Jordan A. Thomas co-authored an article for Law360, discussing the ability of in-house counsel to report securities violations following Dodd-Frank.
At one time, attorneys’ duty to maintain corporate clients’ confidences, even in the face of anticipated or ongoing corporate wrongdoing, was thought to be virtually absolute. But that changed over time, as relevant rules and laws gave lawyers greater discretion to make public disclosures to avert corporate clients’ misconduct. And now, following the enactment of the whistleblower provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, attorneys will sometimes have not only discretion but a financial incentive to blow the whistle, as well as anti-retaliation protections when they do so.
Imagine a scenario such as the following. You are in-house counsel to a public corporation that is subject to the reporting requirements of the Securities and Exchange Act of 1934. In the course of your legal work, you discover that your employer — your client — is making materially false statements about the corporation’s financial performance in its soon-to-be-filed annual report due to an overstatement of the value of its derivative portfolio. Your initial obligation is to report the problem up the corporate client’s chain of command and try to persuade the client to correct the false statements. If you fail, may you report your client’s misconduct to the U.S. Securities and Exchange Commission, and what will happen if you do so?
In many ways, Dodd-Frank has changed attorneys’ calculus. Arguably, the most sweeping financial reform effort since the Great Depression, Dodd-Frank was a potent response to a long series of corporate scandals — beginning with Enron and continuing to the current economic crisis — that involved massive frauds on investors that shook the financial markets. One of Dodd-Frank’s key provisions — and the focus of this analysis — required the SEC to establish a whistleblower program that would offer significant employment protections and monetary awards to individuals who report possible violations of the federal securities laws. Attorneys are eligible to participate in this important investor protection program.
The final rules adopted by the SEC (as Regulation 21F) provide for the payment of a monetary award to any individual who voluntarily provides the SEC with original information leading to an enforcement action in which the SEC obtains at least $1 million in sanctions. The exact amount of an award depends upon several factors, but is required to be between 10 percent and 30 percent of the total monetary sanctions collected by the SEC and other law enforcement and regulatory organizations in related enforcement actions. These awards can be substantial. In fiscal year 2011, the SEC collected monetary sanctions totaling in excess of $2.8 billion. In several cases, sanctions exceeded $100 million.
Dodd-Frank also established robust employment protections that prohibit retaliation against an employee who provides information about possible securities violations to the SEC in accordance with the program’s implementing rules. In the event retaliatory action is taken, the legislation establishes significant remedies including reinstatement with equivalent seniority, two-times back pay with interest, legal fees, and other related expenses. These protections are triggered when a whistleblower makes a written submission in accordance with the program’s rules, and take effect regardless of whether a whistleblower ultimately qualifies for a monetary award. Significantly, whistleblowers are permitted to report possible securities violations anonymously if represented by counsel.
Although Dodd-Frank excludes some classes of persons, the statute allows attorneys to participate in the whistleblower program subject to limitations. In particular, the implementing rules prohibit attorneys from using information obtained through a communication protected by the attorney-client privilege or through the representation of a client, unless the attorney-client privilege has been waived or disclosure of the otherwise confidential information is permitted either by SEC Rule 205.3 or by the applicable state attorney conduct rules.
Rule 205.3 generally requires an issuer’s attorney to report fraud and other material securities violations up the organization’s chain of command. There are three situations, however, when an attorney is permitted to disclose confidential information to the SEC without the issuer’s consent or without having first reported internally. The attorney may disclose the information if the attorney reasonably believes disclosure is necessary to: (i) prevent a material violation that is likely to cause substantial financial injury to the issuer or investors; (ii) prevent the issuer from committing or suborning perjury, or perpetrating a fraud upon the commission; or (iii) rectify the consequences of a material violation, in the furtherance of which the attorney’s services were used.
State professional conduct rules may also authorize attorneys to report corporate client misconduct in certain situations. Rules governing confidentiality include exceptions that vary from state to state. Rule 1.6 of the American Bar Association’s Model Rules of Professional Conduct generally permits disclosure of confidential information to prevent a client, including a corporate client, from committing a serious crime or fraud in which the attorney’s services were used. Like Rule 205.3, Rule 1.6 also permits disclosures to rectify or mitigate a crime or fraud that has or will cause substantial injury to the financial interests or property of another and in furtherance of which the attorney's services were used.
Many states follow this rule, although some give attorneys broader or more limited discretion to prevent or rectify client misconduct. When the client is an organization, most state rules, based on ABA Model Rule 1.13, mandate that the attorney first report any wrongdoing up the organization’s chain of command. Only if the organization fails to take proper action may the attorney then disclose the confidential information as permitted by Rule 1.6.
Rule 205.3 may occasionally conflict with a state confidentiality rule, permitting disclosure in a situation in which the state rule requires preservation of client confidences. In that situation, an attorney could comply with Rule 205.3 and qualify as an SEC whistleblower, yet seemingly face a state bar disciplinary action for violating the state confidentiality rule. However, Rule 205.3 would almost certainly protect the attorney by preempting the state rule. Under the federal Supremacy Clause, a regulation duly enacted by a federal agency preempts conflicting state law as long as its enactment was a valid exercise of congressionally-delegated authority and the federal agency intended to preempt state law when it promulgated the regulation.
There is little doubt that Rule 205.3 was validly enacted by the SEC because Congress required the agency to set minimum attorney-conduct rules in Section 307 of the Sarbanes-Oxley Act. Moreover, SEC Rule 205 clearly manifests the SEC’s intention to preempt conflicting state attorney-conduct rules with the rules set forth in Rule 205, including the disclosure rules of Rule 205.3. Although some may disagree, our view is that an attorney may disclose confidential information in accordance with Rule 205.3 without regard to conflicting state confidentiality rules.
The large potential monetary awards offered by Dodd-Frank could motivate attorneys to become whistleblowers when Rule 205.3 or an exception to the state confidentiality rule gives them discretion to report misconduct. But attorneys must be careful not to jump the gun by failing earnestly to go up the chain of command when required to do so. Disclosures outside the corporation are permitted only where “necessary,” and they are unlikely to be deemed necessary when a conscientious lawyer could have convinced higher-ups to avert or rectify misconduct themselves. A lawyer who makes an impermissible disclosure would be ineligible for a monetary award under Dodd-Frank and would face possible professional discipline, civil liability or reputational harm.
After making a whistleblower submission to the SEC, an attorney must carefully consider other relevant state professional conduct rules, particularly those governing conflicts of interest. Dodd-Frank does not preempt these rules. Whether an attorney whistleblower has a conflict of interest in the ongoing representation of a corporation will depend upon the circumstances. In many situations, the representation would be unaffected by the attorney’s status as whistleblower. But in some situations it would be.
For example, if an attorney triggers an SEC inquiry by reporting corporate misconduct, the attorney could not advise the corporation how to respond to the inquiry because the attorney would stand to benefit financially if the SEC obtained civil sanctions. Outside counsel in this situation could simply decline or terminate the representation; In-house counsel could seek reassignment to matters unrelated to the reported violation. An in-house lawyer denied reassignment would have an interesting quandary. Dodd-Frank’s anonymity provisions generally protect employees from disclosing that they are whistleblowers, but it may be necessary for the attorney to disclose this status if a simple request for reassignment or assertion that “I have a conflict” is ineffective.
In the end, attorneys should regard whistleblowing as a last resort, should endeavor to make a disinterested decision whether to blow the whistle where the law permits, and should proceed with care. In particular:
1) In most cases, potential attorney whistleblowers will be obligated first to conscientiously report possible securities violations to their corporate clients in accordance with the procedures outlined in Rule 205.3 and state professional conduct rules. Confidentiality is an important professional value, and compliance with the federal securities laws is promoted when individuals and entities work together to root out wrongdoing and discipline those responsible.
2) Although the implementing rules for the SEC whistleblower program require a whistleblower to have only a reasonable belief that a possible securities violation has occurred, is ongoing, or is about to occur, potential attorney whistleblowers should attempt to confirm the existence of a violation before reporting to the SEC. This practical step will help prevent unnecessary external reporting and minimize the risk of a later determination that reporting was impermissible.
3) Where internal reporting is inappropriate or has been unsuccessful, potential attorney whistleblowers should consult independent counsel regarding the risks, rewards and requirements (both ethical and procedural) associated with reporting possible securities violations to the SEC.
4) Even though Rule 205.3 preempts state confidentiality rules, potential attorney whistleblowers must continue to comply with other state attorney conduct rules — especially state conflict of interest rules — if an attorney is seeking a monetary award.
5) For those who fear retaliation by their employers (or unwarranted state ethics proceedings), it may make sense to report possible securities violations anonymously to the SEC with the assistance of counsel.
The SEC Whistleblower Program has not changed the important investor protection role that attorneys can play as advisers — a far more common and important role than that of whistleblower. Notwithstanding the protections and incentives of Dodd-Frank, we hope and expect attorney whistleblowing to be limited to the rare situations in which there is a fundamental breakdown in corporate governance.
For the full article on Law360, please click here.