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Page 1 of 5Whistleblower rules -- most hedge fund employees can bypass internalcompliance, but have no remedy for internal report retaliationJun 09 2011 Sam LiebermanOn 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 fraudallegations directly to the SEC to obtain a whistleblower award. Instead, only certain key employees must report fraudinternally before they can become eligible for an award, including officers, directors, partners, and compliance and internalaudit personnel. Separately, the SEC has clarified that employees of private firms like hedge funds are not protectedagainst retaliation for internally reporting wrongdoing. Thus, although the whistleblower rules will somewhat bolster hedgefund internal compliance programs by incentivizing key employees to report internally, the Rules also create strongincentives for most employees to bypass internal compliance. Further, the Rules will leave key hedge fund employees in aCatch-22 of being required to report wrongdoing internally to get an award, and often as a job requirement, while having nolegal remedy for retaliatory firing. This will harm internal compliance programs by chilling key employees from robustlyinvestigating and reporting wrongdoing posing a threat to employers.No general requirement to report internally before going to SECThe most controversial aspect of the Rules is the SECs decision not to require most employees to report internally beforesubmitting a report of wrongdoing to the SEC for a whistleblower award. This issue drew the most public comments afterthe SEC had submitted proposed rules in November 2010. Companies had argued that an internal reporting requirementwas necessary to make internal compliance programs meaningful, and to prevent a flood of employees bypassing internalcompliance to seek an award. By contrast, whistleblower advocates argued that an internal reporting requirement woulddeter many employees from participating in the whistleblower program.The SEC decided to reject a general internal reporting requirement for most employees, while providing "incentives" tointernally report before seeking a whistleblower award. First, the SEC specifically identified a whistleblowers "[p]articipationin internal compliance systems" as a factor which could increase his or her whistleblower award. (Rule 21F-6(a)(4),whistleblower release at 257-58). Second, the SEC identified a whistleblowers interference with internal compliancesystems as a negative factor that can reduce the amount of a whistleblower award. (Rule 21F-6(b)(2), (3)). Third, anemployee internally reporting wrongdoing can get a Whistleblower Award giving credit for all information his company laterprovides to the SEC, even if his information alone was not sufficient for an Award. (Rule 21F-4(c), at 100-01). To qualify forthis 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"https://www.complinet.com/editor/article/preview.html?ref=144645 6/10/2011
Page 2 of 5to participate internally to receive a larger award appears to have little value, because the SEC also states that awhistleblower "could receive the maximum award regardless of whether the whistleblower satisfied other factors such asparticipating in internal compliance programs." Further, these "incentives" will be outweighed at private firms like hedgefunds, where, as discussed below, there is no SEC remedy for internal reporting retaliation.Certain key employees must report internally to be whistleblower-eligibleThe SECs whistleblower rules seek to bolster internal compliance programs by identifying three categories of keyemployees 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, orinternal legal investigation functions. (Rule 21F-4(b)(4)(iii)(B), (C)). Second, officers, directors, trustees or partners of anentity are presumptively ineligible to be Whistleblowers for information learned from another person or through the entitysinternal investigative processes. (Rule 21F-4(b)(4)(iii)(A)). Third, employees of accounting firms retained as an independentpublic accountant under the securities laws are presumptively ineligible for information related to a clients 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-dealerannual audits, because a separate provision addresses financial statement auditing and makes whistleblower eligibilitysubject 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 theinternal report. (Rule 21F-4(v)(C), whistleblower release at 250). The other two exceptions are where (i) a company isimpeding an internal investigation, or (ii) reporting to the SEC is necessary to prevent substantial harm to an entitys or itsinvestors financial interests. (Rule 21F-4(v)(A), (B)). The SEC has stressed that "in most cases" involving the substantialharm exception, "the whistleblower will need to demonstrate that responsible management or governance personnel at theentity were aware of the imminent violation and were not taking steps to prevent it." Thus, it is difficult to imagine a situationwhere an employee could qualify for this exception without showing that he first reported the imminent violation internally.The SECs purpose in requiring these key employees to report internally is to "promote the goal of ensuring that thepersons most responsible for an entitys conduct and compliance with law are not incentivized to promote their own self-interest at the possible expense of the entitys." Indeed, requiring key employees to report internally will ensure that in mostcases hedge funds will have the first opportunity to address fraud through internal compliance programs. This will allowhedge funds to discovery and stop wrongdoing at an early stage, sometimes nipping it in the bud and preventing futurefraud. Further, it enables hedge funds to avoid the legal costs and reputational damage of an SEC investigation by takinginternal action to stop wrongdoing, while self-reporting to the SEC.No retaliation remedy for reporting internally at hedge fundsBut despite requiring key employees to report fraud internally, the SEC has refused to provide a remedy for employees ofprivate firms like hedge funds against retaliation for internal reporting. In particular, the SECs whistleblower rules releasestates that the protections of the Dodd-Frank Acts 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 ratingorganizations are also protected against internal reporting retaliation.https://www.complinet.com/editor/article/preview.html?ref=144645 6/10/2011
Page 3 of 5The SEC applied the Dodd-Frank Acts retaliation provision, which does not specify that it covers internal reporting atprivate entities – only providing information to the SEC, assisting an SEC investigation, or internal reporting at a publiccompany, 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 fundemployees in a Catch-22 of having to report internally to be whistleblower-eligible, and often as a job requirement, whilehaving no legal remedy for being fired in retaliation.The SECs refusal to provide a retaliation remedy for internal hedge fund reporting is particularly significant, because courtshave refused to find a federal or state remedy for such retaliation absent SEC or legislative guidance. For example, justbefore the SEC announced its Rules, a federal court dismissed a Dodd-Frank whistleblower retaliation claim based oninternal reporting of fraud to the private companys President and Board of Directors. Egan v. TradingScreen, Inc., 2011 WL1672066, at *2 (S.D.N.Y., May 4, 2011). The plaintiff in Egan was fired before he could follow-up his internal report with areport directly to the SEC. The Court held that since TradingScreen was a privately-held company, the plaintiff could notstate a Whistleblower retaliation claim unless he established that he "provided information to the SEC." Although the courtnoted 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, 516-17 (2011) recently held that a hedge fund chief compliance officerhas no New York state law remedy for being fired in retaliation for internally reporting fraud, even though he was required tointernally report "on pains of termination." The court reasoned that "[a]s hard as the result may seem," the CCOs jobrequirement to report internally "merely suggest[ed] standards" for performing his job and did not imply that he would beprotected from retaliation for doing his job. The court cited judicial restraint because the legislature barred retaliation inother areas like health care, but not as to hedge funds. Further, the court held that the CCOs role of ensuring the hedgefunds legal compliance did not create an implied contract against retaliation. It reasoned that although law firm attorneyshave an implied contract under ethical rules that they will not face retaliation for internal reporting, hedge funds and CCOsdid not share a similar "understanding so fundamental to the relationship and essential to its purpose."Sullivans holding appears seriously flawed because SEC rules (including the Whistleblower Rules) recognize that a CCOs"fundamental" – if not only – role is to internally investigate, report and enforce compliance with securities laws. SEC rulesrequire covered hedge funds to hire CCOs to administer internal policies for securities law violations, (17 C.F.R. sections275.206(4)-7(a), (c), 270.38a-1(a)(4)), and define a CCOs 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 10-11 (Dec. 17,2003)). Yet the SECs refusal to provide an internal reporting retaliation remedy will only compound the problem created bySullivan.Moreover, Sullivans holding is likely to be followed by other key states like Delaware – where many hedge funds areregistered – 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). Delawares Supreme Court has already narrowly construed a nursinghome whistleblower statute as covering only retaliation for reporting to the government – and "not to ones supervisor." Lordv. Souder, 748 A.2d 393, 401 (Del. 2000). Thus, the SECs whistleblower rules most likely leave key hedge fund employeeswithout any state or federal remedy against internal reporting retaliation.https://www.complinet.com/editor/article/preview.html?ref=144645 6/10/2011
Page 4 of 5The chilling effect of no retaliation remedy on internal compliance programsThe SECs failure to provide a retaliation remedy at private firms like hedge funds will have a chilling effect on theparticipation of all employees in internal compliance programs. As the SEC acknowledged in proposing the whistleblowerrules, many employees "do not avail themselves" of "internal whistleblower, legal or compliance" programs "for fear ofretaliation." (S.E.C. Rel. No. 63237, at 51 (Nov. 3, 2010)). More employees will now bypass internal compliance, particularlygiven the additional incentive to go directly to the SEC for a whistleblower award. As for key employees required to reportinternally to be whistleblower-eligible, they will be discouraged from robustly investigating and reporting wrongdoing posinga threat to their employer.In particular, key employees will have a strong incentive to avoid retaliation by providing the minimum amount ofparticipation necessary to satisfy Whistleblower and/or job requirements. As Sullivan demonstrates, many hedge fundsmake internally reporting wrongdoing a job requirement for key officers, compliance and audit employees. The lack of aretaliation remedy will pressure these key employees to downplay internal reports of wrongdoing, or investigate them lessdiligently, to avoid posing a threat to employers. This means that the employees best able to unearth information mostvaluable 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 employeesupon 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 afteryears of investigation and legal proceedings is unlikely to justify risking ones job. That is particularly true in a troubledeconomy and job market, where the stigma of termination for aggressive internal reporting may deter future employers.Accordingly, the SECs failure to provide a retaliation remedy for internal reporting at private firms like hedge funds will notonly hurt key employees, but also frustrate internal compliance programs and the whistleblower process itself. Indeed, theSECs failure to provide such a remedy places the Dodd-Frank whistleblower program at odds with other whistleblowerprograms like the False Claims Act (FCA), which courts have interpreted as protecting against retaliation for "internalreporting" and an internal "investigation," despite having no internal reporting requirement before bringing an FCAwhistleblowing 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 dotheir 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 Attorneys 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 Attorneys office investigations in matters that include alleged securities fraud, mail fraud, wire fraud and tax evasion.https://www.complinet.com/editor/article/preview.html?ref=144645 6/10/2011