Category: Whistleblower

The Rise of the Professional Whistleblower

With the proliferation of whistleblower regimes at regulatory agencies we should not be surprised that there are professional whistleblowers.

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The Securities and Exchange Commission gave its blessing earlier this year when it granted a whistleblower award to a company outsider.

This week the SEC and the DOJ announced a half billion dollar settlement with State Street for overcharging its customers on foreign currency trades. As part of its custody bank line of business, State Street offered indirect foreign currency exchange trading for clients to buy and sell foreign currencies as needed to settle their transactions involving foreign securities. State Street misleading its custody clients about this service by telling them that it provided “best execution,” or charged “market rates” on the transactions. In practice, State Street set prices largely driven by predetermined, uniform markups and made no effort to obtain the best possible prices for these clients.

FX trading had been a very lucrative area because the pricing was opaque.  It seems a little obscure for the SEC to find this nugget of compliance failure.

Apparently it didn’t find it. The SEC was apparently alerted by Harry Markopolos.

That’s the same Harry who rose to fame for writing letters to the SEC about Madoff. Harry has become a professional whistleblower. Harry has been helping State Street’s clients sue the firm to recover the FX overcharges. He comes with a big name after riding on the glory of his Madoff exploits.

I would guess that we will see a growing number of firms offering services to whistleblowers.

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Whistleblower Revealed

Several weeks ago the Securities and Exchange Commission handed out a big whistleblower award to an industry expert who lacked the first person knowledge of wrongdoing. That whistleblower has been revealed.

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The SEC itself has a strict rule on disclosing the identity of whistleblowers. Eric Hunsader said the Securities and Exchange Commission is sending him a $750,000 whistleblower award according to Francine McKenna of Marketwatch.

The SEC fined the New York Stock Exchange and its parent NYSE Euronext in 2012 for violating Regulation NMS. The NYSE sent data through two of its proprietary feeds before sending that data to the consolidated feeds, according to the SEC.

Hunsader said his firm, Nanex, originally discovered the issue on the day of the flash crash, May 6, 2010: Analysis of the “Flash Crash”.

With high-frequency trading small delays in quotes can lead to dramatic changes in trading. The NYSE data feed was delayed because of the diversion, resulting in the quotes being time-stamped improperly. This inaccuracy in data lead to a flood of short-selling causing prices to drop dramatically.

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Could Whistleblowing Be The New Short-Selling?

The Securities and Exchange Commission made an unusual announcement this week, announcing a whistleblower award to a company outsider. Could this been a new way to profit from companies engaged in fraud? Is this a new alternative to short selling?

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Earlier this week, the SEC announced a $700,000 award to a company outsider who conducted a detailed analysis that led to a successful SEC enforcement action.

“The voluntary submission of high-quality analysis by industry experts can be every bit as valuable as first-hand knowledge of wrongdoing by company insiders,” said Andrew Ceresney, Director of the SEC’s Enforcement Division.

Whistleblowers inside a company are at risk. They risk losing promotions, bonuses, or even their jobs. Of course, they can file whistleblower retaliation claims, but even that recovery can be risky.

The traditional route for an outsider to gain from a company’s malfeasance is to short sell the stock. Of course that is risky as well. When you buy a stock, all that is at risk is the money you paid for the stock. A short position has a much bigger loss potential. If you are wrong and the stock rises, you are at loss for all of that gain. You can look at the problems Bill Ackman is having with his Herbalife short.

Now the SEC has opened the window to earning a whistleblower award for providing “high-quality analysis by industry experts” that leads to a successful SEC enforcement action. The earning potential is lower, but you don’t have capital at risk. You also don’t risk losing your job.

By law, the SEC protects the confidentiality of whistleblowers and does not disclose information that might directly or indirectly reveal a whistleblower’s identity. We don’t know anymore behind the award.

I had expected that the recipient would have stepped forward to trumpet his or her success as a professional whistleblower. So far, that has not happened. I suspect there is more to the story.

The SEC order for the whistleblower award lists four people claiming an award. The preliminary determination denied three of the four. One of those contested, but still lost.  That claimant had supplied tips to the SEC, but whatever was supplied was not sufficient.  Those tips were designated for “no further action.” Upon review of the information it was not sufficient to and lacked factual connections between the tips and the enforcement action.

It sounds the ranks of professional whistleblowers are growing.

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Whistleblower Retaliation

A year ago, the Securities and Exchange Commission charged Paradigm Capital Management with engaging in prohibited transactions and then retaliating against the head trader who reported the trading activity to the SEC. It was the first time the SEC filed a case under its new authority to bring anti-retaliation enforcement actions. Now it has handed part of the penalty to the whistleblower.

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The underlying problem, according to the SEC’s order, was that the firm’s principal conducted transactions between Paradigm and a broker-dealer that she also owned while trading on behalf of a hedge fund client. Principal transactions pose conflicts between the interests of the adviser and the client. Under an SEC rule advisers are required to disclose that they are participating on both sides of the trade and must obtain the client’s consent.

It’s tricky to effectuate consent for a hedge fund. Most hedge funds are privately-owned so there is no board of directors to act on behalf of the fund. The head trader and the SEC thought that the hedge fund’s conflict process was ineffective. Paradigm made the mistake of mistreating the head trader, turning the actions into retaliation against the whistleblower. Paradigm settled the case for $2 million.

In turn, the SEC granted the whistleblower the maximum award of 30% of the settlement.

The whistleblower first submitted the case to the SEC in March 2012 and disclosed that he or she had done so to Paradigm in July 2012, suffering a month of mistreatment before resigning. It took two years before the SEC settled the case with Paradigm and another year for the whistleblower to receive the award.

That’s a long time for the wheels of justice to turn for the whistleblower.

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Compliance Officer Earns Million-Dollar Whistleblower Award

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I’m not sure if this is good news or bad news.

In August 2014 the SEC announced a modest whistleblower award of $300,000 to an unnamed company employee “who performed audit and compliance functions and reported wrongdoing to the SEC after the company failed to take action when the employee reported it internally.

There is little in this latest award to figure out the company involved. The amount of the fine assessed against the company and the percentage chosen by the SEC’s Claims Review Staff are redacted.

“This compliance officer reported misconduct after responsible management at the entity became aware of potentially impending harm to investors and failed to take steps to prevent it.” – Andrew Ceresney, Director of the SEC’s Division of Enforcement

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SEC Action for Stifling Whistleblowers in Confidentiality Agreements

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A story surfaced a few weeks ago that the Securities and Exchange Commission was taking a close look at employment agreements that limited the actions of whistleblowers. The story behind the story came out. The SEC brought an action against KBR, Inc. for violating whistleblower protection Rule 21F-17 enacted under the Dodd-Frank Act.

KBR required witnesses in certain internal investigations interviews to sign confidentiality statements with language warning that they could face discipline if they discussed the matters with outside parties without the prior approval of KBR’s legal department.  Since these investigations could have included allegations of possible securities law violations, the SEC found that these terms violated Rule 21F-17, which prohibits companies from taking any action to impede whistleblowers from reporting possible securities violations to the SEC.

The 2010 Dodd-Frank financial-reform bill granted a financial incentive for whistleblowers. A tipster can get between 10% and 30% of the penalty collected if their information leads to an SEC action. The whistleblower program handed out an award for more than $30 million last year that caught the attention of many.

The Dodd-Frank whistleblower regulations prohibit companies from interfering with employees reporting potential securities-law violations to the SEC. Rule 21F-17 provides in relevant part:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

The form confidentiality statement that KBR has used before and since the SEC adopted Rule 21F-17 requires witnesses to agree to the following provisions:

I understand that in order to protect the integrity of this review, I am prohibited from discussing any particulars regarding this interview and the subject matter discussed during the interview, without the prior authorization of the Law Department. I understand that the unauthorized disclosure of information may be grounds for disciplinary action up to and including termination of employment.

I bet many companies have a similar confidentiality provision.

The SEC brought the action even though it was not aware of any instances in which an employee was prevented from communicating the SEC about a potential securities law violation. Beyond that, the SEC was not aware of any instances in which KBR even tried to enforce the confidentiality provision.

KBR agreed to pay a $130,000 penalty to settle the SEC’s charges. The company voluntarily amended its confidentiality statement by adding the following language:

Nothing in this Confidentiality Statement prohibits me from reporting possible violations of federal law or regulation to any governmental agency or entity, including but not limited to the Department of Justice, the Securities and Exchange Commission, the Congress, and any agency Inspector General, or making other disclosures that are protected under the whistleblower provisions of federal law or regulation. I do not need the prior authorization of the Law Department to make any such reports or disclosures and I am not required to notify the company that I have made such reports or disclosures.

KBR also agreed to reach out to KBR employees subject to that confidentiality after August 21, 2011 (the date the rule was in effect) to say that the agreement does not prevent them from reaching out to the government to report possible violations.

KBR was the sacrifice to alert others to this potential problem. It seems harsh for KBR considering there is no statement of an incident where harm was done. I would assume that the confidentiality provision surfaced as part of some other government investigation of KBR.

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The SEC, Whistleblowers, and Employment Agreements

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The Securities and Exchange Commission is taking a look at the backlash in corporate America over the increased whistleblower regime. As with all new regulations, businesses will change practices to meet the requirements and take steps to lessen the impact. According to a story in the Wall Street Journal, the SEC is looking at these practices.

The 2010 Dodd-Frank financial-reform bill granted a financial incentive for whistleblowers. A tipster can get between 10% and 30% of the penalty collected if their information leads to an SEC action. The whistleblower program handed out an award for more than $30 million last year that caught the attention of many.

The Dodd-Frank whistleblower regulations prohibit companies from interfering with employees reporting potential securities-law violations to the SEC. But the SEC did include a provision in the regulations that promoted talking to the company first.

As you might expect companies want to lessen the chances that an employee that notices a problem will go running to the SEC. A case in point is the recent claim of impropriety and then recant by a compliance officer at Cabot Lodge Securities. The specific details of those transactions were redacted in the complaint so we don’t know exactly what happened. It looks like the whistleblower did not know all of the facts and shot off an errant complaint.

Company’s counters to these problems apparently are taking many forms. I assume a few will catch the SEC’s attention and will find them unacceptable. Prohibiting an employee from telling the government about wrongdoing is going to be a problem.

Requiring an employee to turn over any compensation from government probes to the company is an interesting approach. It removes the financial incentive for participating in the whistleblower program. There are other situations where employees are required to turn over compensation to the company. Those are generally situation where the employee has done something good.

I’m sure there is a wide assortment of severance arrangements. I assume the concern is that there could be a situation where a company paid-off an employee with a rich severance to prevent the employee from reporting a problem to the government.

I’m sure there will be more from this in the future.

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Meet the SEC Whistleblowers

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Since the Securities and Exchange Commission set up its whistleblower program in 2011, 6500 people have stepped forward as “whistleblowers.” Maxwell Murphy of the Wall Street Journal made a Freedom of Information Act request to find out more.

How successful has the program been and are the people filing really “whistleblowers”?

Of those 6500, only 42 listed themselves as executives or board members. Retirees were the largest group with 365 reports, followed by investors with 290 complaints and engineers coming in third.

According to the 2013 annual report, there were 334 whistleblower reports in 2011, with 3001 in FY2012 and 2013 in FY2103.

The SEC has doled out six whistleblower bounties. Discounting the time it takes to bring a case and investigate, the bounties may not have caught up with the complaints filed. Perhaps the ratio will become better than 1 in 1000.

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Whistleblower Mistakes by a Private Fund

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Paradigm Capital Management encountered a whistleblower and handled it poorly. The hedge fund had been conducting principal trades in violation of  Section 206(3) of the Investment Advisers Act. Paradigm’s head trader reported the violations to the Securities and Exchange Commission.

It’s tricky to deal with a hedge fund making principal trades with an affiliated broker-dealer. The principal trade requires consent of the client under SEC Rule 206(3)-2. With a hedge fund, it’s not the investors who are the client. It’s the fund that is the client.

That makes it tricky to structure the consent. Most hedge funds are privately-owned so there is no board of directors to act on behalf of the fund. That was true with Paradigm where Candace King Weir owned 73% of the advisory firm and 73% of the broker-dealer.

Paradigm tried to do the right thing and established a conflicts committee. It consisted of the CCO and CFO of Paradigm. The problem was that the CFO reported to Weir, so the CFO’s presence did not alleviate the conflict.

Paradigm was ordered to pay a penalty of $1.7 million as an “approximation of certain administrative fees the Fund paid in connection with the principal transactions….” The order does not go into detail about the investors in the fund were hurt by the principal trades.

The order spends its most time discussing the whistleblower aspects of the case.

It was Paradigm’s head trader who made a whistleblower submission to the SEC in March 2012. That’s about seven months after the new whistleblower rule went into effect, making the trader eligible for up to 30% of the penalty.

The head trader continued doing his job until the middle of July. At that point he told the firm that he reported a possible securities law violation to the SEC.

The next day Paradigm pulled him off the trading desk and relieved him of his day-to-day responsibilities. The firm sent him off-site to prepare a report on all the facts that supported his claims. Eventually, he ended up working at home.

Paradigm was looking for a “gotcha” moment to fire the whistleblower. That came when he sent a confidential document to Paradigm’s CCO. The firm accused the whistleblower of removing confidential documents in violation of firm policy and the confidentiality agreement he signed when he joined the firm. He eventually resigned because of the adverse treatment.

Paradigm had a compliance failure. Principal trades are bad for investment advisers and tricky for hedge funds.  But I would guess that it was the firm’s treatment of the whistleblower that resulted in such a harsh penalty.

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How Well is the SEC’s Whistleblower Program Working?

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Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act created the SEC’s whistleblower program, awarding cash to individuals who report misdeeds that result in successful SEC cases. If the SEC collects more than $1 million, the whistleblower can receive between 10% and 30% of the award. Section 922 also required the Office of Inspector General to conduct a review of the whistleblower program within 30 months.

Surprisingly, the Inspector General had only good things to say about the program, with only two minor recommendations. I say ‘surprisingly’ because the reports from the Inspector General have recently been harsh criticisms. Not this time.

The implementation of the final rules made the SEC’s whistleblower program clearly defined and user-friendly for users that have basic securities laws, rules, and regulations knowledge. The whistleblower program is promoted on the SEC’s website and the public can access OWB’s website from the site in four or more possible ways to learn about the whistleblower program or to file a complaint with the SEC. Additionally, OWB outreach efforts have been strong and the SEC’s whistleblower program can be promptly located using internet search engines such as Google, Yahoo, and Bing.

The two recommendations from the OIG are both related to adding metrics to in the program to better monitor program performance. For example there is no standard on how long a filing should stay in the manual “triage” step in the program. The average is 31 days. By adding thoughtful metrics and performance goals the SEC could help to avoid degradation in performance and longer response times.

One key finding in the report is that there is no current need to create a private right of action based on the facts of a whistleblower complaint. The OIG report points to a possible reduction of the government’s ability to shape and develop the law. Private suits could lead to wasteful, detrimental developments that are inconsistent with executive and judicial interpretations.

But the concept is not dead. The OIG promises to revisit the private action concept in a few years after there is more data from the new whistleblower program.

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