Whistleblower rules -- most hedge fund employees can bypass internal compliance, but have no remedy for internal report retaliation

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1 Page 1 of 5 Whistleblower rules -- most hedge fund employees can bypass internal compliance, but have no remedy for internal report retaliation Jun Sam Lieberman On May 25, 2011, the SEC adopted final rules implementing the whistleblower provisions of the Dodd-Frank Act (whistleblower rules or Rules). The Rules permit most employees to bypass internal compliance programs and report fraud allegations directly to the SEC to obtain a whistleblower award. Instead, only certain key employees must report fraud internally before they can become eligible for an award, including officers, directors, partners, and compliance and internal audit personnel. Separately, the SEC has clarified that employees of private firms like hedge funds are not protected against retaliation for internally reporting wrongdoing. Thus, although the whistleblower rules will somewhat bolster hedge fund internal compliance programs by incentivizing key employees to report internally, the Rules also create strong incentives for most employees to bypass internal compliance. Further, the Rules will leave key hedge fund employees in a Catch-22 of being required to report wrongdoing internally to get an award, and often as a job requirement, while having no legal remedy for retaliatory firing. This will harm internal compliance programs by chilling key employees from robustly investigating and reporting wrongdoing posing a threat to employers. No general requirement to report internally before going to SEC The most controversial aspect of the Rules is the SEC's decision not to require most employees to report internally before submitting a report of wrongdoing to the SEC for a whistleblower award. This issue drew the most public comments after the SEC had submitted proposed rules in November Companies had argued that an internal reporting requirement was necessary to make internal compliance programs meaningful, and to prevent a flood of employees bypassing internal compliance to seek an award. By contrast, whistleblower advocates argued that an internal reporting requirement would deter many employees from participating in the whistleblower program. The SEC decided to reject a general internal reporting requirement for most employees, while providing "incentives" to internally report before seeking a whistleblower award. First, the SEC specifically identified a whistleblower's "[p]articipation in internal compliance systems" as a factor which could increase his or her whistleblower award. (Rule 21F-6(a)(4), whistleblower release at ). Second, the SEC identified a whistleblower's interference with internal compliance systems as a negative factor that can reduce the amount of a whistleblower award. (Rule 21F-6(b)(2), (3)). Third, an employee internally reporting wrongdoing can get a Whistleblower Award giving credit for all information his company later provides to the SEC, even if his information alone was not sufficient for an Award. (Rule 21F-4(c), at ). To qualify for this provision, the employee must also report his information directly to the SEC within 120 days after reporting internally (Rule 21F-4(c)(3)). But it is unlikely that these "incentives" will keep employees from bypassing internal compliance programs. The "incentive"

2 Page 2 of 5 to participate internally to receive a larger award appears to have little value, because the SEC also states that a whistleblower "could receive the maximum award regardless of whether the whistleblower satisfied other factors such as participating in internal compliance programs." Further, these "incentives" will be outweighed at private firms like hedge funds, where, as discussed below, there is no SEC remedy for internal reporting retaliation. Certain key employees must report internally to be whistleblower-eligible The SEC's whistleblower rules seek to bolster internal compliance programs by identifying three categories of key employees who are ineligible for a Whistleblower Award unless they first report fraud internally and meet an exception. First, internal compliance and audit employees, and employees of outside firms retained to perform audit, compliance, or internal legal investigation functions. (Rule 21F-4(b)(4)(iii)(B), (C)). Second, officers, directors, trustees or partners of an entity are presumptively ineligible to be Whistleblowers for information learned from another person or through the entity's internal investigative processes. (Rule 21F-4(b)(4)(iii)(A)). Third, employees of accounting firms retained as an independent public accountant under the securities laws are presumptively ineligible for information related to a client's violation of law. (Rule 21F-4(b)(4)(iii)(D)). This relates to work other than auditing financial statements, such as Rule 17a-5 broker-dealer annual audits, because a separate provision addresses financial statement auditing and makes whistleblower eligibility subject to section 10A of the 1934 Act. (Rule 21F-8(c)(4)). There are three exceptions for these three categories of employees. The main exception is that 120 days pass after the internal report. (Rule 21F-4(v)(C), whistleblower release at 250). The other two exceptions are where (i) a company is impeding an internal investigation, or (ii) reporting to the SEC is necessary to prevent substantial harm to an entity's or its investors' financial interests. (Rule 21F-4(v)(A), (B)). The SEC has stressed that "in most cases" involving the substantial harm exception, "the whistleblower will need to demonstrate that responsible management or governance personnel at the entity were aware of the imminent violation and were not taking steps to prevent it." Thus, it is difficult to imagine a situation where an employee could qualify for this exception without showing that he first reported the imminent violation internally. The SEC's purpose in requiring these key employees to report internally is to "promote the goal of ensuring that the persons most responsible for an entity's conduct and compliance with law are not incentivized to promote their own selfinterest at the possible expense of the entity's." Indeed, requiring key employees to report internally will ensure that in most cases hedge funds will have the first opportunity to address fraud through internal compliance programs. This will allow hedge funds to discovery and stop wrongdoing at an early stage, sometimes nipping it in the bud and preventing future fraud. Further, it enables hedge funds to avoid the legal costs and reputational damage of an SEC investigation by taking internal action to stop wrongdoing, while self-reporting to the SEC. No retaliation remedy for reporting internally at hedge funds But despite requiring key employees to report fraud internally, the SEC has refused to provide a remedy for employees of private firms like hedge funds against retaliation for internal reporting. In particular, the SEC's whistleblower rules release states that the protections of the Dodd-Frank Act's anti-retaliation provision "do not" generally apply to internal reporting by "employees of entities other than public companies." Employees of public company subsidiaries and national rating organizations are also protected against internal reporting retaliation.

3 Page 3 of 5 The SEC applied the Dodd-Frank Act's retaliation provision, which does not specify that it covers internal reporting at private entities only providing information to the SEC, assisting an SEC investigation, or internal reporting at a public company, as covered by the Sarbanes-Oxley Act, 15 U.S.C. 78u-6(h)(1)(A)(iii). The lack of a remedy puts key hedge fund employees in a Catch-22 of having to report internally to be whistleblower-eligible, and often as a job requirement, while having no legal remedy for being fired in retaliation. The SEC's refusal to provide a retaliation remedy for internal hedge fund reporting is particularly significant, because courts have refused to find a federal or state remedy for such retaliation absent SEC or legislative guidance. For example, just before the SEC announced its Rules, a federal court dismissed a Dodd-Frank whistleblower retaliation claim based on internal reporting of fraud to the private company's President and Board of Directors. Egan v. TradingScreen, Inc., 2011 WL , at *2 (S.D.N.Y., May 4, 2011). The plaintiff in Egan was fired before he could follow-up his internal report with a report directly to the SEC. The Court held that since TradingScreen was a privately-held company, the plaintiff could not state a Whistleblower retaliation claim unless he established that he "provided information to the SEC." Although the court noted that it might defer to a contrary SEC interpretation, the SEC now supports this holding. Similarly, Sullivan v. Harnisch (915 N.Y.S 2d, 514, (2011) recently held that a hedge fund chief compliance officer has no New York state law remedy for being fired in retaliation for internally reporting fraud, even though he was required to internally report "on pains of termination." The court reasoned that "[a]s hard as the result may seem," the CCO's job requirement to report internally "merely suggest[ed] standards" for performing his job and did not imply that he would be protected from retaliation for doing his job. The court cited judicial restraint because the legislature barred retaliation in other areas like health care, but not as to hedge funds. Further, the court held that the CCO's role of ensuring the hedge fund's legal compliance did not create an implied contract against retaliation. It reasoned that although law firm attorneys have an implied contract under ethical rules that they will not face retaliation for internal reporting, hedge funds and CCO's did not share a similar "understanding so fundamental to the relationship and essential to its purpose." Sullivan's holding appears seriously flawed because SEC rules (including the Whistleblower Rules) recognize that a CCO's "fundamental" if not only role is to internally investigate, report and enforce compliance with securities laws. SEC rules require covered hedge funds to hire CCO's to administer internal policies for securities law violations, (17 C.F.R. sections (4)-7(a), (c), a-1(a)(4)), and define a CCO's duties as "administer[ing] compliance policies and procedures," and "compel[ing] others to adhere to the compliance policies and procedures." (SEC Rel. No. IA-2204 at (Dec. 17, 2003)). Yet the SEC's refusal to provide an internal reporting retaliation remedy will only compound the problem created by Sullivan. Moreover, Sullivan's holding is likely to be followed by other key states like Delaware where many hedge funds are registered with limited retaliation remedies that are "narrowly drawn" and "generally statutory." E.I. DuPont de Nemours & Co. v. Pressman, 697 A.2d 436, 442 n.13 (Del. 1996). Delaware's Supreme Court has already narrowly construed a nursing home whistleblower statute as covering only retaliation for reporting to the government and "not to one's supervisor." Lord v. Souder, 748 A.2d 393, 401 (Del. 2000). Thus, the SEC's whistleblower rules most likely leave key hedge fund employees without any state or federal remedy against internal reporting retaliation.

4 Page 4 of 5 The chilling effect of no retaliation remedy on internal compliance programs The SEC's failure to provide a retaliation remedy at private firms like hedge funds will have a chilling effect on the participation of all employees in internal compliance programs. As the SEC acknowledged in proposing the whistleblower rules, many employees "do not avail themselves" of "internal whistleblower, legal or compliance" programs "for fear of retaliation." (S.E.C. Rel. No , at 51 (Nov. 3, 2010)). More employees will now bypass internal compliance, particularly given the additional incentive to go directly to the SEC for a whistleblower award. As for key employees required to report internally to be whistleblower-eligible, they will be discouraged from robustly investigating and reporting wrongdoing posing a threat to their employer. In particular, key employees will have a strong incentive to avoid retaliation by providing the minimum amount of participation necessary to satisfy Whistleblower and/or job requirements. As Sullivan demonstrates, many hedge funds make internally reporting wrongdoing a job requirement for key officers, compliance and audit employees. The lack of a retaliation remedy will pressure these key employees to downplay internal reports of wrongdoing, or investigate them less diligently, to avoid posing a threat to employers. This means that the employees best able to unearth information most valuable to an internal investigation or SEC enforcement will be discouraged from engaging in vigorous fact-finding. Further, the lack of a retaliation remedy will embolden hedge funds engaged in high-level wrongdoing to fire key employees upon the earliest internal report, both to obstruct an internal investigation and prevent effective SEC enforcement. It is no answer that a fired employee can still seek a whistleblower award. The very uncertain prospect of a reward after years of investigation and legal proceedings is unlikely to justify risking one's job. That is particularly true in a troubled economy and job market, where the stigma of termination for aggressive internal reporting may deter future employers. Accordingly, the SEC's failure to provide a retaliation remedy for internal reporting at private firms like hedge funds will not only hurt key employees, but also frustrate internal compliance programs and the whistleblower process itself. Indeed, the SEC's failure to provide such a remedy places the Dodd-Frank whistleblower program at odds with other whistleblower programs like the False Claims Act (FCA), which courts have interpreted as protecting against retaliation for "internal reporting" and an internal "investigation," despite having no internal reporting requirement before bringing an FCA whistleblowing claim. (See, e.g., 31 U.S.C. 3730(h)(1); McKenzie v. BellSouth Telecom., Inc., 123 F.3d 935, 944 (6th Cir. 1997); Hopper v. Anto, 91 F.3d 1269 (9th Cir. 1996) and Yesudian v. Howard Univ., 153 F.3d 731, 740 & n.9 (D.C. Cir. 1998). Providing such a remedy would further bolster internal compliance programs and embolden these employees to do their jobs more effectively. Sam Lieberman is Of Counsel in the Litigation Group at Sadis & Goldberg LLP. He has extensive experience handling all stages of high-profile securities class actions, complex commercial litigation and government investigations. Lieberman has represented individuals and investment advisers in civil and criminal investigations by the SEC and the US Attorney's office. He has litigated securities actions on behalf of plaintiffs and defendants involving a wide array of matters, including subprime mortgage-backed securities, stock option backdating, market-timing, late-trading, accounting irregularities, insider trading, market manipulation, channel-stuffing and alleged false financial disclosures. He has also handled mergers and acquisitions disputes involving key issues of corporate governance and shareholder rights and represented clients in SEC and US Attorney's office investigations in matters that include alleged securities fraud, mail fraud, wire fraud and tax evasion.