SEC Releases 2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program

By all accounts, 2014 was a year of tremendous success for the SEC’s Dodd-Frank Whistleblower Program. According to its 2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program, the SEC paid nine whistleblower awards, including a record $30 million award to a single whistleblower. SEC’s 2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program. Sean X. McKessy, the Chief of the Office of the Whistleblower, told Congress that these awards exceeded the number of awards made “in all previous years combined.” In addition, the SEC brought its first enforcement action under the anti-retaliation provisions of the Dodd-Frank Act.

The Annual Report offers more than just numbers, however. Without disclosing whistleblower identities, the Annual Report provides a “profile” of award recipients. Notably, more than 40% of the individuals who received awards were current or former employees of the company about which they reported. In addition, 80% of the individuals had raised issues internally prior to submitting information to the SEC, but the company failed to “take steps or remedy” the misconduct. Other award recipients included the actual victims of the fraud, individuals who had a “personal relationship” with the perpetrator, and contractors and consultants that worked with the company about which the report was made.

The Annual Report also reflects an increase in the number of whistleblower complaints in general. Complaints related to “Corporate Disclosures and Financials (16.9%), Offering Fraud (16%), and Manipulation (15.5%)” were the most common categories; complaints relating to municipal securities and public pensions were the least common categories. Moreover, the Office of the Whistleblower received 3,620 tips in 2014 (almost 400 more than last year) and returned more than 2,731 phone calls—recall that in May 2011 a whistleblower hotline was established and Whistleblower Office attorneys aimed to return messages within 24 hours.

Two important observations come from our review of the Annual Report. First, growing public awareness of the Whistleblower Program and the increase in the number and amount of whistleblower awards will only lead more individuals to bring alleged violations to the SEC’s attention. Second, given the fact that 80% of whistleblowers had raised their concerns first internally and the fact that nearly one-fifth of all tips, complaints, and referrals relate to accounting issues, it is extremely important for companies to implement adequate policies and procedures to respond to internal reports and to provide training to supervisors on how to handle internal complaints.

SEC’s Broken Window Enforcement Program Gets a Boost from “Quantitative Analytics” and “Algorithms”

The SEC announced last week that it had charged, in settled administrative proceedings, 28 individuals and investment firms that failed to “promptly report information about their holdings and transactions in company stock” and six public companies that contributed to “filing failures by insiders or fail[ed] to report their insiders’ filing delinquencies.” See SEC Press Release: “SEC Announces Charges Against Corporate Insiders for Violating Laws Requiring Prompt Reporting of Transactions and Holdings.” The SEC obtained a total of $2.6 million in civil monetary penalties as a result of the filed charges. The individual amounts ranged from $25,000 to $150,000. These cases are the latest example of the SEC’s focus on strict liability violations of the federal securities laws.

All of the charges arise under Sections 13(d), 13(g), and 16(a) of the Securities Exchange Act of 1934. These sections require certain forms to be filed, irrespective of profits or the reasons for engaging in the stock transactions. Although the SEC does not need to establish that an individual or company engaged in insider trading (nor was there any finding that would suggest such) in order to prove any of the charged violations, legislative history indicates that Section 16(a) was motivated by a belief that “the most potent weapon against the abuse of inside information is full and prompt publicity” and by a desire “to give investors an idea of the purchases and sales by insiders[,] which may in turn indicate their private opinion as to prospects of the company.”

Pursuant to Section 16(a) and Rule 16a-3, company officers, directors, and certain beneficial owners of more than 10% of a registered class of a company’s stock (“insiders”) are required to file initial statements of holdings on Form 3 and to keep this information current by reporting transactions on Forms 4 and 5. Specifically, within 10 days after becoming an insider, the insider must file a Form 3 report disclosing his or her beneficial ownership of all securities of the issuer. To keep this information current, insiders must file Form 4 reports disclosing purchases and sales of securities, exercises and conversions of derivative securities, and grants or awards of securities from the issuer within two business days following the execution date of the transaction. In addition, insiders are required to file annual statements on Form 5 within 45 days after the issuer’s fiscal year-end to report any transactions or holdings that should have been, but were not, reported on Form 3 or 4 during the issuer’s most recent fiscal year and any transactions eligible for deferred reporting (unless the corporate insider has previously reported all such transactions).

Beneficial owners of more than 5% of a registered class of a company’s stock must use Schedule 13D and Schedule 13G to report holdings or intentions with respect to the respective company. According to legislative history, Section 13(d) is a key provision that allows shareholders and potential investors to evaluate changes in substantial shareholdings. The duty to file is not dependent on any intention by the stockholder to gain control of the company, but on a mechanical 5% ownership test. A Schedule 13D must be filed within ten days of the transaction, and a Schedule 13G must be filed within 10 to 45 days of the transaction, depending on the category of filer and the percentage of acquired ownership. Importantly, Section 16(a) also requires an investment adviser to file required reports of behalf of funds that it manages when the fund’s ownership or transactions in securities exceed the statutory thresholds.

Under Section 16(a), public companies are required to disclose in their annual meeting proxy statements or in their annual reports, “known” Section 16 reporting delinquencies by its insiders. This disclosure is commonly referred to as the Item 405 disclosure. The Item 405 disclosure of any late filings or known failures to file must (i) identify by name each insider who failed to file Forms 3, 4, or 5 on a timely basis during the most recent fiscal year or prior fiscal years and (ii) set forth the number of late reports, the number of late-reported transactions, and any known failure to file. An issuer does not have an obligation under Item 405 to research or make inquiry regarding delinquent Section 16(a) filings beyond the review specified in the item. Although insiders remain responsible for the timeliness and accuracy of their required Section 16(a) reports, the SEC has encouraged companies to assist their officers and directors to submit their filings, or even to submit the required form on the insiders’ behalf to ensure accurate and timely filing.

These actions make clear, however, that reliance on the company does not excuse violations as the insider retains ultimate responsibility for the filings. The majority of the charged individuals told the SEC that their delinquent filings resulted from the failure of the company to make timely filings on their behalf. In one case, disclosures in the company’s annual proxy statements relating to Section 16(a) compliance revealed that the filing of the insider reports was late because of “lack of staffing,” “late receipt of necessary information,” and “a change in the processing of these forms and delays caused by an email server malfunction.” The SEC still charged the insider because the insider took “ineffective steps to monitor whether timely and accurate filings were made” on his or her behalf by the company.

Without providing any details, the SEC claimed that it used “quantitative analytics” or algorithms to identifyindividuals and companies with especially high rates of filing deficiencies. The SEC’s filing of these actions underscores its willingness to devote resources to pursuing strict liability violations. It also demonstrates the SEC’s efforts to use quantitative analysis and algorithms to identify violations and to streamline the investigative process.

SEC Enters Into First NPA With An Individual

In 2010, the SEC implemented a Cooperation Initiative designed to encourage individuals and companies to cooperate with SEC investigations. See SEC Announces Initiative to Encourage Individuals and Companies to Cooperate and Assist in Investigations, SEC Press Release No. 2010-6 (Jan. 13, 2010). Although the Division of Enforcement authorized SEC staff to “use various tools to encourage individuals and companies to report violations and provide assistance to the agency,” including cooperation agreements, deferred prosecution agreements (“DPA”), and non-prosecution agreements (“NPA”), the staff has made limited use of the cooperation tools with individuals.

In fact, in April, the SEC announced its first NPA with an individual in connection with an insider trading case involving GSI Commerce Inc.’s (“GSIC”) merger with eBay. See SEC v. Saridakis,Civil Action No. 14-2397 (E.D. Pa.). According to the SEC, prior to GSIC’s public announcement of its merger with eBay, Inc., the CEO of its marketing solutions division, Christopher D. Saridakis, provided material nonpublic information about the transaction to friends and colleagues, and he suggested they immediately purchase GSIC stock. For example, according to the SEC’s complaint, co-defendant Jules Gardner received a series of text messages from Saridakis suggesting that he should “own” GSIC “shares” “soon.” Saridakis and Gardner shared this information with several other individuals who traded GSIC stock in or around the time of the merger and further passed along the confidential merger information to people the SEC referred to as “downstream” individuals. According to the SEC, on the day of the merger announcement, the closing price for the GSIC stock increased significantly, resulting in more than $300,000 in illegal profits to the individuals who traded on the insider information.

The SEC reached an agreement with Saridakis and a number of “downstream” individuals. To resolve the SEC’s complaint against them, Saridakis agreed to an officer-and-director bar and to a substantial monetary penalty while Gardner agreed to cooperate and to disgorge all the profits he obtained. The remaining individuals each settled in separate administrative proceedings on a neither admit nor deny basis. These individuals agreed, among other things, to disgorge profits and/or to pay civil monetary penalties.

The Saridakis case is another example of the SEC’s recent and ongoing efforts to encourage individuals to come forward with information relating to alleged securities violations and to cooperate with the SEC’s investigations of such violations. See, e.g., SEC Announces First Deferred Prosecution Agreement with Individual, SEC Press Release No. 2013-241 (Nov. 12, 2013); see also article in Business Law Today. The director of the SEC’s Division of Enforcement, Andrew J. Ceresney, explained, “The reduction in penalties for those tippees who assisted us, together with the non-prosecution agreement for one of the traders, demonstrate the benefits of cooperating with our investigations. The increased penalties for others highlight the risks of impeding our work.”

Although the SEC did not disclose the identity of the individual who received an NPA, it appears that he or she received the material nonpublic information third hand. In addition, Ceresney explained that the “individual provided early, extraordinary, and unconditional cooperation.” Unlike the DPA that the SEC entered into with an individual and the DPAs and NPAs that the SEC has entered into with entities, the SEC did not publicize this NPA, so it is difficult to evaluate what the SEC considered extraordinary cooperation. The fact that the SEC did not disclose the NPA may signal that the individual may be cooperating with the criminal authorities as well.

Expect more cooperation agreements with individuals to come.

Arbitration Agreements and Whistleblower Protections

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed the SEC to establish a “bounty program” for certain individuals who voluntarily provide the SEC with original information that leads to successful SEC actions resulting in monetary sanctions over $1,000,000. Dodd-Frank also prohibits employers from taking retaliatory action against employees who report potential violations to the SEC and authorizes an employee to bring a private action in federal court alleging retaliation.  If successful, the employee may be entitled to reinstatement, double back pay, litigation costs, expert witness fees, and attorneys’ fees.  See 18 U.S.C. § 1514A.

Dodd-Frank also provides that pre-dispute arbitration clauses are invalid and unenforceable.  See id. at § 1514A(e)(2). This means companies and their executives or employees cannot agree to arbitrate Dodd-Frank whistleblower claims. But does this prohibition apply to employment contracts negotiated and entered into pre-Dodd-Frank?  Based upon a handful of district court rulings, the answer is:  possibly.

Most recently, in Khazin v. TD Ameritrade Holding Corp., Civil Action No. 13-4149 (SDW)(MCA), 2014 U.S. Dist. LEXIS 31142 (D.N.J. Mar. 11, 2014), the court granted the defendants’ motion to compel arbitration on the basis that the arbitration agreement at issue was contained in an employment agreement that pre-dated Dodd Frank. The court reasoned that to disregard a pre-Dodd-Frank arbitration provision “would fundamentally interfere with the parties’ contractual rights and would impair the predictability and stability of their earlier agreement.” The court also emphasized the “strong federal policy in favor of the resolution of disputes through arbitration” and cited a number of other federal courts that have reached a similar result. See Weller v. HSBC Mortg. Servs. Inc., No. 13-00185, 2013 U.S. Dist. LEXIS 130544, 2013 WL 4882758, at *4 (D. Colo. Sept. 11, 2013); Blackwell v. Bank of Am. Corp., No. 11-2475, 2012 U.S. Dist. LEXIS 51991, 2012 WL 1229673, at *4 (D.S.C. Mar. 22, 2012), report and recommendation adopted, No. 11-2475, 2012 U.S. Dist. LEXIS 51447, 2012 WL 1229675 (D.S.C. Apr. 12, 2012); Henderson v. Masco Framing Corp., No. 11-0088, 2011 U.S. Dist. LEXIS 80494, 2011 WL 3022535, at *3 (D. Nev. July 22, 2011); Taylor v. Fannie Mae, 839 F. Supp. 2d 259, 263 (D.D.C. 2012).

Several cases, however, view the prohibition on arbitration clauses from a different prospective and conclude that the prohibition has retroactive effect. See Pezza v. Investors Cap. Corp., 767 F. Supp. 2d 225, 234 (D. Mass. 2011); Wong v. CKX, Inc., 890 F. Supp. 2d 411, 422–23 (S.D.N.Y. 2012). In Pezza, the court followed the U.S. Supreme Court’s decision in Landgraf v. USI Film Products, 511 U.S. 244, 271 (1994), which directs courts to examine whether the statute at issue is one “affecting contractual or property rights” (and thus should not be applied retroactively) or is “conferring or ousting jurisdiction” (and thus may be applied retroactively). The court found that 18 U.S.C. § 1514A(e)(2) is more analogous to the latter because it “takes away no substantive right but simply changes the tribunal that is to hear the case.” The court in Wong found the court’s decision in Pezza persuasive and came to this same conclusion.

Employment agreements and their impact on whistleblowing activity is a hot topic at the SEC as well. Last year, a law firm that represents whistleblowers sent a letter to the Commissioners urging them to take action against what they believe were actions intended to prevent employees from reporting potential corporate violations to the SEC. See Letter to SEC Commissioners (alerting SEC of the use of settlement and severance agreements as a means to prevent reporting and whistleblower claims). Recent comments by Sean McKessy, Chief of the SEC’s Office of the Whistleblower, suggest the Commission may have taken those concerns to heart. Mr. McKessy warned, “[W]e are actively looking for examples of confidentiality agreements, separat[ion] agreements, [and] employment agreements that … in substance say ‘as a prerequisite to get this benefit you agree you’re not going to come to the commission or you’re not going to report anything to a regulator.” See article SEC Warns In-House Attys Against Whistleblower Contracts. Mr. McKessy also said that the SEC not only will penalize companies, but the “lawyers who drafted” such an agreement or language. Id. These comments warn employers and their lawyers to proceed with caution (if at all) when they are thinking about using an employment agreement as a means to curtail or deter Dodd-Frank reporting and claims.