SEC Adopts Whistleblower Program Rules, Proposes Reg. D “Bad Actor” Disqualification

In a 3-to-2 vote, the Commission yesterday adopted rules and forms to implement the whistleblower program under which it will pay eligible individuals for providing evidence of securities law violations that leads to a successful enforcement action. SEC Chair Mary Schapiro noted that the staff had to address a number of tough policy issues in developing the program, but she believes the final rules successfully balance the need to incentivize people to come forward with the risk of unintended consequences. In a separate 3-to-2 vote, the Commission also approved the issuance of proposed amendments to 1933 Act Regulation D to disqualify offerings involving “felons and other bad actors”from using the Rule 506 exemption from registration.

The whistleblower rules state that, in order to be considered for an award, a whistleblower must voluntarily provide original information that leads to the successful enforcement by the SEC of a federal court or administrative action in which the SEC obtains monetary sanctions totaling more than $1 million. The information must be specific, credible and timely, and can apply to a matter that was already under investigation when the information was submitted. The rules provide that whistleblowers can qualify if they report the information to their internal compliance programs before or at the same time they report to the SEC, and their employer then provides the information to the Commission.

Schapiro said that the role of internal corporate compliance programs was the issue that received the most attention in the comment letters the SEC received on the whistleblower rules. Many commenters argued that compliance programs would only survive if the Commission required individuals to report internally before coming to the SEC. If it were not a requirement, they suggested, then whistleblowers would skip over their internal programs to seek an award from the SEC. Other commenters felt that if internal reporting were mandated, then whistleblowers would be dissuaded from coming forward at all.

SEC Enforcement Director Rob Khuzami said that the staff recognizes the value of internal compliance programs, but felt that requiring individuals to report to the company first would be detrimental to the Commission’s enforcement efforts. Requiring internal reporting would place an undue burden on the whistleblower, he said, and would be a deterrent to coming forward. As a result, the final rules do not mandate internal reporting, but provide incentives for individuals to go to the company first.

Khuzami said that the staff had no evidence to prove that not requiring internal reporting first would undermine compliance programs. In addition, the staff noted that there is nothing in the Dodd-Frank Act that requires internal reporting as a condition to qualifying for a reward. In the end, the staff wanted to incentivize people and protect them from retaliation because the information would help the staff bring more cases, move more quickly on them, and generally improve the SEC’s enforcement program, he said.

The expanded incentives include lengthening the period of time from 90 days to 120 days that a whistleblower can wait before coming to the SEC after reporting internally. Whistleblowers will get credit for the original date they reported to the company as long as they notify the Commission within 120 days. The final rules also provide that, when determining the amount of an award, the Commission will consider how much an individual has participated in or interfered with the internal compliance process.

The rules give credit to a whistleblower whose company passes the information along to the SEC, even if the whistleblower does not. Khuzami noted that a whistleblower will get credit for all of the information the company provides to the Commission, even if it is more than the whistleblower originally reported to the company. This means that reporting internally may help a whistleblower qualify for an award where they otherwise would not, he said.

The rules provide that certain people will not be considered for whistleblower awards, including individuals who have a pre-existing legal or contractual duty to report their information to the Commission, and people who obtain the information by means that is determined by a U.S. court to violate federal or state criminal law. Attorneys, including in-house counsel, who attempt to use information obtained from client engagements to make whistleblower claims for themselves also are not eligible, unless the disclosure of information is permitted under SEC rules or state bar rules.

Another controversial issue was the proposal to provide awards to culpable whistleblowers. Khuzami said the staff considered all of the comments on the issue and decided to leave this piece of the rules unchanged. The truth is that it is often only those involved that have the key information needed to enable the Commission to get the leaders of the fraudulent scheme, he said. Culpable whistleblowers are eligible for awards, but the final rules provide that the Commission will not pay awards that are based on the monetary sanctions that the culpable individuals themselves pay in the resulting SEC action, or monetary sanctions paid by entities whose liability is based substantially on conduct that the whistleblower directed, planned or initiated.

Commissioner Kathleen Casey voted against adoption of the rules, saying the whistleblower program as designed suffers in two key respects—it underestimates the impact on internal compliance programs and overestimates the staff’s ability to manage the volume of complaints that will come in. Commissioner Troy Paredes echoed her concerns, expressing his fear that the agency, which already has limited resources, will be inundated with allegations that will command the staff’s attention.

Khuzami said that since the enactment of the Dodd-Frank Act, the Commission has seen an uptick, but not a flood, in tips. He said the staff has also seen an increase in the quality of the tips, with people providing more detailed allegations and better documentation. Stephen Cohen of the Enforcement Division cited a recent instance where the staff spent two days with a whistleblower and received information that saved the staff 6 to 12 months of investigative work. Schapiro noted that the quality of the tips under the program can, in some cases, actually ease the burden on the staff.