whistleblowers to “take no chances” and report any questionable information to the SEC. The potential financial rewards for a whistleblower are huge.

Also, there are numerous reports that plaintiffs’ employment attorneys are actively encouraging whistleblowers to file reports. Broc Romanek in a post in thecorporatecounsel.net Blog referred to this recent article, “Get Snitch Quick,” by Kaja Whitehouse in the New York Post about a lawyer who is playing a commercial in New York movie theaters before showings of “Wall Street: Money Never Sleeps.” The commercial directs viewers to go to his website, SECSnitch.com, to get information about whistleblower reporting. In the words of Gordon Gekko, “Greed is good. . . .”

In light of the bounty program, public companies will need to refine their whistleblower policies and training programs. This is only one of the aspects of Dodd-Frank in which we corporate lawyers will need to partner with our colleagues who specialize in employment law. Just wait until listed companies need to draft new clawback policies, under SEC and stock exchange rules expected in 2011, which will require companies to recover incentive compensation from former as well as current officers. . . .

ISS Recommends Annual Say-on-Pay Vote

In this draft policy recommendation, the shareholder advisory service ISS recommends that Say-on-Pay votes be taken annually as a way of providing the most meaningful communications between shareholders and public companies. Assuming the final ISS policy is to recommend an annual vote, this is one more consideration for boards of directors in deciding whether to recommend an annual, biennial or triennial vote, as described in this prior post.

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As I have reported previously, Dodd Bill, the Restoring American Financial Stability Act of 2010 (1,600 page PDF), includes extensive governance and compensation reforms that apply to all public companies (or, in some cases, all listed companies), not just financial institutions. However, a lesser-known provision in the Dodd Bill could also have a significant impact on public companies: a program that would pay whistleblowers a bounty for reporting violations of securities law.

Under Section 922 of the Dodd Bill (starting on page 974), if a whistleblower provides information on a securities law violation that leads to monetary sanctions of more than $1 million, the SEC will be required to pay the whistleblower an amount ranging from ten percent to 30 percent of what has been collected. This bounty would apply to a wide range of securities law violations, including violations of the Foreign Corrupt Practices Act. The Frank Bill, which is being reconciled with the Dodd Bill in conference committee, contains a similar provision, without the ten percent minimum. Because the Senate and House versions are similar, it seems likely that the provision will be part of the final bill, expected to be passed this summer.

I view this provision as the “sleeper” in the Dodd Bill for public companies. It’s received less publicity than other provisions such as mandatory Say-on-Pay and a majority voting requirement for directors in listed companies. However, its impact on public companies could be even greater than those other provisions. The bounty provision may encourage employees to report perceived violations in a greater number of cases than before. Considering the recent increases in SEC enforcement staffing and activity, public companies will also be at greater risk of SEC investigations and enforcement proceedings.

In preparation for the likely passage of the bill, public companies should ensure that their whistleblower policies are up to date and that they are prepared to process a possible increase in whistleblower reports. The policies should provide clear procedures for employees to report possible violations within the company. Careful preparation may help reduce the chances of an expensive and time-consuming problem in the future.
 

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