Category: Whistleblower

Whistleblower Mistakes by a Private Fund

whistle blower

Paradigm Capital Management encountered a whistleblower and handled it poorly. The hedge fund had been conducting principal trades in violation of  Section 206(3) of the Investment Advisers Act. Paradigm’s head trader reported the violations to the Securities and Exchange Commission.

It’s tricky to deal with a hedge fund making principal trades with an affiliated broker-dealer. The principal trade requires consent of the client under SEC Rule 206(3)-2. With a hedge fund, it’s not the investors who are the client. It’s the fund that is the client.

That makes it tricky to structure the consent. Most hedge funds are privately-owned so there is no board of directors to act on behalf of the fund. That was true with Paradigm where Candace King Weir owned 73% of the advisory firm and 73% of the broker-dealer.

Paradigm tried to do the right thing and established a conflicts committee. It consisted of the CCO and CFO of Paradigm. The problem was that the CFO reported to Weir, so the CFO’s presence did not alleviate the conflict.

Paradigm was ordered to pay a penalty of $1.7 million as an “approximation of certain administrative fees the Fund paid in connection with the principal transactions….” The order does not go into detail about the investors in the fund were hurt by the principal trades.

The order spends its most time discussing the whistleblower aspects of the case.

It was Paradigm’s head trader who made a whistleblower submission to the SEC in March 2012. That’s about seven months after the new whistleblower rule went into effect, making the trader eligible for up to 30% of the penalty.

The head trader continued doing his job until the middle of July. At that point he told the firm that he reported a possible securities law violation to the SEC.

The next day Paradigm pulled him off the trading desk and relieved him of his day-to-day responsibilities. The firm sent him off-site to prepare a report on all the facts that supported his claims. Eventually, he ended up working at home.

Paradigm was looking for a “gotcha” moment to fire the whistleblower. That came when he sent a confidential document to Paradigm’s CCO. The firm accused the whistleblower of removing confidential documents in violation of firm policy and the confidentiality agreement he signed when he joined the firm. He eventually resigned because of the adverse treatment.

Paradigm had a compliance failure. Principal trades are bad for investment advisers and tricky for hedge funds.  But I would guess that it was the firm’s treatment of the whistleblower that resulted in such a harsh penalty.

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How Well is the SEC’s Whistleblower Program Working?

sec-seal

Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act created the SEC’s whistleblower program, awarding cash to individuals who report misdeeds that result in successful SEC cases. If the SEC collects more than $1 million, the whistleblower can receive between 10% and 30% of the award. Section 922 also required the Office of Inspector General to conduct a review of the whistleblower program within 30 months.

Surprisingly, the Inspector General had only good things to say about the program, with only two minor recommendations. I say ‘surprisingly’ because the reports from the Inspector General have recently been harsh criticisms. Not this time.

The implementation of the final rules made the SEC’s whistleblower program clearly defined and user-friendly for users that have basic securities laws, rules, and regulations knowledge. The whistleblower program is promoted on the SEC’s website and the public can access OWB’s website from the site in four or more possible ways to learn about the whistleblower program or to file a complaint with the SEC. Additionally, OWB outreach efforts have been strong and the SEC’s whistleblower program can be promptly located using internet search engines such as Google, Yahoo, and Bing.

The two recommendations from the OIG are both related to adding metrics to in the program to better monitor program performance. For example there is no standard on how long a filing should stay in the manual “triage” step in the program. The average is 31 days. By adding thoughtful metrics and performance goals the SEC could help to avoid degradation in performance and longer response times.

One key finding in the report is that there is no current need to create a private right of action based on the facts of a whistleblower complaint. The OIG report points to a possible reduction of the government’s ability to shape and develop the law. Private suits could lead to wasteful, detrimental developments that are inconsistent with executive and judicial interpretations.

But the concept is not dead. The OIG promises to revisit the private action concept in a few years after there is more data from the new whistleblower program.

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Whistleblower Only Has to Believe There is Something Wrong

Whistleblower rights are growing stronger. The recent award of a reward in excess of $100 million to a whistleblower will certainly attract those looking for financial reward. Dodd-Frank not only increased the chances of getting a reward, it also provided broader rights to employees and the courts are starting to rule strongly in favor of employees. A recent ruling highlights the new legal world of whistleblowers.

An employee wrote a letter to the Securities and Exchange Commission and reported that the company had failed to submit its 2009 amendment to the pension plan to its board of directors for approval and had failed to file its amendment with the SEC. The employee, Richard Kramer, was a human resources officer and member of the pension plan committee. Kramer had also told the company that there needed to be three member of the committee, not just the two in place at that time.

Kramer argues that as a result of his complaints, the company disciplined him, reduced his responsibilities, and eventually fired him.

The Dodd-Frank Act provides this protection against whistleblower retaliation:

No employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower —

(i) in providing information to the Commission in accordance with this section;
(ii) in initiating, testifying in, or assisting in any investigation or judicial or administrative action of the Commission based upon or related to such information; or
(iii) in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002, the Securities Exchange Act of 1934, including section 10A(m) of such Act, and any other law, rule, or regulation subject to the jurisdiction of the Commission.

A “whistleblower” is defined as “any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” 15 U.S.C. § 78u-6(a)(6)

The company first argues that Kramer is not a whsitleblower because he did not us the SEC’s new method of reporting on Form TCR. Mailing a regular letter is insufficient. The court did not believe that it is unambiguously clear that the Dodd-Frank Act’s whistleblower retaliation provision is limited to those individuals who have provided information relating to a securities violation to the SEC, and have done so in a manner established by the SEC. In the court’s view, the company’s interpretation would dramatically narrow the available protections available to potential whistleblowers. I suspect that the use of Form TCR will be required for whistleblower payouts, but not required for retaliation claims.

The company that argued that it had filed the form with the SEC on the date of the 2009 amendment to the plan. There was no securities law violation.

The court noted that in order to qualify for whistleblower protection the employee need only demonstrate that he reasonably believed there had been a violation. There need not be an actual violation of securities laws. The court found that the employee may have reasonably believed the company to be committing violations of SEC rules or regulations.

The ruling was just on the motion to dismiss and amend claims, so it is not over. It does appear to be the first Dodd-Frank whistleblower claim to survive a motion to dismiss in federal court.  I expect it will not be the last.

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SEC’s Whistleblower Annual Report

Sean McKessy, Chief Office of the Whistleblower

Dodd-Frank added Exchange Act Section 21F(g)(5) and requires that SEC’s Office of the Whistleblower to report to Congress annually on the whistleblower program. It’s due each October 30. I’m sure the SEC wanted to be in compliance, so they released the first annual report on the Dodd-Frank Whistleblower program (.pdf).

Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act added Section 21F to the Exchange Act and directs the Commission to make monetary awards to eligible individuals who voluntarily provide original information that leads to successful SEC enforcement actions resulting in monetary sanctions over $1,000,000. Awards are required to be made in the amount of 10% to 30% of the monetary sanctions collected and be paid from the SEC’s Investor Protection Fund.

However, the final whistleblower rules became effective on August 12, leaving only 7 weeks of data under the new program for this report, running to September 30.

Vanessa Schoenthaler notes that “during the seven weeks for which data is available, the Commission received 334 whistleblower tips. Among these, the most common complaints related to market manipulation (54), offering fraud (52) and corporate disclosures and financial statements (51). These tips were categorized by the whistleblowers themselves, not the Commission, and there are 84 that were submitted under the category of “other” or without a category at all, so it’s hard to say how accurate this information really is.”

The whistleblower was able to designate a location, with 37 states and 11 foreign countries in the mix. Although, almost 1/4 left the location blank. The most popular: China, California, Florida, Maryland, New York, and Texas.

The seven weeks of data shows over 20 tips per week coming in on Form TCR.  What will be more interesting is how many of this filings turn into meaningful investigations and how many are unfounded claims from disgruntled employees trying to get back at their company.

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A Weekend of Whistleblowing

Friday marked the effective date of the SEC’s Whistlelower Rule. Lucky whistleblowers can now cash in with bounties of up to 30% of the government’s recovery when cases involve in excess of $1 million. The question I have is whether there was spike in tips submitted over the weekend?

The SEC is trying to make it easy. They rolled out a fancy new website:

Submit a tip:

To qualify for an award under the Whistleblower Program, you must submit information regarding possible securities law violations to the Commission in one of the following ways:

SEC Office of the Whistleblower
100 F Street NE
Mail Stop 5971
Washington, DC 20549
Fax: (703) 813-9322

Please note that if you choose to submit your information anonymously, i.e., without providing your identity or contact information, you must be represented by, and provide contact information for, an attorney in connection with your submission in order to be eligible for an award.

After years of the government pushing for companies to beef up internal compliance and use hotlines to report problems, Congress opened a big barn door for people to go around internal systems. I suppose they think more people like Harry Markopolos will step up and prevent the next Madoff, or Enron, or Worldcom.

Sure, the rewards can be limited for bypassing internal reporting. But people will see the dollar signs. Inevitably there will be some sketchy lawyer advertisements encouraging you get in contact with them so they can help you qualify for the whistleblower bounty.

I suppose it’s too much to expect a big change instantly. I will be interested to see if the new rule has any impact.

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Image: Qiqi Green Whistle 8-16-09 3 by Steven Depolo
CC BY 2.0

The New SEC Whistleblower Rule

In a blow to the efforts of internal compliance, the SEC will let corporate whistle-blowers collect a percentage of penalties when they report financial wrongdoing, even when they bypass companies’ internal complaint systems.

“For an agency with limited resources like the SEC, it is critical to be able to leverage the resources of people who may have first-hand information about violations of the securities laws,” said SEC Chairman Mary L. Schapiro. “While the SEC has a history of receiving a high volume of tips and complaints, the quality of the tips we have received has been better since Dodd-Frank became law. We expect this trend to continue, and these final rules map out simplified and transparent procedures for whistleblowers to provide us critical information.”

The small life ring the SEC threw to internal compliance is that the amount of the amount will be affected by how the person dealt with internal compliance. The amount of the award can be increased if the person reported the problem through internal compliance procedures and decreased if the person interfered with internal compliance or reporting systems.

A May 4 opinion from Judge Leonard Sand held that Dodd-Frank says a person has to report wrongdoing to the SEC — or be able to seek protection under other laws — before receiving legal sanctuary.

The final rule won’t provide protections to those who don’t report to the SEC, reinforcing the court’s interpretation.

While there is lots of discussion around provision providing the incentive to go to the SEC, there is also a question of the anti-retaliation protections. In the recent Egan v. TradingScreen case, a court found that the employee needs to go to the SEC get the statutory anti-retaliation protection.

For private companies, the Egan case also emphasized the point that the whistleblower provisions of Section 806 only apply to public companies subject to the Exchange Act. The employee alleged that Trading Screen was planning to public and should be subject. That didn’t work. He tried to another tactic that since it was a SEC registered broker-dealer it should be subject. The judge didn’t accept that argument either.

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Image: Qiqi Green Whistle 8-16-09 3 by Steven Depolo
CC BY 2.0

Will Cash Incentives for Whistleblowing Undermine Compliance Programs?

Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act provides an expanded whistleblower program that allows the whistleblower to get part of the money paid to the SEC for the violation. After several years of encouraging the development of internal complaint hotlines and compliance programs, Congress seems to now be encouraging a trip to the Feds before reporting a problem internally. On November 3, 2010, the Securities and Exchange Commission (SEC) published its Proposed Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities and Exchange Act of 1934.

I think the approach is poor and could undermine corporate compliance programs. On the other hand, I think employees are more likely to report the problem internally than externally. Reporting externally is a much bigger step. You don’t know who is getting the report or what they will do with it.

The promise of cash payments is a bit remote. It’s not like the SEC will be cutting a check once you make the call. There will months, if not years, of investigation and litigation before there is any money available. And that is assuming the Feds win. In the meantime, the reporter has jeopardized his or her job and career.

I think the typical person is much more likely to talk to their friendly, internal compliance people before they go racing off to the Feds seeking fame and riches.

Now there is some evidence that I’m correct. The National Whistleblowers Center has released a report on the Impact of Qui Tam Laws on Internal Corporate Compliance. Based on a review of qui tam cases filed between 2007-2010 under the False Claims Act, the overwhelming majority of employees voluntarily utilized internal reporting processes, despite the fact that they were potentially eligible for a large reward under the False Claims Act. 89.7% of employees who would eventually file a qui tam case initially reported their concerns internally, either to supervisors or compliance departments.

Their conclusion:

“The qui tam reward provision of the False Claims Act has existed for more than 20 years and has resulted in numerous large and well-publicized rewards to whistleblowers. However, contrary to the disingenuous assertions by corporate commenters, the existence of this strong and well-known qui tam rewards law has had no effect whatsoever on whether a whistleblower first brings his concerns to a supervisor or internal compliance program. There is no basis to believe that the substantively identical qui tam provisions in the Dodd-Frank law will in any way discourage internal reporting.”

It may not be meaningful for some time. The Securities and Exchange Commission is operating under budget constraints and put the whistleblower office on hold until funding clears up. The new Congress may repeal provisions of Dodd-Frank, but they can limit some of the funding.

Much of the whistleblower program is in SEC Release 34-6323. Comments are open until December 17, 2010. Certainly, the proposed rule could change significantly bases on the comments. There have been lots of comments from the compliance community at the public companies subject to this rule. I would like to see the rule changed as a validation of internal compliance programs.

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Corporate Compliance after Dodd-Frank: Dealing with Whistleblower Bounties

Securities Docket produced a webcast “Corporate Compliance after Dodd-Frank: One Voice; How Many Masters?” that focused on the SEC’s proposed new whistleblower rules and their implications for internal controls and compliance programs, investigations, self-reporting incentives and employer/employee relations, including executive compensation and employee reporting responsibilities.

The panelists:

  • Byron Egan, Partner Jackson Walker L.L.P.
  • Jeffrey Sone, Partner Jackson Walker L.L.P.
  • Gary Kleinrichert, Senior Managing Director FTI Consulting

Section 922 of Dodd-Frank provides an expanded whistleblower program that allows the whistleblower to get part of the money paid to the SEC for the violation.

There is a lot of gnashing of teeth among compliance professionals because this provision would encourage an employee to ignore internal complaint processes and head directly to the Feds. Those internal whistleblowing program came out of Sarbanes-Oxley, the legislation enacted as a result of the last financial crisis.

The new program is not applicable to private companies that are not subject to registration under the Securities Act of 1934. Section 922 of Dodd-Frank is an amendment of that law.

Employees with a legal, compliance, audit, supervisory or governance responsibility have limited eligibility for the whistleblower bounty. They are not eligible if the information was communicated to them with the reasonable expectation that they would take steps to respond to the violation. They are then eligible if the company does not disclose the information to the SEC within a reasonable time or proceeds in bad faith.

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In prognosticating the impact, we can look at the False Claims Act which has a similar whistleblower bounty program. Under that legal framework, most people don’t report to the government until they have given their company a chance.

Much of the whistleblower program is in SEC Release 34-6323. Comments are open until December 17, 2010. Certainly, the proposed rule could change significantly bases on the comments.

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Proposed Rules for Implementing the Whistleblower Provisions From Dodd-Frank

The SEC has released the text of its proposed new rules for implementing the whistleblower provisions of Section 21F of the Securities Exchange Act of 1934: Release No. 34-63237.

In fashioning these proposed rules, the Commission has considered and weighed a number of potentially competing interests that are presented in implementing the statute. Among them was the potential for the monetary incentives provided to whistleblowers by Section 21F of the Exchange Act 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. With this possible tension in mind, we have 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. At the same time, the proposed rules would not prohibit a whistleblower in a compliance function from reporting information to the Commission where the company did not provide the information to the Commission within a reasonable time or acted in bad faith.

At this point, it is merely a proposed rule. Comments should be submitted on or before December 17, 2010.

There will be a new Form TCR for submitting a tip, complaint or referral and a new Form WB-DEC, Declaration Concerning Original Information Provided Pursuant to §21F of the Securities Exchange Act of 1934, signed under penalty of perjury, for submission to the SEC to meet the standards of the new regulations.

Save Your Company, Save Yourself

What happens when you have a business disaster on your resume? Maybe listing an Enron or WorldCom would not be so bad. Those companies are big enough that you may not be tainted by the corporate fraud. Unless you ended up in handcuffs.

As the company gets smaller, you’re more likely to get caught in the stink of corporate fraud. That gets even worse when you share the last name on the door.

The Wall Street Journal highlighted the lack of future job prospects with former Madoff employees: Not Exactly a Résumé Highlight: Madoff Work

The story focuses on the Madoff sons, Mark and Andrew, who are labeled as being “untouchable in any firm that deals with the public.” I am not surprised that they are unemployable. Would you hire a Madoff?

But the scar of the fraud falls farther down the corporate ladder. Eleanor Squillari, Bernard Madoff’s former assistant, has moved on to cosmetology. She knows she’ll “never get a job in finance.”

The trading business, which was not implicated in the Madoff fraud and was purchased by Surge Trading, Inc., has the challenge of convincing clients to do business with former Madoff employees.

I suppose the upside is that company schwag could turn into collector’s items.