By Michael W. Phillips and Michael C. Gordon
Dolan Media Newswires
August marked the second anniversary of the implementation of the Securities and Exchange Commission whistleblower program.
At the time of its inception, the whistleblower program attracted attention from the business and legal communities, promising to entice potential whistleblowers with significant awards, while also offering protection to whistleblowers against employer retaliation.
Although recent signals by the SEC have indicated that substantial whistleblower awards are on the horizon, and in October the SEC did announce a significant $14 million award, only six whistleblower awards — resulting from four matters — have been announced since the inception of the program.
Interestingly, a review of annual SEC enforcement actions highlights a decrease in financial fraud cases pursued by the SEC, an unanticipated trend in light of the expectations of the whistleblower program.
Although the impact of the whistleblower program on SEC enforcement activity may be subject to a timing lag, the downward trend in financial-fraud-related actions still is unexpected.
The whistleblower program was created as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which amended the Securities Exchange Act of 1934 by adding Section 21F, “Securities Whistleblower Incentives and Protection.”
The new legislation required the SEC to establish a program that would incentivize individuals, through potentially significant financial awards, to report information that may lead to successful SEC enforcement actions.
Dodd-Frank further specified that the SEC was to create a separate department, known as the Office of the Whistleblower, or OWB, to oversee the process of communicating with whistleblowers and to manage potential award payments.
The OWB is mandated to report annually to Congress regarding its activities, including whistleblower complaints received, and the response of the OWB to such complaints.
Dodd-Frank also provided for the creation of the SEC Investor Protection Fund to be used for funding both the award payments as well as the activities of the SEC’s inspector general. As of the end of fiscal year 2013, the balance in the fund was close to $440 million.
To qualify for a potential monetary award, a whistleblower must meet the following three criteria: (1) the whistleblower must voluntarily provide original information; (2) such information must lead to successful enforcement action(s) taken by the SEC; and (3) such enforcement action(s) must result in monetary sanctions of greater than $1 million.
Provided those conditions have been satisfied, awards of up to 30 percent of any monetary sanctions collected can be granted.
During the period from the program’s inception in August 2011 through the fiscal year 2013, the SEC received more than 6,500 whistleblower tips. Almost half the tips collected during that timeframe related to matters involving manipulation, offering fraud, and corporate disclosure and financials. Interestingly, more than 1,500 of the tips were categorized as “other.” The chart below summarizes the named categories of tips provided by whistleblowers.
As disclosed in the OWB’s 2013 annual report to Congress, despite the volume of leads during the first two years of the whistleblower program, only six awards have been granted, related to the following cases:
• On Aug. 21, 2012, the SEC announced its first whistleblower award related to a multi-million-dollar fraud that ultimately led to $1 million in sanctions, of which the whistleblower was eligible for the maximum 30 percent of sanctions ultimately collected.
• In June 2013, the SEC issued an order approving awards up to $125,000 for three out of four whistleblowers whose tips revealed that Locust Offshore Management LLC and its CEO had defrauded investors of more than $2 million.
• On Oct. 1, 2013, the SEC announced the largest award to date, paying a single whistleblower $14 million for information related to an enforcement action that recovered substantial investor funds.
• On Oct. 30, 2013, the SEC announced another award, of more than $150,000, to a whistleblower providing information that enabled the SEC to identify and halt an ongoing fraudulent scheme.
Trends in whistleblower activity
Initially, the general consensus was the SEC whistleblower program would logically lead to an increase in overall whistleblower activity at both the corporate and SEC level.
The implementation of a formal process promising both increased protections from employer retaliation and potential significant monetary awards was expected to create stronger incentives for individuals to come forward with helpful information.
However, a recent survey summarized in a report issued by the Institute of Internal Auditors shows that the vast majority of surveyed companies have not seen any change in the number of tips or complaints received through internal hotlines since the SEC whistleblower program became effective and have “little to no concern” that employees are circumventing internal reporting channels.
The results of the survey indicate that the general level of whistleblower activity has not significantly increased, but rather has remained steady, since the SEC program was implemented.
A recent decision by the 5th U.S. Circuit Court of Appeals may affect the volume of whistleblower tips provided to the SEC.
SEC regulations provide that an individual may qualify as a “whistleblower,” and thus be protected from employer retaliation under the guidelines of Dodd-Frank, even if the tip is reported by the employee internally at a corporate level and not directly to the SEC.
However, the court decision held that an employee must report directly to the SEC to be afforded such protections. The ruling is in contrast to several District Court decisions, but may ultimately result in an increase in the volume and quality of tips provided directly to the SEC.
Mixed signals from the SEC
The low volume of awards has certainly raised some questions regarding the efficacy of the whistleblower program. Of note, the SEC has experienced considerable turnover in several key positions of late, which some might suggest may have impacted the program’s success.
Despite those concerns, recent indications from the SEC, although mixed, have suggested that substantial awards are looming on the horizon. Stephen Cohen, associate director of the SEC’s Division of Enforcement, was recently quoted saying the information gathered through whistleblowers has led to some “incredibly impactful cases,” which are expected to result in “some extremely significant whistleblower awards”
Indeed, the $14 million whistleblower award far exceeded prior awards granted under the program. Other sources have indicated that additional significant awards are not likely to be seen in the near future.
In an Aug. 12 Wall Street Journal article, Michele Wein Layne, regional director of the SEC’s Los Angeles office, stated, “We try to bring our cases as quickly as possible. They take a long time. It could be further out until you see some of those substantial awards.”
It is difficult to measure the success of the whistleblower program based on the results of the first two years of implementation, particularly in light of the SEC’s remarks that these matters require a significant amount of time to investigate and that pending matters have the potential to result in large award payments.
If true, perhaps the lack of awards thus far is merely a timing issue, which will subside as the program and resulting investigations continue to gain momentum.
Additionally, the 5th Circuit’s recent ruling raises the question as to the message that is being sent to whistleblowers. Individuals seeking the greatest level of protection from potential retaliation by employers may very well be motivated to bypass internal channels and report their concerns directly to the SEC.
Could such a trend bog down the process and burden the SEC with frivolous tips that could have been properly screened through corporate channels?
While it is challenging to predict the future success of the whistleblower program, other developments at the SEC may have a positive impact on the ability to identify financial statement fraud.
The SEC is currently expanding the use of its Accounting Quality Model, a comprehensive tool designed to rank the risk that a company’s public filing contains fraudulent information. The tool, coupled with a renewed focus on financial fraud by Mary Jo White, chair of the SEC, may drive an increase in SEC financial fraud investigation activity regardless of the success of the SEC’s whistleblower program.
Michael W. Phillips and Michael C. Gordon are with Floyd Advisory, a business advisory and forensic accounting firm with offices in Boston and New York.