SOX’s Whistleblower Provision–Promise Unfulfilled
Securities Litigation Reporter Vol. 4, Issue 7
Jason M. Zuckerman, Principal of The Law Office of Jason
M. Zuckerman, PLLC and Of Counsel at The Employment
Law Group, PC, litigates whistleblower retaliation claims
under the Sarbanes-Oxley Act, the False Claims Act, and
various federal and state whistleblower protection laws.
[The following article is one of several Securities Litigation Report we will be presenting beginning in this issue and continuing over the next several
months about the fifth anniversary of the passage of the Sarbanes-Oxley Act.]
In enacting the most comprehensive securities law and investor protection reform in more than half a century, Congress made whistleblower protection a central tool to improve the accuracy and reliability of corporate disclosures. To ensure that employees with first-hand knowledge of accounting fraud feel that they can raise concerns without jeopardizing their livelihood, Congress enacted Section 806 of the Sarbanes-Oxley Act (“SOX”), which was intended to provide robust protection for whistleblowers.1 As stated in the legislative history, “U.S. laws need to encourage and protect those who report fraudulent activity that can damage innocent investors in publicly traded companies.”2
Five years after its enactment, Section 806 has failed to live up to its promise. Indeed, a recent empirical study found that the Department of Labor (“DOL”) has strictly construed, and in some cases misapplied, Section 806, and that less than 5% of whistleblowers prevailed in Section 806 claims before DOL.3 In addition, the Department of Labor’s Administrative Review Board (“ARB”) recently judicially amended Section 806 by imposing a standard for protected conduct that is contrary to the plain meaning and intent of the statute. Despite these developments, however, Section 806 can potentially provide strong protection to whistleblowers, and it has sensitized employers to the importance of encouraging employees to report financial misconduct and taking prompt remedial action to correct accounting fraud or securities law violations. This article discusses how the elements of a Section 806 claim have been interpreted, focusing primarily on the scope of protected conduct.
Section 806 of SOX protects employees who provide information to management, a Federal agency, or Congress relating to alleged violations of the federal mail, wire, radio, TV, bank, securities fraud statutes,4or any rule or regulation of the Securities and Exchange Commission, or any provision of Federal law relating to fraud against shareholders.5 An employee need not prove an actual violation of a law, but only that he reasonably believed that his employer was violating securities laws or regulations. As summarized by the ALJ in Iayaraj v. Pro-Pharmaceuticals, Inc.6
The statute is clear that the Complainant is not required to show that the reported conduct actually constituted a violation of the law, but only that she reasonably believed that the employer violated one of the enumerated statutes or regulations; a belief that an activity was illegal may be reasonable even when subsequent investigation reveals a complainant was wrong.7
Protected Conduct Not Limited to Concerns about Shareholder Fraud
Although the plain language of Section 806 unambiguously protects employees who “provide information, cause information to be provided, or otherwise assist in an investigation regarding any conduct which the employee reasonably believes constitutes a violation of . , , any rule or regulation of the Securities and Exchange Commission, )8 there was conflicting authority as to whether protected conduct under SOX is limited to the reporting of concerns about shareholder fraud. In Grant v. Dominion East Ohio Gas,9 the Administrative Law Judge (“ALJ”) found that the complainant did not engage in protected activity where none of his expressed concerns “contained any reference to fraud or implication that the company had acted intentionally to mislead shareholders or misstate the company’s bottom line.” In Walton v. Nova Info. Systems,10 to however, the ALJ held that complainants disclosures to management about deficient internal controls is within the zone of protection afforded by SOX. The ARB resolved this conflicting interpretation by applying the plain meaning of SOX to conclude that protected conduct is not limited to providing information to management about “just fraud, but also [the] ‘violation of .., any rule or regulation of the Securities and Exchange Commission.’11 Similarly, a federal judge recently held:
If the drafters meant for section 806 to only protect employees who report fraud against shareholders, then they could have easily done so by inserting a comma before “relating to fraud against shareholders.” The
drafters, however, did not do so. Therefore, the Court finds that reporting alleged violations of mail fraud or wire fraud does not have to relate to shareholder fraud in order to be protected activity under the statute.”12
As SOX protects disclosures about what an employee reasonably believes constitutes a violation of any rule or regulation of the Securities and Exchange Commission,)’ providing information to management about a wide range of SEC rules designed to prevent fraud constitutes protected
conduct. This includes SEC rules requiring publicly traded companies to maintain adequate internal controls, such as SEC Rule 13a-15(a).13 Indeed, protecting disclosures about internal controls is critical to effectuating the overall purpose of SOX. As stated in the SEC’s rules implementing the Section 404 internal control requirements, “the required evaluation [of internal controls should help to identify potential weaknesses and deficiencies in advance of a system breakdown,
thereby facilitating the continuous, orderly and timely flow of information … [improved disclosure may help companies detect fraudulent, financial
reporting earlier and perhaps thereby deter financial fraud or minimize its adverse effects.”14 Limiting protected conduct under SOX to actual shareholder fraud would limit the opportunity for companies and shareholders to learn about financial fraud before it is too late.
Degree of Specificity Required
The DOL’s ARB has taken a highly formalistic approach to analyzing whether an employee’s disclosure is protected under SOX. In Platone v.
FLYi, Inc.15 the ARB held that in order to constitute protected conduct, a complainant’s protected communications “must relate ‘definitively and
specifically’ to the subject matter of the particular statute under which protection is afforded.”16 The terms “definitively and specifically,” however, do not appear in Section 806, and this heightened burden to establish protected conduct finds no support in the legislative history. To the contrary, Congress intended “to close the loopholes that have allowed for continued offenses in America’s corporate community,” not to create additional loopholes.17
Moreover; as a remedial statute, Section 806 of SOX should be construed broadly.18 Fortunately, federal courts have generally steered clear of the Platone formalistic approach, and do not require SOX complainants to demonstrate that they provided management with a legal memorandum citing the specific SEC rule about which they raised a concern to management. For example, in Collins v. Beazer Homes USA, Inc.,19 the court held:
[The mere fact that the severity or specificity of her complaints does not rise to the level of action that would spur Congress to draft legislation does not mean that the legislation it did draft was not meant to protect her. In short, if Congress had intended to limit the protection of Sarbanes
Oxley … or to have required complainants to specifically identify the code section that they believe was being violated, it could have done so. It did not. Congress in stead protected ’employees’ and adopted the ‘reasonable belief’ standard for those who ‘blow the whistle on fraud and protect investors.’20
In sum, employers should not assume that federal courts will apply the ARB’s heightened standard for protected conduct, and instead should assume that employees can engage in protected conduct without citing securities law chapter and verse.
In the most closely-watched SOX case-Welch v. Cardinal Bankshares Corp.-the ARB recently issued a surprising interpretation of the “reasonable belief” standard.21 Prior to the ARB’s decision, it was well-established that “a complainant is not required to show an actual violation of the law,” but instead “only that she ‘reasonably believed’ there to be a violation of one of the enumerated laws or regulations.”22
In Welch, the AL] concluded that the complainant engaged in protected activity when he repeatedly provided information to management about deficient internal controls.23 More than three years after the ALl issued this decision, the ARB reversed on the basis that Welch lacked an
objectively reasonable basis to believe that Cardinal was violating SEC rules. In their decision, the ARB set forth a new standard for assessing
reasonable belief: “Because the analysis for determining whether an employee reasonably believes a practice is unlawful is an objective one, the issue may be resolved as a matter of law. “24 The decision was surprising for at least three reasons.
First, limiting protected disclosures to unequivocal, actual violations of securities laws patently undermines the basic purpose of Section 806, which is to provide an early ‘warning of fraud or internal control deficiencies that could result in shareholder fraud, before shareholders have been harmed. As an AL] noted in Getman v. Southwest Securities,25 requiring a SOX complainant to prove an actual violation of law “would require that a whistleblower allow the violation to occur before reporting it. This would defeat the intent of the Act and the whistleblower law in general, which is to prevent the carrying Ollt of the underlying crime.” Similarly, the AL] in Morefield v.
EXel011 Services,26 noted:
The value of the whistleblower resides in his or her Insider status. These employees often find themselves uniquely positioned to head off the type of ‘manipulations’ that have a tendency or capacity to deceive or defraud the public. By blowing the whistle, they may anticipate the deception
buried in a draft report or internal document, which if not corrected, could eventually taint the public disclosure. Beyond that, their reasonable concerns may, for example, address the inadequacy of internal controls promulgated in compliance with Sarbanes-Oxley mandates or SEC rules that impact on procedures through out the organization, or the application of accounting principles, or the exposure of incipient problems which, if left unattended, could mature into violations of rules or regulations of the type an audit committee would hope to forestall.27
Second, the ARB’s construction of “reasonable belief” is contrary to Congressional intent in that the legislative history of Section 806 specifically states that the reasonableness test “is intended to include all good faith and reasonable reporting of fraud, and there should be no presumption that reporting is otherwise, absent specific evidence.”28 Moreover, when Congress chose to include the terms “reasonable belief” in Section 806, it presumably had in mind well-established DOL precedent under analogous whistleblower protection statutes holding that “reasonable belief” is a mixed question of law and fact, and broadly construing “reasonable belief.” By redefining “reasonable belief,” the ARB has substantially narrowed the scope of protected conduct under SOX.
Third, the ARB concluded that Welch’s disclosures about Cardinal’s internal controls were not objectively reasonable without engaging in
any analysis of the actual SEC internal accounting rules that implement Section 404 of SOX and Section 13 of the Securities Exchange Act of 1934.
If reasonable belief is solely an issue of law, then presumably the relevant SEC rules governing internal accounting controls should factor into that
analysis. The ARB’s Welch decision will likely result in ALJs dismissing SOX claims on summary judgment based on an “I know it when I see it” analysis of whether the complainant’s alleged protected disclosure sufficiently states an actual violation of an SEC rule.
Fortunately, SOX whistleblowers have fared better in federal court. For example, Judge Charles J. Siragusa of the Western District of New
York held in Smith v. Corning29 that disclosing a violation of generally accepted accounting principles or deficient internal controls can constitute
protected conduct under SOX.30 Similarly, Judge Sterling Johnson, Jr. of the Eastern District of New York held that helping a coworker raise concerns to a company’s CEO about incomplete executive compensation disclosures constitutes protected conduct, and that summary judgment should be denied where “a fair and reasonable juror could find that Plaintiff reasonably believed that the company was engaging in accounting practices that needed to be corrected before its financial statements misled shareholders. “31
Disclosures about Mail and Wire Fraud
In Platone, the ARB further narrowed the scope of protected conduct under SOX by holding that where a Section 806 whistleblower complaint is
grounded in federal mail and wire fraud statutes, “the alleged fraudulent conduct must at least be of the type that would be adverse to investor’s
interests.”32 The ARB’s only explanation for rewriting this category of protected disclosure is a vague statement in the preamble of SOX that arguably supports a contrary conclusion.33 Federal courts have not followed this judicial amendment to Section 806. For example, in Reyna v. Conagra Foods, Inc.,34 the court held that “[the statute clearly protects an employee against retaliation based upon that employee’s reporting of mail fraud or wire fraud regardless of whether that fraud involves a shareholder of the company.”
In sum, the ARB’s decisions construing the standard for protected conduct under Section 806 have imposed a high bar for complainants, and will likely discourage the types of disclosures that Congress sought to encourage. Federal courts, however, have generally construed protected conduct broadly, and SOX litigation will likely shift to federal courts, thereby diminishing the impact and significance of the ARB’s decisions.35
The range of prohibited retaliatory acts under SOX is very broad. The statute specifically prohibits covered companies from “discharg[ing], demot[ing], suspend[ing], threaten[ing], harass[ing] or in any other manner discriminat[ing] against an employee” with respect to the employee’s compensation, terms, conditions, or privileges of employment.36 Under the plain meaning of SOX, a supervisor’s threat to
terminate an employee in retaliation for the employee engaging in protected conduct constitutes an actionable adverse employment action. The ARB has applied the Supreme Court’s Burlington standard to SOX claims,37 under which conduct that “could well dissuade a reasonable worker from making or supporting a charge of discrimination” constitutes
SOX Burden-Shifting Framework
To prevail under Section 806, a complainant must prove by a preponderance of the evidence that: (1) he engaged in a protected activity or conduct; (2) the respondent knew that he engaged in the protected activity; (3) he suffered an unfavorable personnel action; and (4) the protected activity was a contributing factor in the unfavorable action.39
This burden-shifting framework is very favorable to employees. A contributing factor need not be motivating or substantial, and instead can be “any factor which, alone or in connection with other factors, tends to affect in any way the outcome of the decision. “40 Temporal proximity
alone is sufficient to establish an inference of causation.41 Moreover; if the complainant proves the elements of a Section 806 claim by a preponderance of the evidence, the respondent must demonstrate
by clear and convincing evidence that it would have taken the same unfavorable personnel action in the absence of the complainant’s protected activity.42
Due to the broad range of adverse actions prohibited by Section 806 and the employee-friendly burden of proof, a complainant who can meet the
ARB’s onerous standard for protected conduct has a good chance of prevailing on the merits, Accordingly, the primary focus of Section 806 litigation will be the employee’s protected conduct. If federal circuit courts of appeal continue to reject the ARB’s narrow construction of protected conduct under Section 806 and instead apply a standard that is consistent with the plain meaning and intent of the statute, Section 806 might realize its purpose of encouraging employees to improve the
accuracy and reliability of corporate disclosures.
A recent article in Business Week43 reports that a survey performed by LRN, an ethics and governance consulting firm, found that although companies have adopted comprehensive codes of ethics and anti-retaliation policies, most employees are reluctant to report misconduct. In particular, the survey found that “73% of full-time American employees reported encountering ethical lapses on the job,” but only “one in three … reported an incident they believed to be unethical or qucstionable.” Until employees believe that they are protected from retaliation, Section 806 of SOX will not effectuate Congress’ intent “to encourage and protect those who report fraudulent activity that can damage innocent investors in publicly traded companies. “44
1 See 18 U.s,C § 1S14A. In addition, Congress criminalized retaliation by any person or organization against an individual who has provided truthful information to law enforcement officers concerning the commission of any federal offense, 18 U.s,C § 1513(e).
2 5. Rep, No, 107-146, as reprinted in 2002 WL 863249 at *19,
3 Richard Moberly, Unfulfilled Expectations: An Empirical Analysis of Why 5arbanes-Oxley Whistleblowers Rarely Win, William & Mary Law Review, Vol. 49, Fall 2007, However, many SOX ciaims are settled early on because companies often wish to avoid broad discovery about flawed accounting practices or inaccurate financial reporting.
4 See 18 U,S,CA. §§ 1341, 1343, 1344, and 1348,
5 Taylor v. Wells Fargo Bank, NA, ARB No, 05-062 at 4, AU No, 2004-S0X-43 (ARB June 28, 2007) (citing 18 U,5,CA, § 1514A(a)),
6 Jayaraj v. Pro-Pharmaceuticals, Inc., 2003-S0X-32 at 16-17 (AU Feb, 11, 2005),
7 Jayaraj, 2003-S0X-32 at 16-17.
8 18 U.5,C § 1S14A(a) (emphasis added),
9 Grant v. Dominion East Ohio Gas, 2004-S0X-63 (AU Mar. 10, 2005),
10 Walton v. Nova Info. Systems, 2005-S0X-107 (AU March 29, 2006),
11 Klopfenstein v. PCC Flow Techs, Holdings Inc., ARB No, 04-149, at 3,17; see also Allen v, Stewart Enterprises, Inc., ARB No, 06-081, AU Nos, 2004SOX-60 to 62 (ARB July 27,2006) (“Reporting that a company violated its internal accounting controls may constitute SOX-protected activity,”),
12 Reyna v, Conagra Foods, Inc., 2007 WL 1704577, at *16 (M.D, Ga, 2007),
13 See, e,g” Collins v, Beazer Homes USA, Inc., 334 F, 5upp, 2d 1365, 21I.E,R, Cas, (BNA) 1731, 85 Empl. Prac. Dec. (CCH) P 41896, 15 A,L.R, Fed, 2d 769 (N.D, Ga, 2004),
14 Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Release Nos. 33-8238; 34-47986; and IC-26068 (June 5, 2003),
15 Platone v FLYi, Inc., ARB No, 04-154, AU No. 2003-50X-27, at 17 (ARB Sept, 29, 2006).
16 Id, No, 04-154 at 17.
17 Corporate Fraud Accountability Act of 2002 (July 16,2002), at H4692 (statement of Congresswoman Roukema), See also 149 Cong, Rec,’Sl725-01, Sl725, 2003 WL 193278 (Jan, 29, 2003) (“The law was intentionally written to sweep broadly, protecting any employee of a publicly traded
company who took such reasonable action to try to protect investors and the market”).
18 See, Mackowiak v. University Nuclear Systems, Inc., 735 F,2d 1159 (9th Or, 1984),
19 Collins v, Beazer Homes USA, Inc., 334 F. 5upp, 2d 1365, 21I.E,R, Cas, (BNA) 1731,85 Empl. Prac. Dec. (CCH) P 41896, 15 A,L,R, Fed. 2d 769 (N,D,
20 Id, at 1377 (citations omitted),
21 See Welch v, Cardinal Bankshares Corp” ARBNo, 05-064, AU No, 2003-50X-15 (AR8 May 31, 2007),
22 Kalkunte v. DVI Financial Services, Inc., 2004-50X56 (AU July 18, 2005),
23 Welch, 2003-S0X-1S (AU Jan. 28, 2004).
24 Welch, ARB No. OS-064 at 10 (citing Jordan v. Alternative Resources Corp., 4S8 f.3d 332, 339, 98 Fair Empl. Prac. Cas. (BNA) 1400, 88 Empl. Prac. Dec. (CCH) P 4247S (4th Cir. 2006), cert. denied, 127 S. Ct. 2036,167 L. Ed. 2d 804 (U.S. 2007)).
25 Getman v. Southwest Securities, Inc., 2003-S0X-8, at 13 n.8 (DOL Feb. 2, 2004), reversed on other grounds, ARB No. 04-059 (ARB July 29, 2005).
26 Morefield v. Exelon Services, Inc., 2004-S0X-2 at 5 (AU Jan. 28, 2004).
27 Id. at 5.
28 Legislative History of Title VIII of HR 2673: The Sarbanes-Oxley Act of 2002, Congo Rec. S7418, S7420 (dally ed. July 26, 2002), available at 2002 WL 32054527, citing Passaic Valley Sewerage Com’rs V. U.S. Dept. of Labor, 992 F.2d 474, 8I.E.R. Cas. (BNA) 647, 125 Lab. Cas. (CCH) P 10698, 23 Envtl. L. Rep. 21125 (3d Cir. 1993) (setting forth a broad definition of “good faith” protected disclosures under analogous whistleblower protection statutes).
29 Smith V. Corning Inc., No. 06-CV-6516 CJS (W.D.N.Y. July 9, 2007).
30 Although Congress specifically intended to protect whistleblowers who warn management about the type of accounting chicanery that led to the collapse of Enron, the ARB held in Welch that disclosures about violations of generally accepted accounting practices are not protected
under SOX. Welch, ARB No. 05-064 at 11.
31 Mahony v. KeySpan Corp., 2007 WL 80S813 at *6 (ED. N.Y. 2007).
32 Piatone, ARB No. 04-154 at 15.
33 According to the ARB, a reference in the preamble of SOX to “protectling] investors” must mean that Congress did not intend to protect from retaliation employee who blow the whistle on mail fraud or wire fraud. See Platone, ARB No. 04-154 at 15. As Congress chose to specifically include mail fraud and wire in the categories of protected disclosures in Section 806, it must have assumed that disclosures about mail fraud or wire fraud protect investors. Narrowing the scope of protected conduct based on a vague statement in a preamble does not effectuate Congress’ intent Id. at n. 107.
34 Reyna V. Conagra Foods, Inc., 2007 WL 1704577 at *15 (M.D. Ga. 2007).
35 A Section 806 complaint must be filed with the DOL, but if DOl. has not issued a final decision within 180 days of the filing of the complaint,
the complainant can remove the claim to federal court. 18 U.S.c. § 1514A(b)(1)(B). July/August 2007 ” Volume 4 Issue 7
36 18 U.s.c. § 1514A(a).
37 Hirst “- Southeast Air/ines, Inc., ARB Nos. 04-116, 04-160, AU No. 2003-AIR-47(ARB Jan. 31, 2007).
38 Hirst, ARB Nos. 04-116, at 10-11, quoting Burlington Northern and Santa Fe Ry. Co. “White, 126 S. Ct. 2405, 2409, 165 L. Ed. 2d 345, 98 Fair Empl. Prac. Cas. (BNA) 385, 87 Empl. Prac. Dec. (CCH) P42394 (U.S. 2006).
39 49 U.s.C.A. § 42121 (a)-(b)(2)(B) (ili)-(lv); Tay/or V. Wells Fargo Bank, NA, ARB No. 05-062, AU No. 2004-S0X-43, at 4 (ARB June 28, 2007).
40 Halloum v. Intel Corp., 2003-S0X-7 (AU Mar. 4, 2004) (quoting Marano v. Department of Justice, 2 F.3d 1137, 1140, 8 I.E.R. Cas. (BNA) 1368 (Fed. Cir. 1993)).
41 Bechtel Constr. CO. V. Sec’y of Labor, 50 F. 3d 926, 934 (11th Cir. 1995); Collins, 334 F. Supp 2d at 1379.
42 29 CF.R. § 1980.104(c).
43 Paliavl Gogoi, The Trouble With Business Ethics, Business Week, June 22, 2007.
44 148 Congo Rec. S7418, 7420 (daily ed. July 26,2002).