CLIENT NEWSFLASH

SEC Adopts Final Whistleblower Rules

May 25, 2011

Earlier today, in a divided 3-2 vote, the SEC adopted final rules to implement the whistleblower provisions of the Dodd-Frank Act.  Overall, the final rules appear more permissive and deferential to potential whistleblowers than the proposed rules even though they do provide additional incentives for whistleblowers to utilize corporate compliance systems.  As expected, the final rules, like the proposed rules, do not require employees to first report allegations of wrongdoing through a company's corporate compliance system, despite numerous comments by members of the corporate community urging them to do so.

A summary of the key provisions in the final rules is below.  We expect to host a webcast within the next few weeks to discuss the impact of the rules in more detail.

Dodd-Frank Whistleblower Provisions

Dodd-Frank provides that any eligible whistleblower who voluntarily provides the SEC with original information that leads to the successful enforcement of an action brought by the SEC under the securities laws must receive an award of between 10 and 30 percent of the total monetary sanctions collected if the sanctions exceed $1,000,000.  The provisions also prohibit retaliation against the whistleblower.

The final rules adopted today would generally define a whistleblower for this purpose as someone who provides information about a possible violation of the securities laws that he or she reasonably believes has occurred, is ongoing, or is about to occur.  The SEC states in the adopting release that this would not require that the possible violation be material, probable or even likely, but it would require that the information have a "facially plausible relationship to some securities law violation─frivolous submissions would not qualify for whistleblower status."

Use of Internal Compliance Programs Encouraged but Not Required

A widely expressed fear about the Dodd-Frank whistleblower provisions has been that they create incentives for employees to bypass internal corporate compliance systems in order to be first in line to collect the statutory windfall.  While the final rules do not require whistleblowers to report misconduct internally first in order to be eligible for a whistleblower award, they do expand upon provisions that seek to incentivize whistleblowers to utilize internal corporate compliance systems before reporting their claims to the SEC.  For example, the rules:

  • give employees who first report information internally the benefit of the internal reporting date for purposes of the SEC program so long as the whistleblower submits the same information to the SEC within 120 days of the initial disclosure.  This is a change from the proposal, which would have only given the whistleblower 90 days to report the complaint to the SEC.
  • make it clear that the SEC will consider, as part of the criteria for determining the amount of a whistleblower's award, whether the whistleblower effectively utilized a company's corporate compliance program or hindered the function of the program.  The utility of this provision will depend upon the relative importance the SEC staff places on the whistleblower's use or impediment of a corporate compliance program when determining the amount of potential whistleblower awards.  It will be essential for the SEC staff to give significant weight to the use or misuse of corporate compliance programs when making whistleblower awards in order to make it clear from the outset that the staff strongly supports the use of these programs;
  • would give credit to a whistleblower who reports internally first and whose company passes the information along to the SEC.  Under this provision, all the information provided by the entity to the SEC would be attributed to the whistleblower, which means the whistleblower could get credit, and potentially a higher award, for information gathered in an internal investigation initiated as a result of the whistleblower's internal report.  Chairman Schapiro suggested at the open meeting that this could create an opportunity for a whistleblower to obtain an award through internal reporting where the whistleblower might not otherwise have qualified for an award because his or her information was not sufficiently specific and credible.

Disqualification of Legal and Compliance Personnel Narrowed

Another concern about the Dodd-Frank whistleblower provisions has been the incentive for officers, directors and those with legal, audit, compliance or similar responsibilities to abuse these positions by making whistleblower complaints to the SEC with respect to information they obtain in these roles.  The final rules generally provide that information obtained through a communication subject to attorney-client privilege or as a result of legal representation would not be eligible for a whistleblower award unless disclosure would be permitted by attorney conduct rules.  Officers and directors, auditors and compliance personnel and other persons in similar roles would not be eligible to receive awards for information received in these positions unless:

  • they have a reasonable basis to believe that:

    • disclosure of the information is necessary to prevent the entity from engaging in conduct that is likely to cause substantial injury to the financial interests of the entity or investors; or
    • the entity is engaging in conduct that will impede an investigation of the misconduct, for example, destroying documents or improperly influencing witnesses; or
  • 120 days has passed since the whistleblower provided the information to senior responsible persons at the entity or to his or her supervisor or 120 days has passed since the whistleblower received the information at a time when these people were already aware of the information.

This is a different standard than was contained in the proposed rules, which would have only allowed persons in these roles to qualify as whistleblowers if the entity did not disclose the alleged misconduct within a reasonable amount of time or proceeded in bad faith. According to Chairman Schapiro, this change was made to address concerns that the proposed rules "sought to exclude too many important, potential whistleblowers."

As was proposed, employees of law enforcement and certain regulatory agencies and members of foreign governments would also not be eligible for whistleblower awards.

Restrictions on Awards for Wrongdoers

Like the proposed rules, the final rules limit payment of awards to whistleblowers who have been required to pay monetary sanctions (such as in an SEC enforcement proceeding) or who directed, planned or initiated conduct that has led to entities being required to pay such sanctions, but do not expand the restrictions on awards to culpable parties as commenters had urged.  The rules also contemplate that the whistleblower's culpability would be considered in determining the amount of award.

Effective Date

The SEC's final rules adopted today will become effective 60 days from their publication in the Federal Register, which should occur shortly.  The Dodd-Frank whistleblower provisions became effective upon adoption in July 2010 so potential whistleblowers are already entitled to the general rights provided by these provisions.

Potential Impact of Whistleblower Program

In response to questioning at the open meeting, SEC Director of Enforcement, Robert Khuzami, indicated that, to date, the staff has seen an uptick of complaints under the whistleblower program but has not received the "flood" of frivolous or non-securities law related complaints that some had predicted.  Even so, it is clear that the rules adopted today present significant challenges for corporate compliance efforts.  The full practical impact of these rules and the degree to which they will undercut corporate compliance programs and provide perverse monetary incentives for those with compliance, legal or accounting responsibilities will, however, be highly dependent upon the staff's interpretation and administration of the rules.  We remain hopeful that the staff will administer the rules in a manner that promotes and supports corporate compliance efforts, professional responsibility and attorney-client privilege to the highest degree.

 

If you have questions regarding this newsflash, please contact any of the lawyers listed below or your regular Davis Polk contact.

Ning Chiu212 450 4908ning.chiu@davispolk.com
Joseph A. Hall 212 450 4565 joseph.hall@davispolk.com
Michael Kaplan212 450 4111michael.kaplan@davispolk.com
William M. Kelly650 752 2003william.kelly@davispolk.com
Richard J. Sandler212 450 4224richard.sandler@davispolk.com
Linda Chatman Thomsen202 962 7125linda.thomsen@davispolk.com
Janice Brunner212 450 4211janice.brunner@davispolk.com

 

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