Securities Fraud Whistleblowing
Thinking of blowing the whistle on securities fraud? Thanks to the Dodd-Frank Restoring American Financial Stability Act of 2010 (H.R. 4173), it now makes financial sense to consider it.
Securities whistleblowers may not have much company in cheering H.R. 4173 but Section 922 is a major improvement over the largely non-functional anti-retaliation provisions of the old Sarbanes-Oxley § 806.
What kinds of fraud qualify for SEC whistleblower treatment? Just think of the word “mislead.” Assuming the size threshold is met (see below), pretty much any case in which a market actor (company or individual) misleads investors — recklessly, willfully or just negligently (in the case of Section 17(a) of the Securities Act of 1933 (15 U.S.C. §77q(a)) is a securities whistleblower claim waiting to happen.
Take the Goldman Sachs case, for example. For aspiring SEC whistleblowers, the Goldman case would have produced a minimum bounty of $55 million to a whistleblower. Because the SEC settled the case before the new law became effective, no bounty will be paid.
That said, as outlined in the SEC’s civil complaint against Goldman, the $550 million settlement was the product of alleged misrepresentations that violated three primary federal securities laws: Section 17(a) of the Securities Act of 1933 (15 U.S.C. §77q(a)), Section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. §78j(b)) and Exchange Act Rule 10b-5 (17 C.F.R. §240.10b-5). While these code sections may read like Greek to the uninitiated, what they all boil down to is that companies like Goldman who sell “securities” like stocks and bonds to investors are required to provide potential investors ALL material information — positive, negative and neutral — about the proposed investment.
The SEC alleged, in general, that Goldman made
materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) Goldman structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities (“RMBS”) and was structured and marketed by Goldman in early 2007 when the United States housing market and related securities were beginning to show signs of distress.
More specifically, the defendants “recklessly or negligently misrepresented in the term sheet, flip book and offering memorandum for ABACUS 2007-AC1 … the significant role in the portfolio selection process played by Paulson & Co., a hedge fund with financial interests in the transaction directly adverse” to investors in the fund:
Undisclosed in the marketing materials and unbeknownst to investors [Paulson] played a significant role in the portfolio selection process.
The complaint also alleges that the defendants misled one investor, ACA, into believing that Paulson invested in the equity of ABACUS 2007AC1 and, accordingly, that Paulson’s interests in the collateral section process were closely aligned with ACA’s when in reality their interests were sharply conflicting:
After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS** portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future.
In short, the SEC says, Goldman and Tourre misled ABACUS 2007-AC1′s investors about Paulson’s role in structuring the deal and concealed the fact that Paulson was betting against the fund’s portfolio. Emails figured prominently in the evidence against Goldman.
Key whistleblower takeaways: Failure to disclose material information about the deal and the people who put it together can violate the securities laws in multiple ways.
For readers familiar with the somewhat comparable False Claims Act (a.k.a. “FCA”), in some respects Section 922 is nearly identical. In others, it differs significantly. In theory at least, both statutes offer whistleblowers potentially handsome financial rewards for bringing forward “original information” about fraud. The awards generally range between 15 and 30 percent under the FCA (10-30 percent under § 922) of what the government collects as a result of the whistleblower’s disclosures. The FCA seeks to protect government funds from unscrupulous contractors and tax cheats. In contrast, Section 922 purports to shield investors from securities fraud. Other major points of comparison and divergence follow.
Section 922 makes awards only in cases where the “monetary sanctions” collected from the defendant exceed $1,000,000. In contrast, there is no statutory floor on FCA claims although practically speaking each U.S. attorney’s office has its own threshold. There are just too many FCA cases and too few assistant U.S. attorneys to follow them all. Some won’t consider a case alleging less than $1,000,000 in “single damages”. Others will jump at $500K. Local context looms large.
Section 922 excludes more whistleblowers
Oddly enough, if you gain the case information through the performance of an audit of financial statements required under the securities laws and, for you in your position, submission of the information to the SEC would be contrary to the requirements of section 10A of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1), forget about it.* You can’t be an SEC whistleblower. In this, you’re not alone. The same exclusion applies to to “any whistleblower who is, or was at the time the whistleblower acquired the original information submitted to the Commission, a member, officer, or employee of (i) an appropriate regulatory agency; (ii) the Department of Justice; (iii) a self-regulatory organization; (iv) the Public Company Accounting Oversight Board; or (v) a law enforcement organization.”
No private cause of action under Section 922
Unlike the FCA which authorizes plaintiffs called “relators” to sue even if the government decides not to, under § 922 only the government can pursue a securities fraud claim. If the SEC chooses not to pursue a whistleblower case, the whistleblower is pretty much out of options. To place this in practical context, not even Harry Markopolos — with all of his data and analysis — could force his Bernie Madoff case into court if the SEC didn’t want to go.
“Original information” is broader under Section 922
While the term “original information” is not used in the FCA, the FCA also makes awards only for the provision of new information. That said, Section 922′s formulation of “original information” appears to be more expansive than that of the FCA.
Unlike the FCA, Section 922 includes within its domain of “original information” not only bare “knowledge” but also “analysis” provided by a whistleblower. This should be seen as significantly expanding the “original information” perimeter to include private analysis of publicly available data like that which enabled Harry Markopolos to detect the Madoff fraud long before the SEC did. While it is possible that an FCA whistleblower may have won a settlement on the basis of such analysis alone, I am not currently aware of any such case.
On the flip side, Section 922 excludes from permissible “original information” information “exclusively derived from an allegation made in a judicial or administrative hearing, in a governmental report (as opposed to federal government, in the FCA), hearing, audit, or investigation, or from the news media, unless the whistleblower is a source of the information. The phrases “exclusively derived” and “a source” are exclusive to Section 922 — they do not appear in the FCA.
Arguably, the net impact of “government,” “exclusively derived,” and “a source” — together with the addition of the word “analysis” — is to expand the pool of “original information” for SEC whistleblowers beyond than that available to FCA relators.
Section 922 will be administered by a dedicated SEC office
FCA relators should be so lucky. FCA claims are typically administered and enforced by Main Justice DOJ Civil Division attorneys or by local Assistant US Attorneys who have lots of responsibilities in addition to FCA cases. The focus offered by a special SEC whistleblower office should give SEC whistleblowers a leg up assuming that it is properly staffed and managed.
SEC determines Section 922 awards
Unlike the FCA where the district courts have authority to approve FCA settlements and associated whistleblower awards, Section 922 grants the SEC complete discretion to identify award recipients and set largely unappealable award amounts.
Act § 21F(c)(1)(B) directs the SEC to “take into consideration” a specific list of four factors in making awards.** However, the House-Senate Conference Committee’s softening of the Senate version language of § 21F(c)(1)(B) from “shall account for” to “shall take in consideration” signals that the SEC can weight and apply these factors almost at will. Act § 21F(f) deprives district courts of any supervisory role, sending award appeals directly to the circuit courts which must review SEC decisions in accordance with Section 706 of the federal Administrative Procedure Act. As a practical matter, SEC decisions on awards will be very difficult to overturn on appeal.
Readers may judge for themselves what awards whistleblowers should expect in light of the fact that awards will be paid out of the same SEC Investor Protection Fund from which the SEC’s OIG will fund its activities.
Bottom line: Dodd-Frank offers pros and cons for SEC whistleblowers. While it isn’t nearly as robust as the FCA, Dodd-Frank is a major improvement over Sarbanes-Oxley. If you’re thinking of blowing the SEC whistle and can’t wait to get started, give us a call. We can help you blow with greater velocity and focus.
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* The emphasis on “and” is mine. The contextual meaning of the phrase “contrary to the requirements of section 10A” is anybody’s guess at this point. This kind of legislative loose end keeps litigators employed and drives auditors — who crave definition and bright lines — to distraction. Long live Congress!
** The § 21F(c)(1)(B) award-amount factors are as follows:
1. the significance of the information provided by the whistleblower to the success of the action;
2. the degree of assistance provided by the whistleblower and any legal representative of the whistleblower in a covered judicial or adrninistrative action;
3. the SEC’s programmatic interest in deterring violations of the securities law by making awards to WBs; and
4. such additional relevant factors as the Commission may establish by rule or regulation.