July 21, 2010
During the midst of the financial crisis, the continued existence, much less powers, of the Securities and Exchange Commission were in doubt. But in the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commission emerged with expanded jurisdiction over hedge funds, credit ratings agencies, and governance of public companies, among other areas.
To help implement this authority, the Dodd-Frank Act added several new weapons to the Commission’s already substantial enforcement arsenal. Some of the provisions are clarifications (such as provisions assuring that certain anti-manipulation provisions extend to all non government securities) or simplify the enforcement process (such as providing for nationwide service of process in civil actions).
Several of the provisions could lead to significant changes in SEC enforcement practice and may have long term implications for public companies, their officers and employees, accountants, brokerage firms, investment advisers, and persons associated with them. These provisions (1) authorize new rewards to and provide expanded protections of whistleblowers; (2) provide the SEC authority to impose substantial administrative fines on all persons, not merely securities brokers, investment advisers and their associated persons; (3) broaden standards for the imposition of secondary liability; (4) confer on the SEC extraterritorial jurisdiction over alleged violations involving conduct abroad and enhancing the ability of the SEC and the Public Company Accounting Oversight Board ("PCAOB") to regulate foreign private accounting firms; and (5) increase collateral consequences of securities law violations. The Act also contains a provision which should help expedite the resolution of pending SEC enforcement investigations.
Whistleblowers who recover millions of dollars for reporting alleged fraud, waste and abuse in government contracts have long been a central feature of federal enforcement of the False Claims Act. In recent years, for example, the federal government has recovered hundreds of millions of dollars from pharmaceutical manufacturers who allegedly failed to comply with federal regulations and has paid out tens of millions to alleged whistleblowers.
Section 922 of the Dodd-Frank Act adds a new Section 21F of the Securities Exchange Act governing the treatment of whistleblowers. The Act states that a whistleblower who voluntarily provides information to the SEC that leads to a successful enforcement action resulting in over $1,000,000 of monetary sanctions may be awarded by the SEC an amount not less than 10% and not more than 30% of the monetary sanctions collected. The Act states that determination of the amount of the award shall be in the discretion of the SEC, taking into consideration the significance of the information provided, the degree of assistance provided, and the programmatic interest of the SEC in deterring violations of the securities laws by rewarding whistleblowers and other factors the SEC may establish. Whistleblowers may initially report violations either by name or anonymously. Sec. 922(a).
Under the Act, a "whistleblower" is any individual who provides, or two or more individuals acting jointly who provide, original information relating to a violation of the securities laws to the SEC derived from the individual or individuals’ own independent knowledge or analysis, not previously known to the Commission from another source, and not exclusively derived from external, publicly available information. (The Act prohibits awards paid to persons who were employed by "an appropriate regulatory agency," the Department of Justice, a self-regulatory organization, the Public Company Accounting Oversight Board, or a law enforcement organization, or a person who has been convicted of a crime related to the whistleblower’s complaint.) While the Act gives the Commission discretion to determine to whom or in what amount an award should be made, it does not expressly prohibit persons who are complicit in the alleged violation from collecting an award.
Similar reward provisions apply to whistleblowers who provide information to the Commodity Futures Trading Commission. Sec. 748.
The whistleblower reward provisions are not self-operative and will require SEC rulemaking. Section 924 of the Act requires the SEC to adopt implementing rules within 270 days of enactment. Once rules are adopted, however, public companies, brokerage firms, and investment advisers may see a substantial increase in the number, volume and size of whistleblower complaints made to the SEC regarding their businesses. While the legislation does not create a qui tam right of action analogous to that contained in the False Claims Act, the often large size of disgorgement and civil money penalty awards sought or imposed by the Commission provide a powerful financial incentive for persons to make claims of wrongdoing.
The Dodd-Frank Act creates new whistleblower protections for employees who provide information to or assist the SEC, authorizing a new private right of action for reinstatement, two times back pay, and other relief. This new cause of action can be brought in a federal district court within 6 years of a violation or 3 years of discovery, but in no event later than 10 years after a violation. Sec. 922(a). The Act contains similar but somewhat less expansive protections for employees who provide information to or assist the CFTC. Sec. 748.
The Act also expands the coverage of the existing Sarbanes-Oxley whistleblower protections by expressly including employees of subsidiaries of publicly traded companies included in their parent corporation’s consolidated financial statements, extending the statute of limitations from 90 to 180 days, prohibiting mandatory predispute arbitration agreements for Sarbanes-Oxley claims, and clarifying the right to a jury trial. Sec. 922(c). The Act also creates new causes of action for employee whistleblowers who provide information about certain consumer protection violations, Sec. 1057, and expands the scope of protected whistleblowing activity under the False Claims Act. Sec. 1079b.
The whistleblower provisions build on the SEC’s Enforcement cooperation initiative, announced in January 2010 and memorialized in the SEC’s Enforcement Manual. Securities and Exchange Commission Division of Enforcement, Enforcement Manual (Jan. 13, 2010), § 6 et seq., 123-140, available at www.sec.gov/divisions/enforce/enforcementmanual.pdf. The cooperation initiative permits the SEC and its staff to assure a cooperating individual that he or she will not be charged with a violation or will receive reduced sanctions in exchange for information leading to enforcement action against others and facilitates the process of receiving testimonial use immunity from the Department of Justice. Id., § 6.2, at 128-140.
The SEC first received broad authority to seek or impose civil money penalties in enforcement actions as a part of the Securities Remedies and Penny Stock Reform Act of 1990. Perceiving that such quasi-criminal remedies should not be imposed on persons who did not voluntarily choose to subject themselves to the SEC’s jurisdiction, Congress limited the SEC’s own authority to impose such remedies in administrative actions to persons who were associated with regulated enterprises — brokerage firms, investment advisers, investment companies and other registered entities. For all other persons, the SEC was required to seek an order from a federal district court in a civil action, triable by jury.
Dodd-Frank washes away this distinction. Instead, Section 929P of the Act amends Section 8A of the Securities Act, Section 21B(a) of the Securities Exchange Act, Section 9(d)(1) of the Investment Company Act, and Section 203(i)(1) of the Investment Advisers Act to permit the imposition of civil money penalties in addition to cease and desist orders. Additionally, for cease and desist proceedings instituted under the Securities Act, the Dodd-Frank Act adopts the three-tiered penalty grid already contained in the Securities Exchange Act, but raises the penalty amounts by fifty percent.
In part, the new authority codifies existing regulatory practice and it could facilitate negotiated resolutions of SEC enforcement actions. Historically, the SEC has sought civil money penalties in most of its enforcement actions. With regard to settlements of matters regarding non-registered persons, it has frequently bifurcated its settled proceedings into two different proceedings — one an administrative action imposing prospective cease and desist orders and ancillary relief; the other a civil, district court action seeking only the imposition of a civil money penalty. Because many regulatory provisions of the securities laws, such as the reporting and internal control requirements imposed on public companies by Section 13 of the Securities Exchange Act, are directly applicable only to issuers, the Commission had pursued its claims for civil penalties on a theory that an individual had "aided and abetted" the violation by the public company, a theory of violation that required allegations of scienter — either intentional or reckless misconduct. Now, persons seeking to settle actions can do so in one proceeding, and, if the settlement does not involve a claim of fraud, may do so in an administrative action asserting that the settling party was a "cause" of the violation, a claim which may be premised on negligence, rather than intentional or reckless misconduct.
On the other hand, this new authority also gives the SEC and its Enforcement Division a powerful incentive to bring more cases as administrative actions. Such actions can be disadvantageous to potential defendants in that (1) administrative actions go to hearing on an accelerated schedule in which a hearing must be completed and an initial decision rendered by an administrative law judge within 270 days of the filing of the Commission’s complaint; (2) there is no discovery in administrative proceedings; (3) there is no right of trial by jury; and (4) factual findings by the SEC in an administrative proceeding can only be reversed on appeal if the defendant shows that the findings failed to meet the "substantial evidence" test.
Still, certain enforcement remedies may only be imposed by a federal judge. These include, for example, an order issued pursuant to Section 21(d)(2) of the Securities Exchange Act prohibiting a person from serving as an officer or director of a public company, and an order requiring forfeiture of incentive based or equity based compensation following a restatement of financial statements under Section 304 of Sarbanes-Oxley.
The SEC has long relied on theories of secondary liability to enforce the federal securities laws, particularly those provisions, such as the reporting and internal controls requirements applicable to public companies, and the rules governing brokerage firms and investment advisers that were not directly applicable to individuals. To apply these provisions to individuals, the Commission commonly filed complaints alleging that an individual "aided and abetted" the violation by a company.
The SEC’s authority to allege aiding and abetting was called into question by a Supreme Court decision, Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). In 1995, Congress restored the SEC’s aiding and abetting claims as a part of the Private Securities Litigation Reform Act by adding Section 20(e) of the Securities Exchange Act which extended liability to "any person who knowingly provides substantial assistance to another in violation. . . ." Several circuit courts interpreted the "knowing" requirement to exclude reckless conduct, e.g., S.E.C. v. Fehn, 97 F.3d 1276 (9th Cir. 1996), while others, relying on pre Central Bank authority, held that recklessness sufficed to satisfy the state of mind requirements for liability, e.g., Graham v. S.E.C., 222 F.3d 994 (D.C. Cir. 2000).
Sections 929M through O of the Dodd-Frank Act attempt to end this division by amending Section 15 of the Securities Act and Section 20(e) of the Securities Exchange Act and adding Section 209(f) to the Investment Advisers Act to state that aiding and abetting which is "knowing or reckless" will be a basis for an action.
Securities markets are increasingly global with multinational companies listing securities for trading in the United States and with trading in U.S. securities occurring in overseas markets. At the end of its most recent term, however, the Supreme Court ruled that Section 10(b) of the Securities Exchange Act prohibited fraud only in connection with the purchase or sale of securities listed for trading on a domestic, United States exchange and did not extend to securities listed abroad but traded in the United States through American Depositary Receipts. Morrison v. National Australia Bank, N.A. ___ U.S. ___, No. 08-1191 (June 24, 2010).
In response, Congress added provisions to the Dodd-Frank Act which restored the authority of the SEC and of the Department of Justice. In particular, the Act amended Section 22 of the Securities Act, Section 27 of the Securities Exchange Act, and Section 214 of the Investment Advisers Act to confer U.S. court jurisdiction over violations of the three anti-fraud provisions involving (i) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors, or (ii) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.
Second, the Act amended Section 106 of the Sarbanes-Oxley Act to increase the authority of the Commission and the PCAOB to compel the production to them of audit work papers of foreign private accounting firms by making such firms subject to the jurisdiction of U.S. courts for purposes of enforcing such a request; requiring U.S. registered public accounting firms to secure the agreement of any foreign accounting firm upon which it relies in its audit to produce the work papers of that firm, and making a failure to comply a violation of law. The Act permits a foreign public accounting firm to produce work papers through alternate means, such as through foreign securities regulators.
Third, the Act adds confidentiality provisions that are intended to overcome objections by foreign authorities to inspections by the PCAOB and other US government data requests. For example, in testimony to the Congress, the PCAOB reported that it had been unable to conduct examinations of certain foreign registered public accounting firms because some overseas authorities believed that US law did not permit the PCAOB to share information with its overseas counterparts. Additionally, overseas persons have expressed concern that US law did not adequately safeguard private data as required by overseas laws. The Act amends Section 24 of the Securities Exchange Act to permit the Commission to share documents with the PCAOB and other federal and state agencies without losing the protection from disclosure, to refuse to disclose privileged information obtained from foreign securities or law enforcement authorities, and amends Section 105(b)(5) of the Sarbanes-Oxley Act to permit the PCAOB to share its data with foreign government regulators or authorities empowered by governments to regulate auditors.
5. Increased Collateral Consequences
Historically, bars or limitations on association imposed under one provision of the securities laws, such as the Securities Exchange Act provisions regarding brokers, have not extended to association with another regulated entity registered under a different provision, such as investment advisers. The Dodd-Frank Act gives the SEC the authority to bar that person found to have violated one of the securities acts from associating with a range of SEC-regulated entities, and not just entities regulated by the specific title that was violated. Specifically, Sections 15(b)(6)(A), 15B(c)(4), and 17A(c)(4)(C) of the Securities Exchange Act and Section 203(f) of the Investment Advisers Act are amended to permit the SEC to bar a violator from association with a "broker, dealer, investment adviser, municipal securities dealer, transfer agent, municipal adviser, or nationally recognized statistical rating organization" in each case.
One recurring criticism of the SEC has been delay in the completion of enforcement investigations. The Act inserts new Section 4E to the Securities Exchange Act requiring the SEC staff to, within 180 days of providing a written Wells notification to any person, either file an action against such person or notify the Director of the Division of Enforcement of its intent not to file an action. This deadline can be extended for additional 180 day periods if the Director of the Division of Enforcement or a designee of the Director decides that it is necessary because of the complexity of the case and so notifies the Chairman of the SEC. Sec. 929U.
 See Press Release, Office of Pub. Affairs, U.S. Dep’t of Justice, Pharmaceutical Giant AstraZeneca to Pay $520 Million for Off-label Drug Marketing (April 27, 2010), available at http://justice.gov/opa/pr/2010/April/10-civ-487.html.; Press Release, Office of Pub. Affairs, U.S. Dep’t of Justice, Two Johnson & Johnson Subsidiaries to Pay Over $81 Million to Resolve Allegations of Off-Label Promotion of Topamax (April 29, 2010), available at http://www.justice.gov/opa/pr/2010/April/10-civ-500.html.; and Press Release, Office of Pub. Affairs, U.S. Dep’t of Justice, Justice Department Announces Largest Health Care Fraud Settlement In Its History (Sept. 2, 2009), available at http://www.justice.gov/opa/pr/2009/September/09-civ-900.html.
 Rather than restore private actions, however, the Act directs the Commission to study whether the anti-fraud provisions should be given extraterritorial effect in a private action and to report its recommendations to Congress in eighteen months.
 See Statement of PCAOB Acting Chairman, Daniel L. Goelzer, U.S. House of Representatives Financial Services Committee, Subcommittee on Capital Markets, May 21, 2010, available at
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