Whistleblowers who exposed what has been called “one of the biggest frauds in Texas history” are not eligible to receive Securities and Exchange Commission (SEC) whistleblower awards based on the collections recovered in a bankruptcy proceeding, according to a recent ruling by the United States Court of Appeals for the Fifth Circuit.

The Fifth Circuit ruling, in Barr v. SEC, highlights an important shortcoming in the SEC Whistleblower Program that can lead to an unfortunate outcome for whistleblowers. Despite the fact that whistleblowers voluntarily provided original information that led to a judgment against an entity for a combined $38.7 million in disgorgement and penalties, the SEC ultimately awarded the whistleblowers only $31,000, because the money to compensate investors was distributed in bankruptcy after the defendant took action to avoid paying the SEC’s judgment.

By limiting awards paid to meritorious whistleblowers solely as a result of the defendant entering voluntary bankruptcy proceedings, the SEC and courts are unnecessarily harming valuable informants and risk deterring would-be whistleblowers.

Case Background

The SEC charged Texas-based financial services firm Life Partners Holdings, Inc. with misleading investorsby failing to disclose that it was “systematically and materially underestimating the life expectancy estimates it used to price transactions.” In 2014, the SEC obtained a judgment against Life Partners for $38.7 million. Whistleblowers John Barr and John McPherson voluntarily provided the SEC with information which, according to the agency, “significantly contributed” to the success of an enforcement action against Life Partners.

Prior to entry of the final judgment, the SEC sought from the court the appointment of a receiver to avoid dissipation of assets. However, in order to avoid the appointment of such a receiver, Life Partners filed a voluntary petition for Chapter 11 bankruptcy before the court ruled on the SEC’s motion.

The district court then denied the SEC’s motion for a receiver, instead suggesting that the commission act through the bankruptcy proceeding. Subsequently, the SEC, in its capacity as an unsecured judgment creditor, filed a motion requesting the appointment of a Chapter 11 trustee, which was granted. In 2016, the trustee proposed a plan of distribution, pursuant to which the SEC agreed to reallocate any distributions with respect to its recovery interest to certain harmed investors.

Meanwhile, after the SEC Office of the Whistleblower (OWB) posted a Notice of Covered Action for the Life Partners action on April 1, 2015, Barr and McPherson timely submitted applications for whistleblower awards for the case. Through the SEC Whistleblower Program, qualified whistleblowers are eligible to receive awards of 10-30% of the funds collected by the government in enforcement actions aided by their disclosure. Following an appeal of an initial denial of Barr, the SEC awarded Barr 5% and McPherson 20% of “the amounts collected or to be collected in connection with” the SEC’s enforcement action.

However, the SEC found that the bankruptcy proceeding constituted neither a covered action nor a related action, as it was initiated by a voluntary petition by Life Partners, rather than an action by the SEC or a qualifying agency under the whistleblower rules. The commission also rejected arguments that the award should be based on the amounts that the SEC might have been entitled to but forfeited by agreeing to the plan of distribution.

Thus, the SEC ruled that Barr and McPherson were not entitled to collect an award based on recoveries distributed to harmed investors through the bankruptcy proceeding. According to reporting by Bloomberg, Barr and McPherson “are left to split $31,000 – money collected before Life Partners went bankrupt.”

Fifth Circuit Opinion

Barr and McPherson appealed the SEC’s award determination to the United States Court of Appeals for the Fifth Circuit. They argued that 1) the bankruptcy case was a “covered action” or “related action” because it was brought by the SEC or the Attorney General (via the Chapter 11 trustee); 2) the SEC’s motion to appoint the Chapter 11 trustee constituted bringing a qualifying action under the Dodd-Frank Act; 3) the SEC’s involvement in the bankruptcy case constituted a covered action because it was a continuation of a “single enforcement strategy” by the commission; and 4) the SEC’s position was contrary to the purpose of the whistleblower statute and would damage the design and efficacy of the program.

The court rejected all of Barr and McPherson’s arguments. With respect to the first three, the court focused on the meaning of the word “action,” finding that the use of that word meant that the plain language of the statute referred to the commencement or institution of legal proceedings, a reading that the court held was “unambiguous.” On that understanding, the court held that since the bankruptcy proceeding was voluntarily entered into by Life Partners, the SEC’s motion for a trustee did not constitute an “action” because it did not commence the proceedings. With respect to the whistleblowers’ fourth argument, the court held that, while the “policy concerns are well-taken,” such concerns were appropriate for Congress to consider, not the courts.

The whistleblowers also raised concerns about the SEC’s decision not to exercise its exemptive authority under Exchange Act Section 36(a) to provide a larger award (i.e., one based on the bankruptcy distribution). The court noted that the commission, in its Order,  appeared to acknowledge its ability to provide such an exemption, but nevertheless declined to do so. The SEC reasoned that the whistleblowers were seeking a waiver of the maximum award of 30% of amounts collected in the SEC “action,” that it had never provided a similar waiver, and that it viewed the 10-30% range as a clear congressional mandate.

Implications

The Fifth Circuit’s ruling in Barr v. SEC highlights a significant potential flaw in the whistleblower rules. If a company voluntarily files for bankruptcy, not an uncommon outcome when facing a large judgment in an SEC enforcement case, the whistleblowers who helped uncover the fraud are at risk of being left with awards far less than the 10-30% promised by the program.

Barr and McPherson helped expose Life Partners’ fraud, which resulted in the distribution of significant compensation to harmed investors through the bankruptcy process. Given that a central goal of the SEC Whistleblower Program is to create and incentive for whistleblowing through the promise of monetary awards, denying whistleblowers a fair award in these circumstances threatens to undermine the effectiveness of the program. A whistleblower with knowledge of a massive fraud whose uncovering could force a company to declare bankruptcy may understandably think twice before taking on the risks of whistleblowing.

An effective bankruptcy proceeding (i.e., one in which harmed investors are compensated), resulting directly from the SEC’s successful enforcement action based on a whistleblower’s tip, is fully consistent with the statutory goals of the whistleblower program. By ignoring the clear causal link between the tip and the investors’ recoveries, the Fifth Circuit ruling and the SEC’s refusal to exercise its exemptive authority together create unnecessary and counterproductive tensions between the interests of whistleblowers and the SEC in these types of bankruptcy proceedings.

If the precedent of the Fifth Circuit ruling stands, the SEC should reconsider its position on exercising exemptive authority in circumstances where a distribution to harmed investors in bankruptcy can be clearly identified as a direct result of the SEC’s action and the whistleblower’s tip. Moreover, Congress should consider reforms to resolve this tension. Since the passage of the Dodd-Frank Act, whistleblowers and the SEC have proven to be great partners in cracking down on fraud and protecting the investing public. The holding in this case threatens to place an unnecessary strain on this partnership.

This post comes to us from Andrew Feller and Geoff Schweller at the law firm of Kohn, Kohn & Colapinto, LLP.