The SEC Whistleblower Program: How to Avoid Killing a Good Idea
By Eric R. Havian, Edited by Dina Rasor
Wednesday 15 December, 2010
The American experiment with whistleblower laws is now almost 150 years old. The first attempt was the “False Claims Act” or “Lincoln Law,” passed in 1863 to address fraud against the Union Army by war profiteers who sold the Army sawdust rather than gun powder, and, in place of healthy horses, “spavined beasts and dying donkeys.” Based on the idea of “setting a rogue to catch a rogue,” the False Claims Act provided a reward to anyone who came forward with proof of fraud or “false claims” made against the United States government – a bounty hunter provision.
Nearly a century and a half later, the SEC is at a critical point in setting up an SEC whistleblower reward program that it successfully lobbied Congress to pass earlier this year. It is considering regulations that will determine whether the SEC whistleblower program will be either a revolutionary enforcement tool or another eviscerated government effort to protect investors. Many have predicted that this new law will generate an avalanche of reporting of financial fraud that otherwise would have remained hidden. As the SEC begins to implement that program, it is a fair question whether the agency will heed the lessons learned since 1863. History shows that properly implemented whistleblower programs can return billions of dollars of ill-gotten gains to the Treasury and deter the loss of billions more, but also that whistleblower programs can be stifled by restrictive practices and interpretations of the law by entrenched bureaucrats.
As it implements its own program, the SEC needs to carefully review our nation's long experience with whistleblower laws. Only by paying close attention to that experience can the agency hope to avoid the mistakes made by other agencies that have previously administered similar programs.
The Department of Justice Experience
The False Claims Act has been amended several times since 1863, in an effort to find the “golden mean” between providing an incentive for true whistleblowers with insider knowledge, while denying any reward to those who simply repackage yesterday's news. In one extreme case, a whistleblower collected a reward after reading about a criminal indictment and regurgitating the allegations as a “whistleblower.” At the other extreme, a court denied a reward to a whistleblower based on a finding that the whistleblower's information had already been “publicly disclosed” – by the whistleblower in a private conversation with his AARP counselor.
But the most critical shortcoming of the pre-1986 False Claims Act was that it did not guaranty any minimum reward to whistleblowers; the amount was entirely within the discretion of the Department of Justice (DOJ) and the courts. Without a guaranteed reward, government recoveries in all False Claims Act in 1985, the year before the law was amended, were less than $30 million.
In 1986, in the wake of revelations about the Pentagon's payment of hundreds and even thousands of dollars for hammers and toilet seats, Congress changed the law to guaranty whistleblowers a minimum of 15 percent of any amounts their cases recovered for the Treasury. As it had previously, the law also allowed the whistleblower to file his or her own court case and to participate as a full party (known as the qui tam provision), litigating alongside career attorneys at the Civil Division of the DOJ. Congress expressly encouraged the DOJ lawyers to form a “public-private partnership” with whistleblowers and their attorneys.
Lawyers representing corporate defendants lost little time in predicting dire consequences as a result of what they referred to as the “bounty hunter” incentives created by the new law. Many warned that setting loose avaricious Americans on their employers would result in vindictive and frivolous litigation. They predicted that the law would jeopardize “civil liberties” and undermine “normal business procedures.”
The DOJ Civil Division in 1986 had minimal experience with suing companies that overcharged the government. Much of the Civil Division's work was devoted to defending the government, in such cases as myopic postal workers who ran over pedestrians, rather than suing aerospace contractors for selling defective bombers. Understandably, some in the DOJ viewed Congress' decision to send “help” in the form of whistleblowers and their lawyers as an implicit rebuke.
That attitude was manifest in a number of self-defeating DOJ policies and practices. The DOJ opposed passage of the law, saying it would “seriously hamper our civil fraud enforcement efforts.” DOJ attorneys often tried to limit access to evidence by the lawyers representing whistleblowers, and most did not actively consult with those lawyers in the course of the DOJ investigation. The DOJ advocated restrictive interpretations of the law, and the Civil Division took the position that the law was unconstitutional and should be challenged in court. Many DOJ lawyers treated the whistleblowers worse than ordinary witnesses, and in some instances, as adversaries clawing for a piece of the government's recovery. In these early years, Congress' expressed hope of a public-private partnership was mostly ignored.
The view of many was aptly expressed by one government lawyer who worked on an early blockbuster case challenging the practice known as “bundling,” a technique that medical lab chains were using to overcharge Medicare. The case rested on a legal theory the whistleblower's attorneys had spent months developing and trying to persuade the DOJ lawyer and her skeptical colleagues to adopt. Eventually, the theory proved enormously successful and spawned a nationwide government initiative that recovered hundreds of millions from the defendant and other companies engaged in the same fraudulent practice. Notwithstanding that result, the DOJ lawyer acidly commented to the press that the $22 million reward paid to the whistleblower out of the government's initial $100 million recovery was “a lot of money for a tip.”
Maybe so, but the “tips” began to come fast and furious. As word of multimillion dollar rewards spread, the number of high-quality cases quickly outstripped the DOJ's ability to handle them. Hiring at the DOJ's Civil Division expanded rapidly, resulting in the establishment around the country of special “Affirmative Civil Enforcement” units to deal specifically with False Claims Act litigation, most of which was initiated by whistleblowers. The new lawyers arrived without the baggage of some of the more seasoned veterans, and even many of the old guard came to appreciate that at least some whistleblowers and their attorneys brought a lot more value than just a “tip.”
Today, many of the largest False Claims Act cases are litigated by a few DOJ lawyers sharing the work with dozens of private attorneys representing a whistleblower, for the first time allowing the government to match the armies of lawyers fielded by Fortune 500 defendants. In one of our cases, 30 private whistleblower attorneys teamed up with a few attorneys from the DOJ, squaring off against dozens of corporate litigators. After years of litigation and $35 million in fees spent by the whistleblower lawyers, the defendant capitulated and paid the government $650 million, from which the whistleblowers received $100 million. Most DOJ attorneys greatly appreciate this assistance, and many US attorneys' offices actively court whistleblowers to file cases in their districts.
The result of this collaboration has been an explosion of False Claims Act whistleblower cases, with enormous sums of money returned to the Treasury. Since the law was amended in 1986, whistleblower cases have recovered $18 billion. As more whistleblower cases are filed, more rewards are paid, which prompts still more cases to be filed in a virtuous cycle of positive reinforcement. Moreover, good cases are generally successful. In 95 percent of the cases that the DOJ joins, the defendant pays a settlement or loses in court. Whistleblowers in those cases have collectively received $2.8 billion. On the other hand, when the DOJ declines to join a case (often because it lacks merit), the defendant pays only 6 percent of the time. The message to whistleblowers and their lawyers is clear: good cases yield substantial rewards; weak cases are a bad investment.
The IRS Program
The origins of the IRS whistleblower program strikingly resemble those of the DOJ program in 1986. Like the DOJ, the IRS had a whistleblower reward program in place for decades with no guaranteed reward. As one Senate report observed, this program was “largely ineffective.” With a handful of exceptions, few IRS whistleblower submissions led to recovery of substantial sums of money.
In 2006, Congress debated an IRS whistleblower law for tax cases, which were not covered by the False Claims Act. Determined to learn from the DOJ's successful program, IRS officials met with DOJ lawyers to discuss how to shape the new tax initiative. Ultimately, the IRS decided to copy the False Claims Act's guaranteed minimum 15 percent reward for information leading to the collection of unpaid taxes. In order to avoid small claims by vindictive citizens targeting their neighbors, the legislation created a minimum threshold of $2 million in underpaid tax.
The IRS decided, however, that it did not want a qui tam mechanism, i.e. one in which the whistleblower could file a court case on his or her own and work in tandem with government lawyers. Instead, the IRS chose a program that would require the whistleblower to provide a submission to the IRS, which would handle the case exclusively from beginning to end. Unlike the False Claims Act, there would be no public-private partnership. That proved to be a costly decision.
The doomsayers once again emerged. Donald Korb, formerly the IRS chief counsel and now a partner at Sullivan and Cromwell, told an interviewer, “The new whistle-blower provisions Congress enacted a couple of years ago have the potential to be a real disaster for the tax system,” adding, “It's a ticking time bomb.”
Notwithstanding that gloomy assessment, the IRS program had a promising start. The law directed the creation of a “Whistleblower Office” dedicated specifically to the new program. Wisely, the IRS staffed that office with persons fully committed to the mission of creating a vibrant program to encourage whistleblowers to come forward.
Initially, it appeared that the Whistleblower Office would allow the IRS to avoid many of the problems that had plagued the early DOJ program. Institutional resistance and resentment would be overcome by an office with the specific mission to encourage whistleblowers. Cramped interpretations of the law would be avoided by deferring to the views of the Whistleblower Office on matters within its purview. And whistleblowers would be embraced, rather than resented, by a group of professionals dedicated to encouraging them to come forward.
First results were positive. As word of the new law spread, the IRS received hundreds of high-quality submissions pointing to the evasion of many billions of dollars in taxes. In its first report to Congress on the new law, the IRS stated that in the 2008 fiscal year the agency received 1,246 referrals from whistleblowers, and in 228 cases the alleged tax underpayment was greater than $10 million. Sixty-four alleged a tax underpayment of $100 million or more. The IRS observed that the whistleblowers “often provide extensive documentation to support their claims.”
Unfortunately, another power center in the IRS opposed the creation of this new program, and was determined to do everything possible to blunt its effectiveness. The Office of Chief Counsel (OCC) acts as the attorney for the IRS, and the OCC's memoranda determine how the IRS will promulgate, interpret and apply tax laws and regulations. In its hostility to the new whistleblower program, the OCC was like the early DOJ on steroids.
Korb, the former chief of the OCC, made clear that the IRS did not want the whistleblower program, stating, “The IRS didn't ask for these rules; they were forced on it by the Congress.” He also offered his opinion that “it is unseemly in this country to encourage people to turn in their neighbors.” (Korb must live in a tony neighborhood, since the program is limited to tax underpayments of at least $2 million.)
Although Korb is no longer at the IRS, his views remain. The OCC wasted little time issuing legal edicts that placed a strait jacket around the whistleblower program. The OCC's pronouncements, coupled with the IRS' traditional obsession with investigative secrecy that permeates the organization, have effectively closed down any prospect of collaboration between the IRS and whistleblowers.
Alarmed by these developments, Sen. Charles Grassley, who has oversight responsibility for the IRS and was the legislative architect of both the revitalized False Claims Act and the IRS whistleblower program, sent a letter of protest to the agency. The letter raised concerns over a number of the OCC policies that Senator Grassley perceived as inconsistent with the legislation he had authored. In a letter to Treasury Secretary Geithner, Grassley wrote, “I have serious concerns that the new [Internal Revenue Manual] provisions will deter whistleblowers from filing claims.”
For example, the OCC decided that not only would the IRS typically not collaborate with whistleblowers, it would refuse even to speak with them more than once if they were employed by the target company. The OCC justified this “one-bite” rule as required by the Fourth Amendment. But the DOJ, which also operates under the restrictions of the Fourth Amendment, has no such policy and often interviews whistleblowers many times, whether or not they continue to work for the defendant company. After a firestorm of criticism, the OCC softened its rigid application of the one-bite rule, but the IRS still applies the rule in many circumstances where the DOJ would not.
In an equally short-sighted move, the IRS has adopted a policy that whistleblowers will not be entitled to any reward if they provide information that leads to the denial of a tax refund that otherwise would have been made. So, if a taxpayer fraudulently claimed deductions that resulted in the evasion of $10 million in taxes, the whistleblower would receive a minimum reward of $1.5 million. But if the same fraud caused the IRS to deny a $10 million tax refund that it otherwise would have paid, the whistleblower would get nothing. In both cases, the whistleblower has saved the Federal Treasury $10 million, and the IRS whistleblower statute provides no support for the OCC's arbitrary distinction. Of course, such a rule (if it were allowed to stand) would simply cause whistleblowers to stop reporting fraud in connection with tax refunds. The losers would be the IRS and US taxpayers stuck with the fraudulent bill.
Finally, and perhaps most damaging, the OCC has determined that almost no exceptions to the typical IRS secrecy rules will be made for collaborating with whistleblowers. Under existing law, the IRS is precluded from revealing “taxpayer information” except in certain circumstances. Taxpayer information is interpreted very broadly in a manner that restricts the IRS' ability to share information with a whistleblower or his attorneys. By law, the IRS can make exceptions to the policy by entering into confidentiality agreements with witnesses (including whistleblowers), consultants, and others who can assist with an investigation, but the OCC has taken the position that the permitted exceptions to this secrecy rule will be invoked only rarely (in practice, almost never) in whistleblower cases. While this ironclad secrecy might make sense in the context of personal tax returns, which can reveal sensitive and personal information about individuals, it is inappropriate to apply the protections to corporate taxpayers, who are the primary targets of the whistleblower program.
As a result of these restrictive policies, in most cases the IRS conducts only a single interview with the whistleblower, and subsequently provides no further information to the whistleblower or their attorney about the status of the investigation until the matter is resolved. Where the DOJ takes advantage of whistleblowers' insider status to respond to defenses raised by the target company, and to identify additional witnesses and evidence as the investigation proceeds, the IRS isolates the insider and their valuable information and insights. Where the DOJ draws on the whistleblowers' attorneys to help review documents, draft subpoenas and conduct legal research, the IRS does the entire investigation on its own. In fact, many in the IRS interpret the secrecy requirements in a manner that precludes them even from “brainstorming” with whistleblower attorneys about technical legal issues. IRS policies, coupled with the absence of a qui tam mechanism that would allow whistleblowers to file their own court case, make it impossible to create the public-private partnership that has been so successful for the DOJ.
As a consequence, the IRS finds itself swamped with an enormous and growing backlog of high-quality whistleblower cases. Despite the filing of thousands of submissions in the past four years, the IRS has not yet paid a single reward under the new statute. As most attorneys can attest, cases do not improve with age.
The SEC Whistleblower Law
In 2010, Congress passed the Dodd-Frank bill, which, among other provisions, created an SEC whistleblower law. Dodd-Frank is modeled after the IRS whistleblower statute rather than the False Claims Act. The law entitles whistleblowers to a reward of 10-30 percent of funds recovered by government agencies as a result of the submission of “original information” to the SEC or the Commodities Futures Trading Commission. There is no qui tam provision similar to the False Claims Act provision that allows whistleblowers to file their own cases. Instead, like the IRS program, Dodd-Frank vests complete discretion over whether to pursue a case with the SEC; the whistleblower has no right to participate at all in the investigation or prosecution of his or her referral.
There is reason to believe that this program will result in reporting of significant securities violations and billions of dollars in fines and disgorgement, especially in the area of the Foreign Corrupt Practices Act (FCPA), which prohibits paying bribes to foreign officials. In recent years, FCPA fines have been on the rise: Seimens paid $800 million, BAE $400 million, Technip $340 million and Daimler AG $180 million. It is likely that these instances merely scratch the surface. Large law firms have included extensive discussions of Dodd-Frank in newsletters to clients, warning of the risks of not implementing programs to deal with the potential onslaught of SEC whistleblowers.
The SEC recently released draft regulations to implement the Dodd-Frank whistleblower provisions. Predictably, the targets of the legislation and their attorneys are once again warning about dire consequences unless the SEC creates onerous regulations that would effectively discourage whistleblowers from coming forward.
The central corporate strategy to kill Dodd-Frank has now surfaced. Many corporate advocates insist that the SEC should deny any reward unless a whistleblower exhausts internal corporate compliance procedures (i.e. the company's internal “hotline” or whistleblower reporting programs) before filing an SEC submission. According to this argument, whistleblowers will never report fraud internally as long as they can collect a large bounty by going straight to the SEC. To illustrate the point, recent articles in Forbes and the Wall Street Journal both mentioned the $96 million reward given to a whistleblower under the False Claims Act for blowing the whistle on Glaxo Smithkline, which paid $750 million for defrauding federal health care programs. Citing this award, the articles quote one corporate insider saying that the SEC program “undermines a lot of work that a lot of us have done” to create internal fraud detection programs required by the Sarbanes-Oxley law. Another spokesperson asks, “Which do you think is going to win – an internal whistleblower program that relies on trust or one that offers a huge financial bounty?” The proposal to require formal internal reporting would eviscerate the SEC program at its inception, and addresses a problem that does not exist.
First, a requirement that whistleblowers must first exhaust internal compliance procedures erects an enormous roadblock to SEC reporting, defeating the entire purpose of the new law. For example, Dodd-Frank allows whistleblowers to file their submissions with the SEC anonymously, as long as they do so through an attorney. Even those who file submissions under their own names receive promises of strict confidentiality from the SEC. These provisions recognize that the largest frauds are often known only to the highest level executives, who will be reluctant to come forward without adequate assurances of confidentiality. But if formal internal reporting is a requirement, the instant the SEC begins its investigation and serves its first subpoena, the corporation will have a short list of possible whistleblowers – i.e. those persons who formally reported the fraud to internal compliance. It will not be difficult for corporate attorneys to hone in on the likely turncoats. Nothing will create a greater chilling effect on the SEC whistleblower program than this proposed internal reporting requirement.
Moreover, the internal reporting push is a “solution” in search of a nonexistent problem. As the author of the Forbes article acknowledged, the same supposed incentives have existed under the False Claims Act for 25 years. He observed, “the key question being asked today about Dodd-Frank could just as easily have been asked about the False Claims Act in 1986.” Despite the obvious relevance to their central argument, however, none of the corporate critics examines the track record of the False Claims Act.
In our firm's 20-plus years of filing whistleblower cases, in almost every instance, whistleblowers seek to report their concerns internally, only coming to us as a last resort. Often, the internal reporting is not to the formal “compliance program,” and for good reason. First, a formal report to corporate compliance is effectively an accusation that fraud exists, and that the normal chain of authority refuses to address it. Once that step is taken, the employee is forever branded as “not a team player.” It is far less threatening for the employee to discuss the problem with others in the supervisory chain in a low-key manner. Especially when senior executives are involved in the fraud, reporting to corporate compliance is tantamount to career suicide.
The observation that whistleblowers almost always seek to report internally is not unique to our firm. I recently spoke at a legal conference on the same panel as an attorney from one of the largest corporate firms in the country. In front of an audience of government and private sector lawyers, she suggested that corporations needed to make internal reporting more responsive to employees because, in almost every instance, whistleblowers use internal procedures before filing a False Claims Act case.
There is no evidence that the False Claims Act's large bounties have caused whistleblowers to systematically evade reporting fraud to their employers in order to reap large rewards. The fact that corporate lobbyists cite examples like Glaxo, where the whistleblower did report her concerns to the internal compliance organization and was fired for doing so speaks volumes. The critics cannot expect anyone to heed their dire, but entirely hypothetical, predictions when we have decades of evidence to the contrary. There is no more reason to believe SEC rewards will cause any greater circumvention of internal reporting than the False Claims Act has caused (i.e., almost none).
Despite the lack of any evidence of a problem, the current proposed SEC rules do propose measures to ensure the viability of effective internal compliance programs. The draft rules provide that internal reporting will be a “plus” factor for whistleblowers, justifying a higher reward, but such reporting is not a prerequisite to getting a reward within the guaranteed 10-30 percent range. In addition, if a whistleblower reports internally, then goes to the SEC, the rules provide that the SEC submission will be deemed made as of the date of the internal reporting. That mix of incentives strikes the right balance. The SEC should stick with its proposed rules on compliance programs and ignore the self-serving proposals by the fraud lobby to require internal reporting.
Another concern is whether the SEC, like the IRS and the DOJ initially, will seal itself off from the assistance that whistleblowers and their attorneys can provide. Unlike the IRS, the SEC has no secrecy statutes that limit its ability to share information with whistleblowers. If the SEC cuts itself off from private resources, it will be due to agency choice rather than statutory restrictions. Unfortunately, the SEC's newly created form letter sent to Dodd-Frank whistleblowers is hardly encouraging. Citing longstanding SEC “policy” to keep its investigations confidential, the letter informs whistleblowers, “we are unable to report to you if any action has or will be taken with respect to the issues you have raised.” The decision whether to shut whistleblowers and their attorneys out of SEC investigations could be the linchpin of whether this new law will be successful at curtailing fraud that has cost investors billions.
The DOJ's experience with the False Claims Act is, again, instructive. Once the DOJ overcame its initial reluctance to allow whistleblower lawyers “inside” their investigations, they were able to exploit the greatly increased resources those lawyers were able to provide. This multiplied the number of cases that the DOJ could effectively pursue with its limited staff. Although DOJ does have a backlog of pending cases, it concludes a large number of cases each year with impressive results, due in part to the assistance of whistleblowers and their lawyers.
The IRS provides the opposite example. Limited to its own internal resources, the IRS has a growing backlog of over a thousand cases, and since the law was passed in late 2006, not a single one of those cases has been resolved (other than the cases that lack merit and have, therefore, been rejected). The IRS is drowning in good cases that it simply lacks the resources to pursue in a timely way.
Congress has specifically required the SEC inspector general to report on whether there should be a qui tam mechanism for SEC cases, allowing whistleblowers to file their own cases. That approach is likely to be adopted unless the SEC follows the current DOJ approach and works closely with whistleblowers and their lawyers during the investigation of their submissions. Given the enormous volume of cases the SEC will likely receive, any other approach will swamp the agency and cause interminable investigative delays, allowing the Ponzi operators to bilk many more victims out of millions of dollars in savings.
As the SEC moves forward with its new program, it should ignore the strident howls of corporate lawyers beseeching the agency not to shred the fabric of corporate governance, and should rely on experience rather than rhetoric. The power and money of corporate lobbyists should not trump the proven track record of success established by whistleblowers under the False Claims Act.