Deterring Corporate Fraud from the Inside: Encouraging Whistleblowing Without Jeopardizing Trade Secrecy

Since 2000, the financial world and global economy have been shaken by two catastrophic and entirely avoidable waves of financial scandals. At the turn of the millennium, accounting fraud at Enron, Worldcom, Tyco, and several other large enterprises rocked financial markets and the U.S. economy. In response, Congress enacted the “Public Company Accounting Reform and Investor Protection Act of 2002,” commonly known as the Sarbanes-Oxley Act (SOX). SOX imposed stronger reporting requirements and stiffer criminal penalties to prevent corporate fraud. SOX also established a whistleblower program to pierce the “corporate code of silence” by encouraging well-placed insiders to assist in unraveling these complex schemes. Time Magazine named “The Whistleblowers,” including Sherron Watkins of Enron and Cynthia Cooper of WorldCom, as “Persons of the Year” for 2002.

Yet just a few years later, a second wave of financial scandals shook the U.S. economy, bringing major financial institutions to the brink of collapse, causing widespread housing foreclosures, and triggering steep drops in stock prices and financial unrest throughout the world. We also learned that Bernard Madoff had perpetrated a massive Ponzi scheme that resulted in losses of approximately $50 billion.1 Like the 2000-01 financial crisis, the second wave was entirely avoidable had regulatory officials known what was going on inside these financial institutions. Congress responded in 2010 by passing the Dodd-Frank “Wall Street Reform and Consumer Protection Act,” which, among other measures, created a bounty for whistleblowers who report violations of the securities, commodities, and futures trading laws.

Such whistleblowing is essential to protecting financial markets and the broader economy. The possibility that corporate insiders could receive a significant financial reward for reporting illegal financial schemes can have an enormous deterrent effect. As the past decade and a half have revealed, the social benefits of avoiding financial scandals, as opposed to cleaning up the mess, are massive.

Yet, substantial impediments still discourage many insiders from coming forward. Employees face tremendous personal, financial, legal, and professional risk by reporting illegal activity within their companies. Whistleblowers jeopardize their career, financial security, emotional stability, health insurance, and social community. Many struggle to find other positions in their field. As the authors of a recent empirical study examining 230 corporate frauds at large U.S. companies note, “[t]he surprising part is not that most employees do not talk; it is that some talk at all.”2

In addition, whistleblowers, and their attorneys, increasingly face the risk that they will be sued for misappropriation of trade secrets. As whistleblower laws have gained traction, a growing number of companies (and enterprising defense counsel) have landed upon the strategy of suing whistleblowers and their attorneys for violation of non-disclosure agreements (NDAs). The same routine agreements that are essential to safeguarding trade secrets are now being used to chill those in the best position to reveal illegal activity.

Unfortunately, U.S. trade secret law lacks an express public policy exception to trade secret liability. Courts have partially addressed this defect by recognizing a limited privilege to disclose trade secrets when doing so would advance a significant public interest. The test for establishing this defense, however, is murky. Whether the defense applies depends on the nature of the information, the purpose of the disclosure, and the means by which the actor acquired the information. Such a case-by-case balancing of potentially subjective factors means that an employee who divulges proprietary information to the government could be sued over their breach of their NDA, even if the information is never divulged to the public and hence the trade secrets remain secure. The prospective whistleblower would likely have to consult an attorney, with the attendant costs and potentially greater exposure. More generally, most prospective whistleblowers are not even aware of the judicially-crafted public policy exception.

Fortunately, there is a straightforward and effective solution to this dilemma that fully comports with the principles upon which trade secret protection is built. Due to mounting threats to trade secrets in the global information age, Congress is actively considering legislation to provide a federal trade secret cause of action.3 The Defend Trade Secrets Act of 2015 attracted broad, bi-partisan support and will likely be taken up again in the new year.

This legislation can be strengthened through the addition of a sealed disclosure/trusted intermediary exception to trade secret protection. The proposed safe harbor would insulate whistleblowers and their counsel from trade secret liability for disclosing trade secret information in confidence to government officials or as part of lawsuit alleging retaliation by an employer. This statutory exception to trade secret liability would provide clear assurance to potential whistleblowers that they do not violate their NDAs merely by consulting legal counsel regarding reporting allegedly illegal conduct to a responsible government official through a confidential channel. In addition, this safe harbor would insulate lawyers advising potential whistleblowers about their options and serving as conduits for presenting evidence of allegedly illegal conduct to the government.

This approach fully preserves the protection of legitimate commercial trade secrets while reducing the sizeable impediments to whistleblowing. The federal government holds all officers and employees strictly accountable for disclosing trade secrets to the public without authorization. Furthermore, attorneys have responsibility to protect the confidences of their clients and regularly deal with a broad range of proprietary, confidential, and sensitive material. Thus, the sealed disclosure/trusted intermediary mechanism, which has long been used in government and judicial institutions to protect confidential information, is appropriately tailored to protect legitimate corporate secrets while providing a channel for deterring and ferreting out illegal activity.

The safe harbor can be further enhanced by requiring that NDAs prominently include notice of the law reporting safe harbor to ensure that those with knowledge of illegal conduct are aware of this important public policy limitation on NDAs and exercise due care with trade secrets in reporting such activity. The SEC has taken a strong stance against the use of confidentiality agreements to prevent whistleblowers from reporting to the government. SEC Rule 21F-17 prohibits employers from taking measures through confidentiality, employment, severance, or other types of agreements that may silence potential whistleblowers before they can reach out to the SEC.

Congress can foster the important policies reflected in SOX and Dodd-Frank, and more generally promote reporting illegal corporate activity, by adding a public policy safe harbor and notice provision to the proposed Defend Trade Secret Act. By so doing, Congress would align trade secret law with the larger public interest and create powerful incentives for whistleblowers to report allegedly illegal activity in a secure and timely manner. This will foster robust and legitimate competition and innovation while deterring and driving out illegal practices.

ENDNOTES

[1] Harry Markopolos, an independent forensic accounting and financial fraud investigator, brought Madoff’s suspicious profitability to the SEC’s attention, but the SEC declined to take action. Had an insider brought concrete evidence to the SEC, the likelihood that this Ponzi scheme could have been halted earlier would have been far greater.

[2] Alexander Dyck, Adair Morse & Luigi Zingales, Who Blows the Whistle on Corporate Fraud?, 65 J. Fin. 2213, 2245 (2010).

[3] With the exception of the Economic Espionage Act, which authorizes federal criminal prosecution of trade secret violations, trade secrets are protected under state laws.

The preceding post comes to us from Professor Peter S. Menell, Koret Professor of Law and Director, Berkeley Center for Law & Technology, at the University of California at Berkeley School of Law. It is based on his recent article entitled “Tailoring a Public Policy Exception to Trade Secret Protection,” available here.