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Fifth Circuit Decision Clarifies the Scope of Protected Conduct Under SOX

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On January 22, 2008, the Fifth Circuit issued an opinion providing significant guidance about the parameters of protected conduct under Section 806 of the Sarbanes-Oxley Act. See Allen v. Administrative Review Board, No. 06-60849 (5th Cir. Jan. 22, 2008). Affirming the ARB’s decision that the plaintiff did not engage in protected conduct, the Fifth Circuit established the following standards for assessing whether a SOX whistleblower engaged in protected conduct:

 

  • “Reasonable Belief” Standard Protects a Mistaken Belief That an Employer Violated an SEC Rule. Consistent with the plain meaning of Section 806, which requires a plaintiff to demonstrate only a “reasonable belief” that there was a violation of one of six enumerated categories of protected conduct (not an actual violation), the Allen Court held: “Importantly, an employee’s reasonable but mistaken belief that an employer engaged in conduct that constitutes a violation of one of the six enumerated categories is protected.” This is significant because it counters a popular defense contention that a SOX whistleblower must demonstrate that shareholders have been harmed by the SEC violation or other misconduct about which the whistleblower complained.
  • Objective Reasonableness is Not Solely a Question of Law. In Welch v. Cardinal Bankshares Corp., 2003-SOX-15 (ARB May 31, 2007), the ARB erroneously held that objective reasonableness is a question of law. That decision is pernicious because it encourages ALJs who lack knowledge of securities law to determine prior to trial whether a SOX whistleblower engaged in protected conduct. The Allen Court, however, has held that while the objective reasonableness of an employee’s belief can be decided as a matter of law in some cases, “the objective reasonableness of an employee’s belief cannot be decided as a matter of law if there is a genuine issue of material fact . . . . [and if] reasonable minds could disagree on this issue, the objective reasonableness of an employee’s belief should not be decided as a matter of law.”
  • SOX Protects a Disclosure About a Reasonably Perceived Violation of “Any Rule or Regulation of the SEC.” Although the plain language of Section 806 protects an employee who provides information to a person with supervisory authority over the employee related to a violation of “any rule or regulation of the SEC,” many employers continue to argue that protected conduct is limited to disclosures about shareholder fraud. The Fifth Circuit has rejected that tortured construction of SOX, holding that a disclosure about a violation of any SEC rule is protected.
  • Consult a Securities Law Expert Before Engaging in Protected Conduct. Unfortunately, the Fifth Circuit appears to be requiring SOX complainants to become experts in securities law in order to engage in protected conduct. In particular, the Fifth Circuit held that because the plaintiff was a licensed CPA, “the objective reasonableness of [plaintiff]’s belief must be evaluated from the perspective of an accounting expert” and she therefore should have known that internal consolidated financial statements need not be compliant with SAB-101, which prohibits publicly-traded companies from recognizing sales revenue before they deliver merchandise to the customer. Under this decision, complaining to management about internal accounting repots overstating gross profit is not protected conduct because the relevant SEC rule does not technically apply to internal financial statements. This aspect of the Allen Court’s holding completely misses the point of Section 806. As Judge Levin pointed out in Morefield v. Exelon Servs., Inc., 2004-SOX-2 (ALJ Jan. 28, 2004), Section 806 “is largely a prophylactic, not a punitive measure” designed to encourage employees 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. Section 806 is not a private right of action to enforce SEC rules, but instead is a retaliation action designed to ensure that employees can disclose accounting fraud and reasonably perceived violations of SEC rules without fear of reprisal, before shareholders are defrauded.Blowing the whistle on deceptive or inaccurate draft financial statements should be protected because if left uncorrected, the draft statements will be distributed to shareholders. If an employee is retaliated against for blowing the whistle on misleading internal financial statements, then the employee will not take the risk of blowing the whistle on publicly-filed financial statements.Finally, a SOX whistleblower should not need to consult a securities lawyer in order to engage in protected conduct.

Although Section 806 of SOX has been narrowed by some courts, it continues to afford robust protection to whistleblowers and does not require proof of an actual violation of an SEC rule. The lesson of Allen is that SOX whistleblowers need to plead protected conduct in detail and be prepared to establish a strong link between their disclosure and a reasonably perceived violation of an SEC rule, which in some cases will require expert witness testimony.

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