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Wednesday, December 17, 2014

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SRC Insights: Third Quarter 2008

How Effective Are the Whistleblower Provisions of Sarbanes-Oxley?

In an effort to avert future corporate scandals, certain whistleblower provisions were implemented with the Sarbanes-Oxley Act of 2002 (SOX) to encourage employees to come forward with allegations of financial wrongdoings within public corporations. The law specifies that an employee will be protected for providing information to, causing information to be provided to, or assisting in an investigation by a federal regulatory or law enforcement agency, a member or committee of Congress, or an internal investigation by the company. Given the fact that tips remain the most prevalent source of fraud detection, it is interesting to consider whether the whistleblower provisions of SOX are being widely used, and, if so, do the provisions within SOX seem to be effective in protecting the whistleblowers? 1

The Whistleblowing Process Defined
Specifically, Section 806 of SOX (18 U.S.C. 1514A) was intended to protect employees of public corporations from retaliation or adverse employment consequences from their employer for reporting suspected fraudulent activity. SOX broadly defines "employee" as including any officer, employee, contractor, subcontractor, or agent of a company. To be covered under the provision, the employee needs to "reasonably" believe that the alleged misdeed constitutes a "violation of any rule or regulation of the Securities and Exchange Commission, or any provision of federal law relating to fraud against shareholders."

Any employee who reasonably believes that he or she received a retaliatory action or negative employment consequence as a result of reporting a protected activity is able to file a claim with the Department of Labor's (DOL's) Occupational Health and Safety Administration (OSHA), the governing body of the provision. Upon receipt of the filing, an OSHA official must determine whether the case satisfies the requirements of the whistleblower provisions within SOX. In doing so, the OSHA official must ensure that: 2

  1. The employee or complainant filed the complaint with OSHA within 90 days from the date of the alleged violation.
  2. The complainant "reasonably believed" that the company violated the law(s) specified in the statute.
  3. The complainant made a prima facie showing that the "protected activity" was a "contributing factor" in the adverse employment action stated in the claim.
  4. The employer was aware of the protected activity and did not demonstrate by "clear and convincing evidence" that it would have taken the same personnel action in absence of the protected behavior.

In theory, Section 806 of SOX is intended to protect a whistleblower even if their account of the alleged wrongdoing is incorrect, provided that the complainant "reasonably believed" that what they reported constituted a covered violation. Following its initial investigation, OSHA will issue its findings. For cases with merit, OSHA will issue a preliminary order and direct the complainant to be rehired. According to Daniel Westman, author of Whistleblowing: the Law of Retaliatory Discharge, SOX has "a very strong preference for reinstating the employee as soon as possible." 3

Conversely, if OSHA determines that a case has no merit, the case is dismissed. Complainants or employers dissatisfied with the initial ruling from OSHA are able to appeal the decision to the next level of the DOL process, the Administrative Law Judge (ALJ). The process within OSHA, including any trial or appeal, is required to be completed within 180 days from the date the complaint was initially filed. Cases extending beyond the 180-day timeframe enable the complainant to file suit in federal district court, where the proceedings would begin again from the start.

If the complainant prevails, SOX requires that the employee be reinstated to his or her position and receive back pay with interest, as well as compensatory damages, including reasonable attorney's fees and costs, in an effort to prevent losses to the whistleblower. While SOX does not provide for either punitive damages or a jury trial, employees are able to seek such damages through court actions. Again, if either party is dissatisfied with the ALJ's rendering, they may file a petition for review by the DOL's Administrative Review Board (ARB). This review is limited to the factual determinations of the ALJ under the substantial evidence standard.4 The ARB is the final interpreter of the whistleblower provisions at the DOL; any further proceedings may be appealed to the federal court of appeals. Other possible outcomes for each level in the DOL process may result in the complainant withdrawing his or her complaint or accepting a settlement offered by the employer.

Whistleblowing by the Numbers
While the DOL does not report its statistics, the law firm of Orrick, Herrington, and Sutcliffe LLP tracked whistleblower cases from the inception of SOX in July 2002 through fiscal year 2006 and determined that employees fared poorly at each level of the whistleblower DOL litigation process. The results of the study concluded that 947 complaints were filed with the DOL during that time frame, yet only 17 (or 1.8%) of the cases were deemed to have merit.5

Conversely, of the cases filed, approximately 665 (or 70.2%) were dismissed as having no merit, 138 (or 14.5%) resulted in a settlement between the complainant and the employer before the DOL provided a ruling, and 126 (or 13.3%) were withdrawn by the complainant. The study further concluded that only six of the cases made their way through the DOL appeals process and survived the first level of appeal (ALJ level), and no complainants have prevailed at the highest level of appeal (ARB level).

Richard E. Moberly, a professor at the University of Nebraska, conducted a separate study of DOL SOX whistleblower determinations from July 2002 through May 2005. His study concluded that OSHA rejected a majority of the cases based on "procedural elements," meaning that the case was not filed within the law's procedures or within the prescribed 90-day timeframe. Other reasons for dismissal include the following:6

  • Boundary Issues—the employee, employer, activity, and adverse employment action did not appear to be covered within the boundaries of SOX.
  • Causation—the employee failed to prove that he or she was fired for the "protected activity."
  • Clear and Convincing Evidence—the employer provided evidence to satisfy its requirements.

Unfortunately, the specifics of settlements or withdrawals are not tracked by the DOL. Nevertheless, it could be argued that the overall low success rate of employees is surprising since the SOX provisions could be considered more "employee friendly," as the complainants are only required to prove that they "reasonably" believed that there was a fraud perpetrated against shareholders and that the "protected activity" was a "contributing factor" in the unfavorable personnel action. Conversely, the burden of proof by the employer could be considered to be more onerous, as the plaintiff needs to demonstrate by "clear and convincing evidence" that it would have taken the same unfavorable action against the employee absent the whistleblowing activity.

Conclusion
Given the exceptionally small percentage of employees who have prevailed at the DOL level and the fact that no complainant has ever prevailed at the ARB or final level of appeal within the DOL, it is questionable whether the whistleblower protections within SOX are living up to the intentions of the law. Nevertheless, although the statistics relating to the SOX whistleblower cases filed to date do not seem very supportive of the employee, such claims continue to increase year after year, thereby inferring that employees do not necessarily believe historical resolutions preclude future rulings from protecting employees who come forward to report allegations of fraud within their workplace.

Case Study: Results of the First Case Filed Under Sarbanes-Oxley Whistleblower Rules

In May 2007, the case of David Welch, one of the first employees in the nation to seek whistleblower protection under the Sarbanes Oxley Act of 2002 (SOX), concluded. After four years, the case (Welch v. Cardinal Bankshares Corp) proceeded through all available levels within the SOX whistleblower litigation process. Following a review by the Department of Labor (DOL) Administrative Law Judge (ALJ), Welch was deemed to be the first whistleblower to win reinstatement and other remedies from an ALJ. Nevertheless, the case was appealed by his employer, Cardinal Bankshares, Inc. (Cardinal) to the DOL Administrative Review Board (ARB), which, in turn, reversed the ALJ's decision. The ARB's final decision precluded the first "win" of a SOX case by an employee at the ARB level.

David Welch was hired in 2000 as the chief financial officer of Floyd Bank, a subsidiary of Cardinal Bankshares, Inc., located in Floyd, Virginia. According to records of the case, Welch initially had a good relationship with the bank's board of directors, but that changed in a relatively short period of time. Over approximately six months, Welch became increasingly concerned about the company's financial statements and operating procedures, citing suspicions of insider trading of Cardinal's stock by the CEO's friends, a lack of adequate internal controls, and limited access to the company's external auditors.

Welch repeatedly raised his concerns to the CEO and other senior personnel in writing, and as a result, he refused to certify company financial reports for the third quarter of 2001 and the second quarter of 2002. Following Welch's assertions, the CEO informed the audit committee, which, in turn, appointed an accountant and lawyer to investigate the charges. During the investigation, certain claims made by Welch were verified, yet several performance-related issues were also raised. Following the investigation, the company repeatedly asked Welch to meet with the audit committee without his personal attorney present. Welch refused, and as a result, Cardinal terminated his employment. Two months later, within the 90-day SOX filing requirement, Welch complied with the administrative procedures within SOX and filed his complaint with OSHA, citing that he was fired for raising the allegations.

OSHA investigated Welch's complaint and dismissed the case, citing that it found no basis for action. As a result, Welch appealed the denial to the DOL ALJ. Accordingly, an ALJ reviewed the case and on January 28, 2004, issued a decision in Welch's favor that required Cardinal to reinstate Welch and pay his back wages, attorney's fees, costs, and expenses. The ALJ found that Welch "reasonably believed" that the company violated SOX, and that there were circumstances sufficient to infer that Welch's conduct was a "contributing factor" to his termination.*

Cardinal appealed the ALJ's decision to the DOL ARB and argued that Welch was not terminated for his whistleblowing activities but rather because he refused to meet with Cardinal's audit committee without his personal attorney present, citing that the company was concerned that certain confidential information might be disclosed improperly if the attorney had been present. On May 31, 2007, the ARB issued an opinion that denied Welch's complaint and overturned the ALJ's previous ruling to reinstate Welch to his position. The ARB ruled that the ALJ's ruling was erroneous since Welch's assertions related to accounting standards, rather than violations of federal law relating to "fraud against shareholders," and, as a result, Welch's complaints were not considered "protected activity" under SOX.

Furthermore, the ARB opined that Welch could not have "reasonably believed" that the alleged fraud would result in misleading the company's shareholders about the company's financial condition. Additionally, while Welch's case was under review by the ARB, the U.S. District Court for the Western District of Virginia refused to enforce the ALJ's order to reinstate Welch's position. At this point in time, Welch plans to take his case to the Fourth Circuit U.S. Court of Appeals.

  • 1   The implementation of such provisions is warranted, since the 2006 Association of Certified Fraud Examiners (ACFE) Report to the Nation on Occupational Fraud and Abuse (ACFE Report), as in previous ACFE reports, identified tips as the most common method for detecting occupational fraud. Of the 1,134 fraud cases analyzed within the 2006 ACFE Report, 34.2% of the cases were identified by tips, with employee tips accounting for 64.1% of the allegations, followed by anonymous individuals (18%), customers (10.7%), and vendors (7.1%). Tips appeared to provide even greater value in detecting frauds totaling $1 million or larger, as they represented the primary detection method in 44.1% of the aforementioned cases.
  • 2   The Whistleblower Protection Program, U.S. Department of Labor, Occupational Safety and Health Administration Exterior Link.
  • 3   Engen, John R., "Backlash!," Bank Director Magazine Exterior Link, fourth quarter 2006.
  • 4   Carey, Mark P., "What is a SOX claim? Exterior Link"
  • 5   Taub, Stephen, and Reason, Tim, "Whistle-Blowers Never Win Exterior Link," June 8, 2007.
  • 6   Moberly, Richard E., "Unfulfilled Expectations: An Empirical Analysis of Why Sarbanes-Oxley Whistleblowers Rarely Win," bepress Legal Series Exterior Link, Working Paper 1987, February 6, 2007.

     
  • *   Wissert, David M.; Levinson Werner, Julie; and Anoniello, Vincent A., "Sarbanes-Oxley Strikes…The First Whistle Has Been Blown," The Metropolitan Corporate Counsel Exterior Link, Vol. 12, No. 5, May 2004.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.