Kohn, Kohn & Colapinto Discusses Changes to SEC Whistleblower Rules

On September 23, 2020, the U.S. Securities and Exchange Commission approved changes to its highly successful Dodd-Frank Act whistleblower program in a 3-2 vote [1]. The program has resulted in over $2.5 billion in penalties against public companies, $750 million returned to investors, and $500 million paid in rewards.  Paying corporate whistleblowers mandatory monetary rewards of between 10-30 percent of all penalties obtained from commission enforcement proceedings triggered by their allegations has been a highly controversial law from the start.  These controversies all played out during the commission’s prolonged whistleblower rulemaking proceeding.

The whistleblower advocacy community strongly opposed the major changes proposed by the three Republican members of the SEC in a June 2018 rulemaking proposal.  The U.S. Chamber of Commerce was supportive of the commission’s proposals, which centered on approving a mechanism to lower the amount of rewards in large cases and creating additional administrative barriers to qualifying for rewards.  After two years and three months of deliberations, and two cancelled public meetings, the commission finally held its vote.

The results were a surprise.

Perhaps the most significant outcome was that every commissioner, regardless of political party, praised the Dodd-Frank Act’s SEC whistleblower law.  They pointed to the importance of paying rewards to whistleblowers and the invaluable contributions whistleblowers make to protecting investors (see statements from commissions) [2].  The unanimity of support for the basic principles underlying the whistleblower law sends a powerful message to Wall Street.  After watching how the law works over 10 years, critics could no longer justify their initial arguments against.

Whistleblowers also scored other significant victories, especially when the SEC backed down from two proposals that would have devastated its whistleblower reward program.  The commission did not approve proposals that would have triggered an automatic reduction in the amount awarded in large enforcement actions.  However, the dissents of commissioners Lee and Crenshaw demonstrate that significant issues remain that could affect the program’s integrity and the commission’s ability to properly reward whistleblowers [3]. Here is a breakdown of the commission’s most significant decisions:

No Power to Reduce Large Rewards Based on Size

Proposed Rule 21F-6(d) was initially introduced in 2018 as a mechanism that would allow the commission to automatically reduce rewards over $30 million. This discretion would not be subject to meaningful review and would be based solely on the size of the reward. Whistleblower advocates forcefully argued against this proposed amendment, and Kohn, Kohn and Colapinto mentioned the issue in several comment letters – including one that extensively discussed issues with any “cap” on rewards and how such a rule would dilute the deterrent effect of rewards [4].

The commission’s complete rejection of the proposed automatic reduction rule was a significant recognition of the importance of paying large rewards. Such rewards play a vital public role as incentives for whistleblowers to step forward and deterrents to future misconduct by the regulated community. And, as Kohn, Kohn and Colapinto argued, lowering rewards simply on the basis of size is inconsistent with the plain meaning of the statute. These arguments were successful, and the commission demonstrated that reward amounts will continue to be assessed consistent with and unmodified from the criteria of the Dodd-Frank Act.

During the commission’s discussion of this rule, there was a difference of opinion as to whether the commission could make reductions based on the size of the reward.  In a discussion between commissioner Lee and the SEC Office of General Counsel, it became clear that the SEC general counsel believed that claims decisions could vary based on the dollar amount of a reward even when all other factors were identical. However, Kohn, Kohn and Colapinto believed that no such variation, or size-based reduction, would be permitted because the Securities and Exchange Act, 15 USC § 78u-6(c), does not permit any adjustment of a reward based on size [5].

However, the law does mention “such additional relevant factors as the commission may establish by rule or regulation.”  The commission could have attempted to follow through on their original proposal, but they did not.  Without a rule change, the commission cannot use any criteria outside of what is specifically set out in the law and the current regulations. Under the current regulations, §240.21F-6(b), factors that may be considered to increase or decrease the amount of a whistleblower reward do not include the size of the reward [6]. Therefore, such a criterion cannot be lawfully applied.  When the commission withdrew its proposal to grant itself the authority to reduce large awards on the basis of their size, it passed on adding this criterion to the list of options they can apply when setting award amounts.  Based on the clear language of the Dodd-Frank Act, without an explicit rule providing for such adjustments, the initial proposal to reduce rewards solely based on their size is dead.

Presumptive Maximum for Rewards Arising from Penalties of Up to $5 Million

Rule 21F-6(c) initially proposed the power to increase rewards in instances where the whistleblower would be entitled to a less than $2 million. This rule was warmly welcomed and received little commentary. Because of this, the whistleblower community did not expect any radical developments in terms of small rewards. The commission delivered a welcome surprise when it announced in its final rules that not only would it have power to upwardly adjust rewards under $2 million, but that it would set a presumptive maximum reward when the sanction was up to $5 million, and there were no negative factors at play. This hugely positive development is a victory for whistleblowers and should give many of them an incentive to come forward and fully cooperate with SEC investigations. Moreover, the commission correctly explained that another major benefit of this amendment is that the automatic assessment of a maximum reward in this manner would save time and eliminate delays. This news is encouraging because delay in the assessment of awards has been a source of widespread criticism.

The TCR Requirement Will Not Bar Rewards for Meritorious Whistleblowers

Rule 21F-9(e) was initially proposed as a highly restrictive rule that would require whistleblowers to first file a TCR to be eligible for a reward, prior to any other contact with the commission. Thus, for example, whistleblowers who wrote letters to the chairman, filed investor complaints, or spoke to the SEC enforcement team could have been automatically disqualified from the mandatory reward because they failed to initially file a TCR as their first method of communication with the commission. Whistleblower advocates fiercely resisted this proposed amendment because it restricted the commission’s ability to recognize whistleblower contributions and deprived the commission of appropriate discretion to assess a whistleblower reward based on merit. The proposed rule also limited the commission’s discretion to waive filing requirements, binding the commission to enforce the restrictive rule.

The rule adopted on September 23 reflects that the commission took criticism of this rule seriously. Rather than create unreasonable restrictions, the adopted rule allows the commission to make reward determinations in favor of whistleblowers who have not “first” filed TCRs when the record shows they are otherwise qualified for a reward. The rule clarifies a process for filing that encourages whistleblowers to file a TCR and grants a 30-day grace period to file a TCR as soon as a whistleblower has “actual or constructive knowledge” of the TCR filing requirement.

Although the commission does not specify how it will define actual or constructive knowledge generally, it is important to note that the commission specifically explained that “obtaining counsel in connection with a submission” would constitute constructive knowledge. This element is important for attorneys to note, because it means that the 30-day grace period begins to toll when a client retains their services for the purpose of filing a whistleblower submission.

New Standard for Related Actions Rewards

Rule 21F-3(b)(4) was adopted without modification or improvement. This was a major loss for whistleblowers and rewrites the related-action requirement by granting the SEC authority not to pay a related action reward when it deems that the action is more “relevant” to another agency’s reward program.

The original related action requirement gave whistleblowers and incentive to work with corresponding federal and state law enforcement agencies. It simply holds that if a whistleblower’s original information is used by one of these other agencies, the whistleblower can also obtain a reward of 10-30 percent. This recognized the fact that many securities investigations also implicate violations that other agencies have an interest in policing. The original related action provision was one of the most important parts of the Dodd-Frank Act because it encouraged whistleblowers to fully cooperate with all enforcement actions. The new rule radically undermines the strength of that original provision.

The commission’s new rule permits the SEC to deny related action rewards when the commission determines that another agency has a reward program. The problem with this proposal is two-fold: First, it violates the clear statutory requirements of the DFA; second, there are numerous older reward laws that have extremely low caps or are completely discretionary. Should the commission enforce this rule as currently understood, a whistleblower who assisted in a significant enforcement action may be rewarded minimally for his or her efforts because the SEC deems another reward program more “relevant” to the sanction. This is problematic because some programs have very low mandatory payouts for whistleblowers regardless of the size of the sanction. Thus, the new rule discourages whistleblowers from cooperating with other law enforcement agencies.

The concept of choosing between a related action reward and an SEC reward was explicitly rejected by Kohn, Kohn and Colapinto, which argued that the Dodd-Frank Act mandates the payment of related-action rewards [7]. Unfortunately, the commission declined to recognize the statutory requirement that the agency “shall” pay 10-30 percent to whistleblowers when they assist in successful enforcement actions by other agencies. Even worse, the commission adopted a subjective standard for assessing whether a related action would be paid by the SEC, which promises to give rise to future conflict and confusion.

Refusal to Protect Internal Whistleblowers

Rule 21F-2(d)(4) was not modified and was adopted as proposed. This rule addressed questions about how the commission would respond to the Supreme Court decision in Digital Realty v. Somers, which effectively excluded internal whistleblowers from DFA anti-retaliation protections [8]. The proposed version of this rule codified this exclusion. During the rulemaking process, many argued that in doing so, the commission would be undermining efforts to support internal compliance programs.

The commission received a number of comments arguing that internal whistleblowers should not be rejected simply because they did not communicate with the SEC before raising concerns internally. In their September 23 rulemaking, the commission effectively turned its back on internal whistleblowers by adopting a rule that codified Digital. This move is a significant strike against the success of internal compliance programs. As a result, internal whistleblowers would be wise to communicate with the SEC before making internal disclosures – depriving internal compliance officials an opportunity to cure violations before facing sanction or government investigation.

Kohn, Kohn and Colapinto commented on this rule, proposing alternative approaches that included the incorporation of SOX protections [9]. These recommendations were rejected. Significantly the U.S. Chamber of Commerce supported the commission’s proposal to deny internal whistleblowers any protections whatsoever. Oddly, the chamber endorsed the commission’s proposal to strip internal whistleblowers of any protections under the DFA.

Confusing Guidance on Analyst Contributions

As part of the rules, the commission issued “guidance” on how to interpret the analyst provisions of the DFA.  This provision of law is unique to the DFA and permits Wall Street analysts to qualify as whistleblowers, even if they do not have unique “insider” information.  The guidance recommends that analyst whistleblowers who derive insights from publicly available information be severely limited in their ability to qualify under the rule. This guidance was widely criticized because of its subjective and confusing elements, which would allow the commission to deny a whistleblower a reward if it could assert that there was any likelihood that the commission would have arrived at the same conclusion without the analyst’s assistance. The commission did not revise this guidance upon the adoption of the final rule.

While many may view the commission’s refusal to revise this guidance as a defeat, the important thing to note is that the instruction is only interpretive guidance and was not codified as a rule. Therefore, the commission’s application of the rules governing independent analysis is not strictly controlled by this guidance, and any rulings that conflict with the clear definition of “analyst” that exists in the statute or the current rules (which were good) can be applied by commissioners or the courts to ensure that analysts are properly covered. The explicit wording of the statute and the rules which were not amended will ultimately determine reward eligibility for analysts.

Conclusion

The September 23 decision yielded a number of positive outcomes.  Many problematic provisions were abandoned or significantly modified. However, the few disappointing outcomes discussed above make clear that work still needs to be done to ensure that whistleblowers are fully protected and the intent of Congress is achieved.  Additionally, by adopting rules contrary to the statutory intent and plain language of the Dodd-Frank Act, the commission has opened itself to litigation based on its change to the related action rule and the guidance provided concerning analysts.

ENDNOTES

[1] Securities and Exchange Commission, Release No. 34-89963; File No. S7-16-18, September 23, 2020, available at https://kkc.com/wp-content/uploads/2020/09/34-89963.pdf.

[2] See Strengthening our Whistleblower Program, Chairman Jay Clayton, September 23, 2020, stating “Over the past ten years, the whistleblower program has been a critical component of the commission’s efforts to detect wrongdoing and protect investors and the marketplace, particularly where fraud is well-hidden or difficult to detect.” Available at https://www.sec.gov/news/public-statement/clayton-whistleblower-2020-09-23; Statement on the commission’s New and Improved Whistleblower Program Rules, Commissioner Elad L. Roisman, September 23, 2020, stating “Needless to say, contributions from whistleblowers have leveraged the efforts of our Enforcement division and other agencies, enabling us to protect investors ever more effectively.  To call this program a success is an understatement.” Available at https://www.sec.gov/news/public-statement/roisman-whistleblower-2020-09-23; Statement of Commissioner Caroline Crenshaw on Whistleblower Program Rule Amendments, Commissioner Caroline A. Crenshaw, September 23, 2020, stating “I am proud of the Commission’s whistleblower program. In 10 years, we have received more than 1,500 submissions, resulting in more than $2.6 billion in financial remedies. . . whistleblowers are of tremendous value to the agency. They are a critical part of our enforcement program and allow us to cover more ground in our efforts to protect investors.” Available at https://www.sec.gov/news/public-statement/crenshaw-whistleblower-2020-09-23 ; and Amendments to the commission’s Whistleblower Program Rules, Commissioner Hester M. Peirce, September 23, 2020, stating “The whistleblower program has, in its decade of existence, become an integral part of our enforcement program.” Available at https://www.sec.gov/news/public-statement/peirce-whistleblower-2020-09-23.

[3] Commissioner Caroline Crenshaw on Whistleblower Program Rule Amendments, Commissioner Caroline A. Crenshaw, September 23, 2020, available at https://www.sec.gov/news/public-statement/crenshaw-whistleblower-2020-09-23.

[4] Kohn, Kohn and Colapinto’s, Tenth Supplemental Comment, January 16, 2020, available at https://kkc.com/wp-content/uploads/2020/08/KKC-TENTH-SUPPLEMENTAL-DETERRENCE.pdf

[5] 15 USC § 78u-6(c), available at https://kkc.com/wp-content/uploads/2020/03/15-USC-§-78u-6h.pdf.

[6] §240.21F-6(b), available at https://kkc.com/wp-content/uploads/2020/03/17-C.F.R.-§-240.21F-1-17.pdf.

[7] See Kohn, Kohn and Colapinto’s Eleventh Supplemental Comment, September 10, 2020, available at https://kkc.com/wp-content/uploads/2020/09/KKC-ELEVENTH-SUPPLEMENTAL.pdf.

[8] Digital Realty Trust, Inc. v. Somers, 583 US _ (2018), available at https://kkc.com/wp-content/uploads/2020/03/Digital-realty-v-somers.pdf

[9] Kohn, Kohn and Colapinto’s Ninth Supplemental Comment, January 8, 2020, available at https://kkc.com/wp-content/uploads/2020/01/KKC-Ninth-Supplemental-Internal-Whistleblowers.pdf.

This post comes to us from Kohn, Kohn & Colapinto LLP. It is based on the firm’s memorandum, “SEC Dodd-Frank Act Whistleblower Reward Regulations Analysis [September 2020],” available here.

Leave a Reply

Your email address will not be published. Required fields are marked *