From the September 2010 issue of Treasury & Risk magazine

SEC Bounty Hunters

Dodd-Frank and the SEC's zeal make it easier and more lucrative for whistleblowers to tip the feds off to securities violations.

The shudder felt in C-suites across the country in late July was not an earthquake, but the trembling of corporate executives and general counsels contemplating back-to-back events that could presage a much more aggressive approach to securities law violations by the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Dodd-Frank financial reform bill signed into law on July 22 includes a provision that mandates the SEC, as well as the CFTC, to award a bounty of 10% to 30% to any whistleblower who provides significant information about securities fraud involving a public company, or even a private company owned by a public company, that results in a judgment in excess of $1 million.

On July 23, the SEC granted an unprecedented $1 million bounty to Karen Kaiser and her husband Glen, of Southbury, Conn., because she provided data that helped the agency win a $28 million settlement, including a $10 million penalty, against hedge fund Pequot Capital Management.

The insider trading case involved Kaiser's ex-husband, former Microsoft employee David Zilkha, who is alleged to have received $2.1 million from Pequot in exchange for information about a Microsoft earnings report. (Zilkha denies any wrongdoing and is challenging the SEC in an administrative hearing set for this fall.)

"The SEC is going to be very aggressive with this law, and may even put more teeth in it through the implementing regulations that they have to draw up" before the law goes into effect next spring, says Steven Pearlman, a partner in the Chicago-based law firm of Seyfarth Shaw. "We're getting a lot of calls from corporate counsel offices. They all want to get their arms around this new law."

Congress gave the SEC and CFTC 270 days from enactment of Dodd-Frank, meaning until April 18, 2011, to draw up and approve regulations for the bounty program, which will include a public comment period.

Tony Alexis, an attorney in the Washington office of law firm Mayer Brown, agrees the bounty provision in Dodd-Frank is likely to significantly increase SEC fraud and financial misconduct investigations. "Since 1934, 50% of all SEC cases have been the result of whistleblower tips provided to the agency, and that has happened despite little or no chance of a bounty," Alexis says. "So now, if the SEC is expected to pay the whistleblower a 10% to 30% bounty on large cases involving penalties of over $1 million, you are likely to see a big increase in the number of cases."

And unlike the federal False Claims Act, upon which the whistleblower provision was modeled, the Dodd-Frank Act allows whistleblowers to provide information to the SEC or CFTC anonymously through an attorney, and even, after identifying themselves to either agency confidentially, to receive their bounty while remaining publicly unidentified.

To be eligible for a bounty, a whistleblower must provide "original" information, meaning it must be "derived from the independent knowledge or analysis of the whistleblower." The information cannot be known to the SEC from any other source and cannot be "exclusively derived" from an allegation made in a judicial or administrative hearing, a government report or a news report.

The SEC has been authorized to pay bounties in insider cases for 21 years, but before the Pequot settlement, bounties played an insignificant role in agency cases. There were only five payments made before the award to the Kaisers, the largest of which was just $55,200.

In addition to the bounty provision, Dodd-Frank doubles the statute of limitations period for reporting on securities law violations and allows whistleblowers whose tips are ignored by financial regulators to go directly to federal court.

Mark Sherman, the Stamford, Conn., attorney who represented the Kaisers, says, "The timing of this bounty and the passage of the Dodd-Frank Act with its whistleblower bounty provisions was no coincidence. Even though our case was brought under the old insider-trading law, it was clearly meant to send a message to all potential whistleblowers that the SEC is serious about paying bounties for information about financial misconduct.

"Prior to this case, the bounty program was rarely used and rarely publicized," Sherman adds. "Now this case has raised awareness. This new law could be a game changer for the prosecution of financial fraud."

Steve Kohn, executive director of the National Whistleblowers Center in Washington, an organization that defends whistleblowers, argues the new law will benefit "honest corporations.

"It levels the playing field," he says. "It hasn't been fair that some companies could profit by not following the rules. Now it will be profitable to be honest."

Kohn notes that the False Claims Act (FCA), which awards bounties to whistleblowers who report fraud by government contractors, has recovered some $25 billion in fraudulent billings by corrupt vendors since it was enacted in 1863, while paying out some $2.5 billion in bounties. "This approach can really work," he says. "Just as the FCA changed the way contractors do business with the federal government, I think this new law will change the way corporations do their financial business."

Attorney Pearlman, for his part, worries the new law could lead to more cases of disgruntled employees attempting to blackmail employers. But he concedes that restricting bounties to cases in which regulators win penalty judgments in excess of $1 million will reduce the incidence of frivolous cases.

Meanwhile, Pearlman warns that companies are going to have to respond to the new statute by taking steps to try and keep employee whistleblowing within the company. He says this will take more than just setting up hotlines for reporting fraud anonymously--something many companies have already put in place in response to Sarbanes-Oxley. It will mean, he says, establishing a corporate culture that encourages employees to report fraud and financial misbehavior and discourages management retaliation against those making such charges.

Even then, Pearlman warns that the bounty provision in the new law will make it difficult to keep employee whistleblowing in-house. "No matter what you do, you're still competing with a potential agency award of 10% to 30%, which even in a $1 million case could be $100,000," he says. "Companies are going to have to come up with some pretty tasty carrots to compete with that!"

Pearlman predicts one area that is likely to see a lot more activity under the new law will be overseas SEC investigations of securities law violations based upon whistleblower claims.


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