Author: William L. Carr

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 Announces Highest Whistleblower Award to Date

The SEC recently announced a record-breaking whistleblower award of $30-35 million, which shattered the previous high award of $14 million. See SEC Awards More Than $14 Million to Whistleblower. Not only is this award noteworthy for its size, but also because it was made to a foreign resident and it could have been even higher if the whistleblower did not unreasonably delay in reporting the violations.

This was not the first award made to foreign residents, but it was the first award made to a foreign resident since the Court of Appeals for the Second Circuit found that the anti-retaliation protections of Section 21F(h) of the Dodd-Frank Act do not apply to foreign whistleblowers who experience retaliation overseas from foreign employers. Liu v. Siemens, __ F.3d __, 2014 WL 3953672 (2d Cir. Aug. 14, 2014); see also Made for the U.S.A. Only: Second Circuit Holds That the Dodd-Frank Act’s Antiretaliation Provision Applies Only Domestically. In making this award, the SEC reiterated that any extraterritorial aspects of tips, such as a whistleblower’s foreign residency or alleged misconduct that occurs abroad, do not matter when there is a “sufficient U.S. territorial nexus”—i.e., “whenever a claimant’s information leads to a successful enforcement of a covered action brought in the United States, concerning violations of the U.S. securities laws, by the Commission, the U.S. regulatory agency with enforcement authority for such violations.” Order Determining Whistleblower Award Claim, Whistleblower Award Proceeding, File No. 2014-10 (Sept. 22, 2014). It found that the Second Court’s holding in Liu v. Siemens, __ F.3d __, 2014 WL 3953672 (2d Cir. Aug. 14, 2014), was not controlling and that “the whistleblower award provisions have a different Congressional focus than the anti-retaliation provisions, which are generally focused on preventing retaliatory employment actions and protecting the employment relationship.”

In announcing the award Sean McKessy, Chief of the Office of the Whistleblower, underscored the extraterritorial reach of the program: “This award of more than $30 million shows the international breadth of our whistleblower program as we effectively utilize valuable tips from anyone, anywhere to bring wrongdoers to justice. Whistleblowers from all over the world should feel similarly incentivized to come forward with credible information about potential violations of the U.S. securities laws.” See SEC Press Release: “SEC Announces Largest-Ever Whistleblower Award.”

Further, this already staggering award amount had the potential to be even higher if the whistleblower did not unreasonably delay in reporting to the SEC. The whistleblower delayed for an undisclosed period of time after first learning of the violations, which the SEC said caused investors to suffer significant losses that might have been avoided. The SEC found that the whistlblower’s delay was unreasonable under the circumstances and reduced the award from the maximum percentage allowed under the statute. It rejected the whistleblower’s argument that the percentage awarded was below the average percentage awarded to other whistleblowers as irrelevant. The SEC, however, did not apply the unreasonable delay consideration as severely as it otherwise might have done because a period of the delay occurred before the implementation of the whistleblower program established by the Dodd-Frank Act.

This latest award shows the SEC’s willingness to make awards to whistleblowers across the globe.

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.

Made for the U.S.A Only: Second Circuit Holds That the Dodd-Frank Act’s Antiretaliation Provision Applies Only Domestically

According to the SEC, in fiscal year 2013, foreign whistleblowers accounted for 404 of the 3,238 whistleblower reports received by the SEC (nearly 12%). Recently, the Second Circuit Court of Appeals may have significantly undermined incentives for foreign tipsters to report potential violations to the SEC.

On August 14, 2014, the Second Circuit held that the Dodd-Frank Act’s whistleblower antiretaliation provision (15 U.S.C. § 78u-6(h)(1)) does not apply “extraterritorially” and thus did not cover a foreign tipster’s allegation that he had been terminated for reporting potential Foreign Corrupt Practices Act (FCPA) violations to his employer. Liu v. Siemens AG, Docket No. 13-cv-4385 (2d Cir. Aug. 14, 2014). The antiretaliation provision of the Dodd-Frank Act, which gives employees easy access to U.S. district courts, prohibits employers from retaliating against whistleblowers employees who make certain protected disclosures. The provision incentivizes reporting and facilitates the SEC’s enforcement of securities law violations.

The plaintiff Liu, a citizen and resident of Taiwan, alleged that he was fired from a Siemens Chinese subsidiary after he reported potential FCPA violations and other misconduct to his superiors. None of the alleged events related to Liu’s firing occurred in the United States. Nevertheless, Liu filed suit in the United States District Court of the Southern District of New York claiming that Siemens had violated the antiretaliation provision of the Dodd-Frank Act.

The Second Circuit affirmed the District Court’s order dismissing the complaint with prejudice and held that the Dodd-Frank Act’s whistleblower antiretaliation provision does not apply “extraterritorially.” The Second Circuit reasoned that the Dodd-Frank Act, like any statute, is presumed, in the “absence of clear congressional intent to the contrary, to apply only domestically.” Id., slip op. at 2. And the Second Circuit found “absolutely nothing in the text of the [antiretaliation] provision … or in the legislative history of the Dodd-Frank Act, that suggests that Congress intended the antiretaliation provision to regulate relationships between foreign employers and their foreign employees working outside the United States.” Id. at 12.

Because the antiretaliation provision did not extent extraterritorially, the court found that it did not cover Liu’s allegations since all events related to his termination¾the alleged misconduct, Liu’s discovery of the misconduct, and Liu’s termination¾occurred outside the United States. As such, the District Court correctly dismissed Liu’s complaint. The Second Circuit’s decision will likely impact the willingness of potential whistleblowers outside the United States to report misconduct to the SEC. Moreover, the lack of protection afforded to foreign-based whistleblower may adversely effect on the SEC’s FCPA investigations which usually involve misconduct that occurs outside of the United States. There is nothing in the Second Circuit’s decision, however, to indicate that foreign-based whistleblowers are prohibited from receiving payment under the Dodd-Frank bounty program.

While the ruling clarifies the Dodd-Frank Act’s geographical reach, it did not resolve another outstanding issue, namely whether or not Dodd-Frank applies to reports made internally, as opposed to reports made directly to the SEC.

Quarterly Whistleblower Award Update

Since our last quarterly update, the SEC’s Office of the Whistleblower (“OWB”) has issued four denial orders and three award orders. Here are some lessons learned from this activity:

• The SEC Will Not Award Whistleblowers Who Provide Frivolous Information. The SEC determined that a claimant (who submitted “tips” relating to almost every single Notice of Covered Action”) was ineligible for awards because he/she “has knowingly and willfully made false, fictitious, or fraudulent statements and representations to the Commission over a course of years and continues to do so.” Under Rule 21F-8, persons are not eligible for an award if they “knowingly and willfully make any false, fictitious, or fraudulent statement or representation, or use any false writing or document knowing that it contains any false, fictitious, or fraudulent statement or entry with intent to mislead or otherwise hinder the Commission or another authority.” 17 C.F.R. § 240.21F-8(c)(7). The OWB found that a number of passages submitted by the claimant were patently false or fictitious and that the person had the requisite intent because of the (1) incredible nature of the statements, (2) continued submissions that lack any factual nexus to the overall actions, and (3) refusal to withdraw unsupported claims at the request of the OWB. (May 12, 2104.)

• The SEC Will Enforce the Time Frames Set Forth in the Statue. The OWB denied two awards because the claimants did not submit an award claim within the 90-day period established by Rule 21F-10(b). The claimants argued that OWB should waive the 90-day period due to extraordinary circumstances. See 17 C.F.R. § 240.21F-8(a). The OWB determined that neither a lack of awareness that the information that the whistleblower had shared would lead to a successful enforcement action nor the lack of awareness that the Commission posted Notices of Covered Actions on its website constitutes an extraordinary circumstance to waive the timing requirement. See SEC Release No. 72178 (May 16, 2014) and SEC Release No. 72659 (July 23, 2014).

• Whistleblowers are Not Eligible for an Award Unless the Information Leads to a Successful Enforcement Action. The OWB denied an award to a claimant because the provided information did not lead to a “successful enforcement by the Commission of a federal court or administrative action, as required by Rules 21F-3(a)(3) and 21F-4(c) of the Exchange Act.” OWB also noted that the claimant did not submit information in the form and manner required by Rules 21F-2(a)(2), 21F-8(a), and 21F-9(a) & (b) of the Exchange Act. See In the Matter of Harbinger Capital Partners, LLC, File No. 3-14928 (July 4, 2014).

• The OWB Can Be Persuaded to Change Its Preliminary Determination. Although the OWB initially denied the whistleblower’s award claim on the basis that the information did not appear to have been voluntarily submitted within Rule 21F-4(a)(ii) because it was submitted in response to a prior inquiry conducted bya self-regulatory organization (“SRO”). In a Final Determination issued on July 31, 2014, however, the OWB determined that claimant was entitled to more than $400,000. OWB noted that a submission is voluntary if it is provided before a request, inquiry, or demand for information by the SEC in connection with an investigation by the Public Company Accounting Oversight Board, any self-regulatory organization, Congress, the federal government, or any state Attorney General.

On the basis of the unique circumstances of this case, the OWB decided to waive the voluntary requirement of Rule 21F-4(a) for this claimant. The SEC noted that the claimant “worked aggressively … to bring the securities law violations to the attention of appropriate personnel,” the SRO inquiry originated from information that in part described claimant’s role, claimant believed that the company had provided the SRO with all the materials that claimant developed during his/her own internal efforts, and claimant promptly reporting to the SEC that the company’s internal efforts as a result of the SRO inquiry would not protect investors from future harm. Sean McKessy, chief of the SEC’s Office of the Whistleblower, remarked that “[t]he whistleblower did everything feasible to correct the issue internally. When it became apparent that the company would not address the issue, the whistleblower came to the SEC in a final effort to correct the fraud and prevent investors from being harmed. This award recognizes the significance of the information that the whistleblower provided us and the balanced efforts made by the whistleblower to protect investors and report the violation internally.” See SEC Release No. 72727 (July 31, 2014); SEC Press Release, “SEC Announces Award for Whistleblower Who Reported Fraud to SEC After Company Failed to Address Issue Internally,” (July 31, 2014).

• SEC Continues to Make Awards to Qualified Claimants. On June 3, 2014, the SEC awarded two claimants 15% each for a total of 30% percent of the monetary sanctions collected in the covered action. See SEC Release No. 72301 (June 3, 2014). On July 22, 2014, the SEC awarded three claimants 15%, 10%, and 5% respectively (for a total of 30%) of the monetary sanctions collected in the Covered Action. See SEC Release No. 72652 (July 22, 2014).

Profits Do Not Always Equal Disgorgement

Judge Scheindlin of the Southern District of New York recently rejected the SEC’s attempt to seek disgorgement of almost $500,000,000 from Samuel Wyly and Donald R. Miller Jr., the Independent Executor of the Will and Estate of Charles J. Wyly Jr. (collectively, “defendants”). According to the SEC, this amount represented the total profit that the defendants gained from their illegal conduct, which included securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Section 17(a) of the Securities Act of 1933 and failure to make certain disclosures in violation of Sections 13(d), 14(a), and 16(a) of the Securities Exchange Act of 1934.

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Director of SEC’s Division of Investment Management Provides Insights into Agency’s View of Alternative Mutual Funds and Focus of Upcoming Sweep Exam

On June 30, 2014, in remarks to the Practising Law Institute’s Private Equity Forum, Norm Champ, Director of the SEC’s Division of Investment Management, addressed the increase in the number of mutual funds that use alternative investment strategies and the potential risks that the Division of Investment Management has identified with those strategies. See SEC Press Release. Champ’s observations are particularly relevant in light of the Office of Compliance Inspections and Examination’s (“OCIE’s”) announcement that it will conduct a national sweep exam involving between fifteen and twenty alternative mutual funds beginning this summer and continuing into the fall. According to Champ, the exams are intended to produce valuable insight into how alternative mutual funds attempt to generate yield and how much risk they undertake, in addition to monitoring how boards are overseeing the funds’ operations. To that end, Champ said that the exams will focus on liquidity, leverage, and board oversight.

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SEC Resolves First Case Under New Municipalities Continuing Disclosure Cooperation Initiative

On July 8, 2014, the SEC announced that it had settled charges that a school district in California misled bond investors about its failure to comply with its continuing disclosure obligations under Rule 15c2-12 of the Exchange Act. Pursuant to the Municipalities Continuing Disclosure Cooperation (“MCDC”) Initiative, Kings Canyon Joint Unified School District, without admitting or denying the SEC’s findings, agreed to entry of an Order (1) finding that it was in violation of Section 17(a)(2) of the Securities Act, (2) requiring it to cease and desist from violating Section 17(a)(2), (3) requiring it to establish written policies and procedures and to conduct periodic training regarding continuing disclosure obligations, and (4) requiring it to cooperate with the Enforcement Division in any subsequent investigation and to disclose the settlement in future bond offering materials. The SEC did not order any disgorgement or civil penalty.

Rule 15c2-12 requires that an underwriter obtain a written agreement from an issuer, for the benefit of bondholders, in which the issuer promises to submit certain financial information on an annual basis. This financial information is usually submitted to appropriate national and state repositories where it is available to the investing public. Notably, a broker-dealer must consider an issuer’s failure to disclose such financial information in determining whether to recommend a security and must disclose the failure to provide such financial information to customers. Rule 15c2-12 undertakings must be described in final Official Statements.

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