I. The Dodd-Frank Wall Street Reform and Consumer Protection Act

In the wake of the financial crisis resulting from the global economic events of 2007 and 2008, Congress enacted financial reform legislation to reorganize financial regulators and to reform the regulation of financial markets and financial institutions. Enacted on July 21, 2010 and recently effective on August 12, 2011, the sweeping reforms, known as the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), established a whistleblower program that requires the US Securities and Exchange Commission ("SEC" or "Commission") to pay an award to eligible whistleblowers who voluntarily provide the SEC, either directly or through an entity's internal compliance program, with "original information" about a violation of the federal securities laws that leads to a successful enforcement of a covered judicial or administrative action. This legislation also strengthens the whistleblower protection provisions of the Sarbanes-Oxley Act and False Claims Act.

In order to be considered eligible for an award, a whistleblower must provide information that is sufficiently specific, credible, and timely that it causes the staff to open an investigation, or significantly contributes to the success of an enforcement action.1 To qualify for a whistleblower award, Section 922 requires that the "original information" is "a) derived from the independent knowledge or analysis of a whistleblower; b) is not known to the Commission from any other source, unless the whistleblower is the original source of information; and c) is not exclusively derived from an allegation made in a judicial administrative hearing, in a government report, hearing, audit, or investigation, or from the news media, unless the whistleblower is a source of the information."

However, there are several exclusions that do not qualify as "original information". For example, in cases where a whistleblower's only source of information is through an existing investigation or proceeding or that is exclusively derived from a governmental investigation is expressly excluded from the definition of "original information".

Section 922 of Dodd-Frank added new Section 21F to the Securities Exchange Act of 1934, entitled "Securities Whistleblower Incentives and Protection."2 Section 21F directs that the Commission pay awards, subject to certain limitations and conditions, to whistleblowers when the information leads to a successful enforcement of an action brought by the Commission that results in monetary sanctions exceeding $1,000,000 in civil or criminal proceedings. The intended purpose of the reward program is to "motivate those with inside knowledge to come forward and assist the Government to identify and prosecute persons who have violated securities laws and recover money for victims of financial fraud."

II. The Effect of Dodd-Frank Reform on Whistleblower Activity for SEC Violations

The U.S. Senate has reported that more than half of all uncovered frauds originated from whistleblower tips.3 Accordingly, it can reasonably be expected that the new monetary incentives and protection set forth under Dodd-Frank will only increase the frequency of whistleblower activity. Dodd-Frank also prohibits retaliation by employers against individuals who provide the Commission with information about possible securities violations. Considering the economic challenges that many companies currently face, the pressure to commit financial statement fraud intended to distort earnings and mask poor earnings performance may be on the rise. As a result, whistleblower activity for securities violations may be on the increase that will require companies and regulators to investigate.

Recent studies performed by the Association of Certified Fraud Examiners and the Institute of Internal Auditors support this theory and found that fraudulent acts by employees and outsiders rise during periods of economic downturn.4 It is commonly understood that fraud and misconduct are committed primarily because of three factors. These factors, often referred to as the Fraud Triangle, are financial pressure, opportunity, and rationalization.

While these factors are always present during a stable economy they can be more pervasive during an economic downturn. Some common examples of financial statement fraud include revenue recognition schemes such as fictitious sales, channel stuffing and improper revenue recognition practices; incomplete or improper financial statement disclosures; manipulation of inventory value, reserves and recognition of expenses. Also noted, violations of the Foreign Corrupt Practices Act ("FCPA") are covered within the framework of the Dodd-Frank whistleblower provision. The heightened risk of fraudulent behavior during an economic downturn coupled with monetary incentive and whistleblower protection creates the perfect storm for whistleblower activity giving rise to SEC inquiry and internal investigations.

Dodd-Frank defines a whistleblower as an individual who, alone or jointly with others, provides information to the Commission relating to a possible violation of the securities laws that "has occurred, is ongoing, or is about to occur."5 In addition, there is no requirement in Dodd-Frank that the information relate to a "material" violation of the securities laws but instead the Commission concluded that instead of using a materiality threshold barrier that might limit the number of submissions, it preferred that individuals provide information about possible securities violations to allow the Commission to evaluate whether the information warrants action.

To qualify as a whistleblower eligible for the award program and the confidentiality provisions of the Exchange Act, an individual must submit his or her information to the Commission in accordance with the procedures set forth in Rule 21F-9(a).6 However, the rule states that a company or another entity could not qualify as a whistleblower. Furthermore, an individual who submits information that relates only to a state law or foreign law violation would not satisfy the whistleblower definition.

The new law greatly expands the SEC's authority to incentivize and reward whistleblowers. Previously, the SEC could only reward whistleblowers on for tips on insider-trading cases.7 The implementation of Dodd-Frank will likely spur increased whistleblower activity which, in turn, will result in a new spectrum of SEC inquiry and internal investigations. These internal investigations will require an assessment of the conduct of company management, the actions of the board of directors, and its independent financial auditors. The investigations will undoubtedly review the internal control environment and compliance programs set forth in the Sarbanes-Oxley legislation. These renewed internal investigations stemming from whistleblower activity will require companies to investigate claims, re-evaluate internal controls and strengthen anti-fraud programs. These investigations create unique opportunities for attorneys and financial consultants. Financial consultants such as forensic accountants can provide an invaluable role to aide resource constrained in-house legal departments perform an independent internal investigation and assist outside counsel. Forensic accountants are trained to review the books and records of an organization to detect possible indicia of fraudulent behavior or identify unusual financial transactions.

The potential award payments to eligible whistleblowers will equal between 10 and 30 percent, at the SEC's discretion, of the monetary sanctions collected in successful actions, creating a compelling incentive for employees to come forward and disclose "original information" to the Commission. To demonstrate the scale of potential whistleblower incentive awards under Dodd-Frank, a whistleblower in the Tyco accounting fraud and securities laws violation case would have received an award of between $5 million and $15 million. Similarly, a whistleblower in the Siemens FCPA case would have received a award of between $80 million and $240 million.

III. The Importance of Internal Investigations Under Dodd-Frank Reform

The SEC's stated intentions are not to circumvent and undermine a company's internal compliance and reporting system. Rather, Dodd-Frank includes several provisions that support the effective functioning of company compliance programs and that encourage a whistleblower to use a company's internal process. The intended goal is to create a significant financial incentive for whistleblowers to report possible violations to internal compliance programs before, or at the same time, they report to the Commission. Reporting internally can increase both the probability and the magnitude of a potential recovery. Whistleblowers who report internally first, have 120 days from the internal reporting date to subsequently report possible violations to the SEC, preserving their rights under the SEC's whistleblower program. Voluntary participation in internal compliance systems is one of four specific factors specifically mentioned in the new law that may lead to an increase in the award percentage, creating a motivating incentive for whistleblowers to report internally.

Moreover, if a company conducts an internal investigation based on a whistleblower's disclosure of original information through internal processes, and the company reports the information to the SEC that leads to a successful Commission action, the whistleblower will get credit, and potentially a greater award, for any additional information resulting from the company's investigation. The whistleblower will receive full credit for the information provided to the SEC by a company as if the whistleblower had provided all of the information to the SEC him or herself. And, even if the original information provided to the employer by the whistleblower does not meet the eligibility requirements under Dodd-Frank, the whistleblower will still be eligible for an award if the resulting employer provided information leads to a successful enforcement action.

Companies are also incentivized to maintain effective internal compliance programs and to be forthcoming with information on possible violations. The SEC states that when determining if and how much leniency to grant an entity cooperating with an investigation, "the promptness with which entities voluntarily self-report their misconduct...is an important factor." A well designed and widely advertised internal compliance program will encourage employees to initially report perceived violations internally, rather than directly to the SEC. This will reduce the risk of a company being blind-sided by an SEC investigation and afford the company the opportunity to launch an internal investigation and voluntarily self-report violations, possibly earning the company leniency. The SEC notes that companies frequently contact their staff in the early stages of an internal investigation to self-report known violations. In certain cases the staff may agree to wait for additional results from the internal investigation before deciding on an investigative course of action.

Notably, Section 1057 of Dodd-Frank specifically provides new whistleblower protection for financial services employees who might suffer retaliation for disclosing information about fraudulent or unlawful conduct related to the offering or provision of a consumer financial product or service. The scope of coverage is far reaching in that it applies to organizations that extend credit or service or broker loans; provide real estate settlement services or perform property appraisals; provide financial advisory services to consumers relating to proprietary financial products, including credit counseling; or collect, analyze, maintain, or provide consumer report information or other account information in connection with any decision regarding the offering or provision of a consumer financial product or service.

IV. The Availability of Insurance Coverage for the Resultant Costs of Internal Investigations and Enforcement Actions

Anticipating the possibility of increased internal investigations and enforcement actions as a result of Dodd-Frank's whistleblower provisions, organizations should consult outside coverage counsel regarding the availability of insurance coverage for the resultant costs. Coverage counsel can review an organization's existing portfolio of Directors & Officers ("D&O") coverage, as well as provide valuable advice regarding enhanced coverage for upcoming renewals. The wording and terms of D&O policies can vary widely, so it is critical that an organization review its policies carefully in the context of the potential allegations or actions they face.

D&O coverage protects organization officers and directors – and sometimes the organization itself – against loss arising out of alleged breaches of fiduciary duty, misrepresentation, failure to disclose, or other "wrongful acts" in their capacity as directors and officers. Historically, D&O coverage has included defense and settlement costs for directors and officers named as defendants in whistleblower-initiated investigations or actions, originating with qui tam claims filed under the federal False Claims Act and later claims under the Sarbanes-Oxley Act. Whistleblower claims under Dodd-Frank should be subject to similar defense and settlement cost coverage, where the SEC names individual directors and officers as defendants in an enforcement action. Internal investigation costs associated with whistleblower claims, but before commencement of a formal administrative, criminal, or civil proceeding, may also be covered depending on the provisions of the particular D&O policy.

Particular attention should be paid to the definition of key terms such as "claim" and "loss." For example, some D&O policies define "claim" broadly to include any inquiries and investigations against the insured, while other policies exclude regulatory proceedings brought against the insured. Similarly, some insurers offer coverage enhancements that define "loss" to include both defense costs and investigative costs, whereas other policies include only defense costs. A few insurers, such as Arch and CNA, have introduced coverage enhancements specifically addressing coverage for loss resulting from "Dodd-Frank-954 Costs." As defined in the Arch enhancement, "Dodd-Frank-954 Costs" include "reasonable and necessary fees, costs and expenses (including the premium or origination fee for a loan or bond) incurred by any Insured Person solely to facilitate the return of amounts required to be repaid by such Insured Persons pursuant to . . . Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 . . . Dodd-Frank 954 Costs shall not include any amounts requested or required to be repaid by any Insured Person pursuant to . . . Section 954."

Insureds should also be aware of certain coverage exclusions that insurers may attempt to utilize in addressing claims for whistleblower-initiated investigations or actions, including:

  • Penalty exclusions that preclude coverage for costs that constitute financial penalties against the organization or its directors and officers.
  • "Insured v. Insured" or "Organization v. Insured Persons" exclusions that preclude coverage for claims or suits between insureds; although many contain carve-back provisions for claims and suit initiated with the assistance of a whistleblower.
  • Conduct exclusions that preclude coverage for losses resulting from fraud and illegal profit; although such exclusions should apply only if there has been a "final adjudication" or finding "in fact" that the alleged conduct was fraudulent or criminal.
  • Prior Acts exclusions that preclude coverage where the alleged "wrongful acts" occurred prior to a specified date.

Conclusion

While Dodd-Frank's impact has yet to be tested, it can reasonably be anticipated that the monetary award provision and retaliation protection will provide ample incentive for whistleblowers to report possible SEC violations, both internally and/or directly to the SEC. As a result, organizations should re-examine their internal compliance programs to ensure they are prepared to address possible whistleblower activity, including having a team of outside professionals to perform an independent internal investigation. Organizations should further consult outside coverage counsel regarding the availability of insurance for costs associated with potential internal investigations and enforcement actions. Thus, the enhanced regulatory environment under Dodd-Frank stemming from the recent financial crises will drive a renewed need for legal counsel and forensic accountants to investigate, report, and remedy SEC violations.

Footnotes

1. Rule 21F-4 (c).

2. Pub. L. No. 111-203, Section 922(a), 124 Stat 1841 (2010).

3. Senate Report 111-176.

4. Business Wire, ACFE Survey of Experts Finds Increase in fraud During Economic Crisis, April 16, 2009; http://www.ethicssage.com/2010/12/business-fraud.html; Research Advisory Board Study, May 2008.

5. Section 21F-2

6. The statutory definition of "whistleblower" in Section 21F(a)(6) of the Exchange Act provides that the Commission may "establish by rule or regulation " the "manner" in which an individual provides the Commission information so as to quality as a whistleblower for purposes of the awards program.

7. www.reuters.com/article/2011/05/25/us-sec-whistleblower-rule-idUSTRE74O5KP20110525

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