The US Securities and Exchange Commission (SEC) always hated the whistleblower program that Congress imposed on it as part of Dodd Frank reforms. Congress was responding to the SEC’s grotesque institutional failure in ignoring Harry Markopolos’ repeated, detailed warnings about the Bernie Madoff fraud, a Ponzi scheme that reached $65 billion due to SEC inaction.
But as we’ll describe, the SEC issued new guidance – on a Saturday night in the summer – that guts the whistleblower program by imposing new standards that look to be contrary to the intent of Congress by making it difficult to win awards for large-scale frauds, and then reducing the payouts on them. It looks like career-minded SEC officials who resented that whistleblower filings could force them to probe wrong-doings of prospective employers are making sure the agency will only hand out parking tickets.
Admittedly, Congress had set out to enfeeble the SEC, by keeping it budget-starved and having Congressmen like Joe Lieberman threaten to cut its funding even further if it went too aggressively after big financiers. The agency had retreated to focusing enforcement almost entirely on insider trading, to the degree that became almost incapable of seeing the world any other way. For instance, it botched its first major crisis case involving the collapse of two Bear Stearns hedge funds, by bizarrely pursuing the execs managing the funds as insider traders, rather than understanding that they were victims of other Wall Street firms (and perhaps even Bear’s own trading desks) that were selling toxic subprime mortgage securities and CDOs. ‘
Nevertheless, the new whistleblower program established an awards fund entirely outside the SEC’s budget, and also tasked the SEC to set up a “Whistleblower Office.” The agency was obligated to pay sources compensation set as a portion of the SEC’s recovery if they contributed information that was valuable to an enforcement action.
The program went live in 2012, and under Chairman Mary Jo White, the SEC feigned enthusiasm for the new initiative, dutifully reporting how many tips it had received and asking for more funding to do a better job, even as high level SEC insiders grumbled about how the whistleblower program trampled on the agency’s discretion.
Last Saturday, in the dead of night, the SEC moved to make explicit, with the release of draft rule revisions, what close observers long suspected, that despite the agency’s weak support for whistleblowers, they have proven nevertheless too successful.
The proposed new rules have two main thrusts. First, they would change the formula for computing whistleblower awards so that large awards would receive fewer dollars. Second, new barriers to receiving awards would be placed in front of whistleblowers who include any public information in their evidence of wrong-doing. The reason that matters, as we’ll explain in detail, is that whistleblowers who provide evidence of widespread or systemic frauds will almost certainly be relying significantly on public information. Perversely, that could even been deemed to include information the whistleblower got into the public domain via FOIA.
In recent years, whistleblowers have complained to us that the SEC has simply failed to respond to award applications. Mind you, we are not talking about the SEC ignoring tips about potential wrong-doing. Most of the SEC filings are along the lines of “Everything JP Morgan does is crooked,” as opposed to actionable information.
Instead, what the SEC frequently doesn’t respond to are the formal “award applications” that whistleblowers submitted after the SEC made an enforcement action where the whistleblower believes his filing made a contribution. The SEC requires that whistleblowers submit these requests in order to be considered for an award within 60 days of the SEC announcing a settlement.
The SEC has been remarkably and indefensibly, opaque about what is clearly a massive backlog of unresolved award claims. The agency produces a ludicrous annual report to Congress of its whistleblower program, full of useless statistics, such as the number of tips received by state, yet it has refused to disclose the number of outstanding award applications or their average age. Only once, in 2015, has it even reported on how many award claims it received in the previous year, which was 120. Contrast this figure with the fact the agency has been resolving about 40 claims a year in recent years. That means the SEC’s backlog of unresolved claims has been growing by approximately two years with each passing year. Its total backlog could realistically be more than five years at this point. That wait to receive an answer on an award is typically on top of the three to four years wait for an enforcement action to be prosecuted and resolved.
The SEC publishes heavily-redacted final orders ruling on each whistleblower award application. We found two recent ones where the agency took around five years to decide (5.25 years in one case and just under five years in the other).
In 2015, a Wall Street Journal article entitled SEC Backlog Delays Whistleblower Awards offered a similar snapshot of delay, as well as, the SEC resistance to disclosure:
Of the 297 whistleblowers who have applied for awards since 2011, about 247—or roughly 83%—haven’t received a decision from the SEC, according to data obtained by The Wall Street Journal in response to a public-records request. Some of the award claims have been delayed more than two years.
Later in 2015, the Wall Street Journal also reported on a whistleblower who sued the SEC demanding an answer after waiting three years with no response to his award application. Almost immediately, the SEC coughed up a response, which Wikipedia, for what it’s worth, says was favorable.
Even when the SEC does rouse itself to rule in favor of an award application, the agency has shown a clear bias in favor of penny-ante cases.
Since the inception of the program, more than 60 percent of the awards have been for less than $2 million. While $2 million can seem like a life-changing windfall, keep in mind that many whistleblowers are represented by contingency fee counsel who will take a quarter of the award, and many awards are shared among multiple whistleblowers. As a result, a $2 million total award could ultimately amount to no more than a few hundred thousand dollars to a whistleblower after taking into account these factors, plus taxes. And bear in mind that the best positioned whistleblowers in many cases are highly-placed people in the financial industry who might be making a million or more dollars annually who risk never working again by becoming whistleblowers.
This brings us to the proposed changes to the program. By law, the SEC is required to pay an award to whistleblowers equal to between 10 and 30 percent of any fines, disgorgement, restitution, and interest paid by a defendant in an enforcement case, with the exact amount based on a formula keying off how helpful the whistleblowers were (for example, delay in reporting a fraud lowers the percentage). The SEC is now proposing to include a new factor in the formula, which is how large the recovery is, where larger recoveries would result in a penalty to the formula and small recoveries would receive a formula bonus.
This favoring of small-bore enforcement reflects the longstanding institutional bias of the SEC to chase petty frauds while overlooking big ones, a tendency that is more obvious during Republican administrations but operative in Democratic ones as well.
Trump’s SEC chairman, Jay Clayton, has explicitly promoted an enforcement agenda of re-directing resources away from frauds impacting institutional investors toward frauds impacting retail investors. His patter is, “We’re here for the little guy, and the big guys can fend for themselves,” though that assertion falls apart when you recognize that the institutional frauds he is tolerating impact millions of ordinary people. For example, as we have extensively covered, private equity firms defraud their public pension fund investors. That hurts public workers and taxpayers. Similarly, banks securitize mortgages and sell designed-to-fail CDOs to institutional investors and other banks, which had the effect of severely exacerbating the foreclosure crisis.
Clayton has instead amped up the SEC’s focus on penny stock fraud and very small Ponzi schemes. These frauds impact a tiny sliver of the investing public. Mary Jo White, the SEC chair under Obama, had her own version of this bias, which she articulated as a “broken windows” theory of enforcement. In practice, this meant citing big institutions for petty infractions under the supposed theory that Goldman Sachs and Bank of America would refrain from major frauds if they were fined a few hundred thousand dollars for technical infractions. This approach allowed White, as a good Democrat, to issue press releases naming powerful Wall Street enforcement targets while sparing those targets any real pain.
To their credit, when it was brought before them last week, the two Democratic commissioners on the five person board did vote against the entire proposal to change the whistleblower rules. Commissioner Kara Stein went so far as to question whether the proposed changes were even legal under the Dodd-Frank enabling statute. Their dissent makes it clear that insiders understand the genesis of the proposal, not as some re-balancing justifiable as an improvement to the whistleblower program, but as an explicit attempt to weaken it, including the incentive to report large frauds. After all, if the SEC were concerned merely that the financial incentive to report smaller frauds is too weak, it could simply change the formula to give a bonus in the smallest cases without penalizing awards in the largest cases. This is especially true because the SEC is effectively unconstrained by budget authority in this instance, since Congress appropriated $550 million to initially prime the award pump and authorized the SEC to pay awards from the fines it receives once that initial amount runs low.
Much of the initial press focus has been on the proposal to limit large awards, given the easy-to-grasp hostility to whistleblowers evident in this scheme. However, the much more impactful part of the SEC’s proposal imposes a new standard, misleadingly labeled as a “clarification” of the existing rule, which disqualifies many award claimants whose initial tips include what the SEC expansively considers “public records.” The SEC’s talking point here is that nobody should get paid a whistleblower award for sending the SEC New York Times articles about sketchy financial behavior.
But this extreme example, which Congress already disallowed in the enabling Dodd-Frank legislation, is a red herring.
The real issue is that massive evidence of financial and corporate fraud exists in public documents, including the SEC’s own publicly-accessible databases. The SEC proposes to deny awards based on such public records if the agency determines, in its own opinion, that it could have figured out the fraud without the whistleblower’s help, had it reviewed the public records presented by the whistleblower:
[A] whistleblower’s submission must provide evaluation, assessment, or insight beyond what would be reasonably apparent to the Commission from publicly available information. In assessing whether this requirement is met, the Commission would determine based on its own review of the relevant facts during the award adjudication process whether the violations could have been inferred from the facts available in public sources.
Whistleblower lawyers call this as the “woulda, coulda, shoulda” standard, where the SEC would be relieved from arguing that it did know about a securities law violation prior to receiving a whistleblower’s public records, but instead would merely have to assert that it could have known if it had, for whatever reason, independently reviewed the documents presented by the whistleblower.
This proposal amounts to a middle finger directed at the entire securities analysis industry, where thousands of experts toil over public records looking for, among other things, signs of fraud. Make no mistake, given the resources allocated to them, professional investors are by far the most likely source of insight about credible, large-scale corporate fraud. Those insights are derived largely from public SEC filings. It must be very uncomfortable, whenever the SEC meets with such whistleblowers and asks them to explain the source of their evidence about fraud unknown to the SEC, and the whistleblowers effectively say, “I found it in your file cabinets.”
By contrast, Mary Jo White loved to sing the praises of corporate insider whistleblowers, whom she repeatedly described in public statements as giving the SEC insight into wrong-doing that would otherwise never have been visible to the agency. In other words, to some degree, the agency made its peace with the good citizen, corporate insider “see something, say something” paradigm, especially since the SEC staff was able to tell itself that these people have information advantages that no outside law enforcement person could ever hope to replicate. Stock analysts and professional fraud hunters like Ted Siedle, on the other hand, are at a clear information disadvantage relative to SEC staff, since they can’t do things like subpoena corporate records. Yet we’ve seen lots of evidence that these people are running circles around the SEC staff, In other words, it looks like resentment is driving this proposed change.
It’s also important to recognize that many of the most important securities law violations, in the sense of those that rise to the level of “industry practice,” can really only be uncovered with public records. The obvious reason is that, other than accountants and lawyers, who are barred from receiving awards, almost nobody is an insider at more than one company at a time, so if something pervasive is to be unearthed, it will almost certainly involve information that has leaked into the public domain.
The stock option back-dating scandal from the early 2000s is a classic example of outsiders finding what the SEC missed with the SEC’s won information, though it predated the whistleblower award program. A series of academic papers, leading to a Wall Street Journal series of articles, demonstrated that companies were pervasively back-dating stock options. The revelation leading to the resignation of more than 50 senior executives. How had the professors and the Wall Street Journal unearthed the practice? They simply compared the dates on companies’ more widely viewed SEC filings, which showed earlier dates for the option issuance, with the dates on more obscure, seldom viewed SEC filings, which showed that the options had been issued later.
Had this backdating been unearthed by a whistleblower, would they meet the standard for an award? Who knows? The SEC could merely claim that, if it had bothered to compare these different filings in the relevant cases, it would have spotted the date discrepancy. Notably, the SEC would not need to claim that there is any likelihood that it would have ever looked at this on its own, just that if it had reviewed the needles-in-a-haystack documents, once the whistleblower had done the work of pulling them out of the haystack, they would have figured it out.
Moreover, the SEC’s proposal tries to give comfort by claiming that public documents are admissible if the whistleblower uses them as a basis for “independent analysis,” which means revealing the pattern of fraud that otherwise would not be apparent to the SEC. The SEC contrasts this hazy standard with the non-qualifying action of a whistleblower who merely “aggregates information from multiple different sources.” Again, there is a reasonable argument that, basically, the academics and Wall Street Journal did little more than “aggregate information from multiple sources” in the options backdating case, since once the work of assembling the documents had been completed, it needed effectively no analysis.
We’ve heard over and over that the SEC hates cases implicating a large number of firms in wrong-doing. Such cases present severe staffing challenges for the agency. But more important, they challenge a core ideological assumption of the SEC, which is that wrong-doing is a problem of “a few bad apples.”
This orthodoxy is so strong within the agency that, when evidence of industry-practice lawbreaking emerges, the SEC is known to engage in “it’s me, not you” self-flagellation. This means the SEC embracing a narrative that it failed in some way to properly educate the industry about its legal obligations with respect to the practice where the widespread law-breaking is occurring. You can see how this attitude leads to a hostility toward the people bringing them evidence of widespread wrong-doing and results in the current effort to choke off incentives for such individuals to come forward.
It’s also worth noting that the concept of what the SEC considers a public record is extremely broad and encompasses many types of documents that the agency would effectively never have access to without whistleblowers. For example, a whistleblower might fly from the US to Botswana and then travel hundreds of miles over dirt roads to access records of mine production that exist only on paper in a local government office there. These records could contradict statements that the mine owner makes in SEC filings about their mine productivity, thereby exposing a fraud. Yet the whistleblower in this case would get no credit for knowing the one location on Earth where the mine record exists or for having expended considerable effort to obtain it. Instead, the SEC would apply a test where it would look at the Bostwana mine record and the mining company’s SEC filings, and if the agency considered the fraud to be self-evident based on those, the whistleblower would be barred from an award.
Ultimately, the SEC whistleblower program closely parallels many financial reform initiatives we have chronicled on the blog. They are announced with great fanfare and hailed as showing real promise of implementing lasting reform. But success proves fragile and hostile forces look for every opportunity to weaken the initiative through inaction and bureaucratic strangulation. In moments when they are powerful, as the whistleblower program foes are now, they seek structural changes, often dressed up as mere administrative accommodations, that would permanently kill the program in all but name.