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Alert

SEC Proposes Whistleblower Program Rules

November 12, 2010

On November 3, 2010, the Securities and Exchange Commission ("SEC") proposed widely anticipated rules that would implement the whistleblower provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). The proposed rules reflect the SEC's attempt to balance rewarding individuals who provide the SEC with high-quality tips leading to successful enforcement actions and minimizing potential, unintended consequences of paying such awards, such as undercutting internal compliance programs and rewarding wrongdoers. 1 Background Dodd-Frank added new Section 21F to the Securities Exchange Act of 1934, which requires the SEC to award whistleblowers -- individuals who provide original information that leads to successful SEC and certain related enforcement actions -- 10 to 30 percent of the total monetary sanctions collected if sanctions exceed $1 million. Dodd-Frank vastly expands the SEC's ability to pay rewards for federal securities law violations. Prior to Section 21F, the SEC's "bounty" program was limited to insider trading cases and awards were capped at 10 percent of the penalties collected in the action. Whistleblower Requirements According to the SEC, receipt of useful tips is crucial to its ability to protect investors and take action against wrongdoers. The proposed rules establish several requirements for being deemed a whistleblower: Only natural persons are eligible to be whistleblowers. although they may provide information alone or jointly with others and may do so anonymously. Under the proposed rules, the SEC would not reveal the whistleblower's identity, except under certain circumstances, such as when disclosure is required in connection with related litigation. Whistleblowers must voluntarily provide the SEC with the information. In general, they are deemed to have provided information voluntarily if they provide information before the government, a selfregulatory organization or the Public Company Accounting Oversight Board asks for it. Whistleblowers must provide original information based on their independent knowledge or independent analysis, not on information already known to the SEC and not derived exclusively from certain public sources. A whistleblower's information must lead to successful enforcement by the SEC of an injunctive action in federal court or an administrative proceeding. The information may be deemed to have led to successful enforcement in two circumstances: (1) if the information results in a new examination or

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The SEC's proposed rules are available at http://sec.gov/rules/proposed/2010/34-63237.pdf.

investigation being opened and significantly contributes to the success of a resulting enforcement action, or (2) if the conduct was already under investigation when the information was submitted, but the information is essential to the success of the action and would not have otherwise been obtained. The SEC would determine whether either criteria are satisfied. The last requirement for whistleblower status is that the SEC is able to obtain monetary sanctions totaling more than $1 million. 2

Other Key Issues Mindful of the potential impact of its congressionally mandated whistleblower program, the SEC's proposed rules seek to both enhance the SEC's effectiveness -- which Congress clearly intended through DoddFrank -- and avoid disabling effective internal corporate compliance programs and rewarding wrongdoers -- which the SEC recognizes would be an unfortunate result of its program. Supporting Internal Compliance Programs Dodd-Frank's whistleblower framework has been criticized as potentially undercutting internal compliance programs. Although the SEC's proposed rules do not require that would-be whistleblowers report complaints internally before reaching out to the SEC, the proposed rules respond to this criticism by attempting to discourage employees from bypassing their own company's internal compliance mechanisms. For instance, the proposed rules would: Treat an employee as a whistleblower under the SEC program as of the date that the employee reports information internally -- provided that the employee provides the same information to the SEC within 90 days. Through this provision, employees would be able to report their information internally first, while preserving their "place in line" for a possible SEC award. Permit the SEC to consider higher percentage awards (i.e., closer to 30 than 10 percent of resulting monetary sanctions) for whistleblowers who first report their information through effective company compliance programs.

Moreover, in some circumstances, the SEC may, "upon receiving a whistleblower complaint, contact a company, describe the nature of the allegations, and give the company an opportunity to investigate the matter and report back" to the SEC. Doing so would both work with, rather than circumvent, existing internal compliance programs and permit the SEC to leverage its resources by deputizing companies to investigate 3 their own alleged violations. Eligibility Exclusions Certain individuals are not eligible for whistleblower awards under the proposed rules. 4 These include: Specified Employees: Individuals with pre-existing legal or contractual duties to report their information. This includes those who learn about violations through a company's internal compliance program or are in positions of responsibility for an entity and the information is reported to them with the expectation that they would take appropriate steps to respond to the violation. 5

The SEC also would pay awards based on amounts collected in related actions brought by certain agencies (including the Department of Justice) that are based upon the same original information that led to a successful SEC action. Indeed, in prepared remarks, SEC Chair Mary L. Schapiro described the SEC's whistleblower program as a "leveraging tool." Opening Statement at the SEC Open Meeting: Item 3 -- Whistleblower Program, by Chairman Mary L. Schapiro (Nov. 3, 2010) (available at http://www.sec.gov/news/speech/2010/spch110310mls-whistleblowers.htm). Others -- such as employees of certain agencies and people who are criminally convicted in connection with the conduct -- are excluded by Dodd-Frank. This exclusion is intended to prevent company personnel from "front-running" legitimate internal investigations. It does not apply, however, if an individual reports the information internally but the company does not disclose the information to the SEC within a "reasonable time" or acts in "bad faith." In these circumstances, such individuals may qualify for whistleblower awards.

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© 2010 Schulte Roth & Zabel LLP. All Rights Reserved.

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Attorneys: Attorneys who attempt to use information they obtain from attorney-client relationships to make whistleblower claims for themselves (unless disclosure of the information is permitted under SEC or state bar rules). Accountants: Independent public accountants who obtain information through an engagement required under the securities laws. Others: Foreign government officials and persons who obtain information from others who are subject to exclusions.

Also, under the SEC proposal, the agency would not pay awards to culpable whistleblowers that are based on either (1) the monetary sanctions that such persons themselves pay in the resulting SEC action or (2) sanctions paid by entities whose liability is based substantially on conduct that the whistleblower directed, planned or initiated. This provision is intended to prevent wrongdoers from blowing the whistle on themselves and collecting a windfall from the SEC. Criteria for Award Amounts Section 21F mandates awards of 10 to 30 percent of monetary sanctions collected based on the information provided. Under the proposed rules, when determining the amount of the award within the statutory range, the SEC must consider the following: Significance of the information to the success of the SEC or related action; Degree of assistance provided by the whistleblower; Programmatic interest of the SEC in deterring violations by rewarding whistleblowers; and Whether the award enhances the SEC's ability to enforce the federal securities laws.

And the SEC may consider the following, among other factors: Character of the enforcement action, including whether it reflects an SEC priority; Dangers to investors from the underlying violations; Timeliness, degree, reliability and effectiveness of the whistleblower's assistance; Unique hardships experienced by the whistleblower; Degree to which the whistleblower took steps to prevent the violations or remediate the resulting harm; Culpability of the whistleblower; and Whether the whistleblower reported the violation through effective internal compliance programs.

Future SEC Action Public comment on the SEC's whistleblower proposal is due by December 17. Entities at risk of increased whistleblower activity should consider submitting comments, particularly as to whether the proposed rules strike an appropriate balance between rewarding individuals who provide the SEC with information leading to successful enforcement actions and undercutting internal compliance programs. Helpful comments, including alternative rule proposals and follow-up communications with the SEC, may result in necessary revisions to the proposed rules. After reviewing submitted comments, the SEC will consider whether to modify or adopt its proposed rules. The SEC is expected to issue final rules to implement the Dodd-Frank whistleblower provisions on or before March 31, 2011. Authored by Richard J. Morvillo and Jeffrey F. Robertson. If you have any questions concerning this Alert, please contact your attorney at Schulte Roth & Zabel or one of the authors.

© 2010 Schulte Roth & Zabel LLP. All Rights Reserved.

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www.srz.com U.S. Treasury Circular 230 Notice: Any U.S. federal tax advice included in this communication was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties.

This information has been prepared by Schulte Roth & Zabel LLP ("SRZ") for general informational purposes only. It does not constitute legal advice, and is presented without any representation or warranty as to its accuracy, completeness or timeliness. Transmission or receipt of this information does not create an attorney-client relationship with SRZ. Electronic mail or other communications with SRZ cannot be guaranteed to be confidential and will not (without SRZ agreement) create an attorney-client relationship with SRZ. Parties seeking advice should consult with legal counsel familiar with their particular circumstances. The contents of these materials may constitute attorney advertising under the regulations of various jurisdictions.

© 2010 Schulte Roth & Zabel LLP. All Rights Reserved.

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