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SEC/SRO Update

Wall Street Lawyer (Vol. 21, Issue 11)

Is Blowing the Whistle Internally Enough to Be Covered by the Anti-Retaliation Provisions of the Dodd-Frank Act? New SEC Guidance Related to Excluding Shareholder Proposals

 

Is Blowing the Whistle Internally Enough to Be Covered by the Anti-Retaliation Provisions of the Dodd-Frank Act?

Consider the following fact pattern: Paul Somers worked at Digital Realty Trust, Inc. as a vice president of portfolio management. He reported internally to senior management regarding possible securities law violations, including accusing his supervisor of eliminating certain internal controls required by the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act). Mr. Somers’ employment was subsequently terminated. He never reported this information to the Securities and Exchange Commission (SEC).

On November 28, the U.S. Supreme Court will hear arguments in Digital Realty Trust, Inc. v. Paul Somers1 on whether the anti-retaliation protections for “whistleblowers” in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) extend to individuals who have reported alleged misconduct internally, but not to the SEC.

Mr. Somers sued Digital Realty in federal court accusing the company of violating the Dodd-Frank Act by firing him for complaining internally about alleged Sarbanes-Oxley violations. Digital Realty failed to have the lawsuit dismissed on the grounds that Mr. Somers is not a “whistleblower” under the Dodd-Frank Act because he complained about the alleged securities law violations only internally, and not externally to the SEC. The district court denied the motion to dismiss in reliance on the SEC’s interpretation of the definition of the term “whistleblower” and certified its order for review by the U.S. Court of Appeals for the Ninth Circuit. The Ninth Circuit panel affirmed the district court’s decision, and Digital Realty took its case to the U.S. Supreme Court.

The ambiguity stems from different definitions of the term “whistleblower” in the Dodd-Frank Act and rules promulgated by the SEC to implement the Dodd-Frank Act’s whistleblower program2.

Section 922 of the Dodd-Frank Act added Section 21F3 to the Securities Exchange Act of 1934, as amended (the Exchange Act), to provide both incentives and protections to whistleblowers of securities violations. Section 21F enables the SEC to pay an award to whistleblowers who voluntarily provided original information to the SEC that leads to the successful enforcement of a judicial or administrative action. Such award can range from 10% to 30% of the collected monetary sanctions imposed in the action. In addition, Section 21F(h)(1)(A) includes the following prohibition against retaliation:

[n]o employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower

  1. in providing information to the SEC in accordance with Section 21F;
  2. in initiating, testifying in, or assisting in any investigation or judicial or administrative action of the SEC based upon or relating to such information; or
  3. in making disclosures that are required or protected under the Sarbanes-Oxley Act. . . , the Exchange Act. . . and any other law, rule, or regulation subject to the jurisdiction of the SEC. (emphasis added)

Section 21F(a)(6) defines the term “whistleblower” as any individual who “provides. . . information relating to a violation of the securities laws to the SEC, in a manner established, by rule or regulation, by the SEC.”

In May 2011, the SEC adopted rules4 implementing Section 21F of the Exchange Act and expanded the definition of the term “whistleblower” provided in Section 21F. Rule 21F-2(a) defines with the term “whistleblower” as an individual who provides the SEC with information relating to a possible violation of the federal securities laws (including any rules or regulations) that has occurred, is ongoing or is about to occur. In addition, Rule 21F-2(b) states that, for purposes of the anti-retaliation protections under Section 21F(h)(1), a person is a whistleblower if: (i) such person possesses a reasonable belief that the information provided relates to a possible securities law violation that has occurred, is ongoing or is about to occur; and (ii) such person provides that information in a manner described in Section 21F(h)(1)(A) of the Exchange Act, which includes internal reporting protected under the Sarbanes-Oxley Act.

Various parties filed amicus briefs with the Supreme Court in connection with Digital Realty Trust, Inc. v. Paul Somers. For example, the briefs filed by the U.S. Chamber of Commerce and the Center for Workplace Compliance (formerly the Equal Employment Advisory Council) support the petitioner, Digital Realty Trust, Inc., while briefs filed by the SEC and the National Whistleblower Center support the respondent, Mr. Somers.

Briefs filed in support of Digital Realty Trust argue that the Dodd-Frank Act anti-retaliation protections apply only in those situations where an employee reports a violation to the SEC based on the definition of “whistleblower” in Section 21F (for example, an employee may initially report to the SEC, then report internally and be fired for the internal reporting; an employee may simultaneously report to the SEC and internally and be fired for either disclosure; or an employee may report internally, then report to the SEC and be fired for the internal reporting).

The SEC’s position is consistent with its interpretive guidance5 issued in August 2015 and relies on its definition of the term “whistleblower” in Rule 21F-2, which includes two separate definitions of the term “whistleblower” that the SEC argues “apply in different circumstances.” The first definition, set forth in Rule 21F-2(a), “mirrors the statutory definition of whistleblower. . . and applies only to the award. . . provisions of Section 21F” in connection with reporting a violation to the SEC. The second whistleblower definition, set forth in Rule 21F-2(b), does not require reporting to the SEC and provides “employment retaliation protections for individuals who report internally first to a supervisor, compliance official, or other person working for the company that has authority to investigate, discover, or terminate misconduct.”

Although the issue of the definition of the term “whistleblower” may seem to be very technical, the Supreme Court’s decision in this case may lead to very important consequences for companies and employees.

The SEC believes that requiring employees to report a violation to the SEC as a condition for obtaining the anti-retaliation protections of the Dodd-Frank Act may “discourage some individuals from first reporting internally in appropriate circumstances and, thus, jeopardize the investor-protection and law-enforcement benefits that can result from internal reporting.” If the Supreme Court rules that anti-retaliation protections can be obtained only if an employee reports the violation to the SEC, there may be little incentive for an employee to report a violation internally. Such development may jeopardize companies’ ability to have an effective internal compliance program, to investigate and remediate violations internally and may also significantly increase the number of complaints received by the SEC just to preserve a retaliation claim under the Dodd-Frank Act.

The employers’ concern is that the Ninth Circuit interpretation of the term “whistleblower” that relies on the SEC’s position will result in employees either bypassing anti-retaliation protections of the Sarbanes-Oxley Act or using the Dodd-Frank Act protections if they are not satisfied with the result of their claims under the Sarbanes-Oxley Act. This, they say, would lead to the proliferation of costly litigation under the Dodd-Frank Act. They believe that plaintiffs would be more likely to invoke the anti-retaliation provisions of the Dodd-Frank Act than the Sarbanes-Oxley Act because, under the Dodd-Frank Act, an employee can (i) file a complaint directly in a district court without exhausting administrative procedures prescribed under the Sarbanes-Oxley Act; (ii) obtain a double-backpay award as opposed to single-backpay remedy available under the Sarbanes-Oxley Act; and (iii) benefit from a longer statute of limitations under the Dodd-Frank Act—up to 10 years after the date on which the violation occurs, compared to 180 days under the Sarbanes-Oxley Act.

New SEC Guidance Related to Excluding Shareholder Proposals

On November 1, the SEC Staff issued Staff Legal Bulletin (SLB) No. 1416 which provides guidance related to seeking exclusion of shareholder proposals under Exchange Act Rule 14a-8.

Rule 14a-8(i)(7)—Ordinary Business Exception

Rule 14a-8(i)(7) permits a company to exclude a shareholder proposal that deals with a matter relating to the company’s ordinary business operations. Historically, the SEC has stated that “proposals that raise matters that are so fundamental to management’s ability to run a company on a day-to-day basis that they could not, as a practical matter, be subject to direct shareholder oversight may be excluded, unless such a proposal focuses on policy issues that are sufficiently significant because they transcend ordinary business and would be appropriate for a shareholder vote.”

In the SLB, the SEC Staff explains that the Division believes a company’s board is in a better position to determine and explain whether a shareholder proposal implicates a significant policy issue. Accordingly, in connection with no-action requests to exclude a shareholder proposal based upon the ordinary business exception, companies will need to include “a discussion that reflects the board’s analysis of the particular policy issue raised and its significance. That explanation would be most helpful if it detailed the specific processes employed by the board to ensure that its conclusions are well-informed and well-reasoned.”

Rule 14a-8(i)(5)—Economic Relevance Exception

Rule 14a-8(i)(5) permits a company to exclude a shareholder proposal that relates to operations which account for less than 5% of the company’s total assets at the end of its most recent fiscal year, and for less than 5% of its net earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related to the company’s business. Historically, the Division has not often granted no-action requests to exclude a shareholder proposal based upon Rule 14a-8(i)(5). The SLB explains that the Division’s practice has been to not permit exclusion of a proposal “where the proposal has reflected social or ethical issues, rather than economic concerns, raised by the issuer’s business, and the issuer conducts any such business, no matter how small.”

In the SLB, the SEC Staff explains that its historical analysis did not fully consider whether the proposal dealt with a matter that is significantly related to a company’s business. In the future, the Division’s analysis will focus “on a proposal’s significance to the company’s business when it otherwise relates to operations that account for less than 5% of total assets, net earnings and gross sales.” Similar to the ordinary business exception, the SEC Staff explained that it believes a company’s board is in a better position to determine whether a proposal is otherwise significantly related to such company’s business. Therefore, no-action requests to exclude a shareholder proposal based upon the economic relevance exception, should “include a discussion that reflects the board’s analysis of the proposal’s significance to the company. That explanation would be most helpful if it detailed the specific processes employed by the board to ensure that its conclusions are well-informed and well-reasoned.”

In connection with both the ordinary business exception and the economic relevance exception, the SLB puts the burden on boards to analyze the issue raised by the proposal and the issue’s significance to the company. This new requirement has raised a number of questions as to the application of the SLB. At the 49th Annual Institute on Securities Regulation, held November 8-10 in New York City, the Division of Corporation Finance Director Bill Hinman indicated that the SEC Staff would not expect a new full analysis related to an issue if there is a well-worn path. In addition, Hinman explained that the SEC Staff does not expect the no-action request to follow any particular format and that companies do not need to submit board books. Hinman indicated that the SEC Staff expects that the analysis to be included in future no-action requests will be similar to the analysis that the Division has historically received from law firms.

 Proposals Submitted on Behalf of Shareholders

The Division believes that a shareholder’s submission of a proposal through a representative, referred to as “proposal by proxy,” is consistent with Rule 14a-8. Going forward, shareholders submitting proposals by proxy, must provide documentation which: (i) identifies the shareholder-proponent and the person or entity selected as proxy; (ii) identifies the company to which the proposal is directed; (iii) identifies the annual or special meeting for which the proposal is submitted; (iv) identifies the specific proposal to be submitted; and (iv) be signed and dated by the shareholder. If this documentation is not provided, there may be a basis to exclude the proposal under Rule 14a-8(b).

Use of Images in Shareholder Proposals

The Division believes that graphics can have a role in a shareholder proposal so long as they are fairly presented. The SLB provides that exclusion of graphs and/or images would be appropriate under Rule 14a-8(i)(3) where they:

  • make the proposal materially false or misleading;
  • render the proposal so inherently vague or indefinite;
  • directly or indirectly impugn character or make charges concerning improper, illegal or immoral conduct without factual foundation; or
  • are irrelevant to a consideration of the subject matter of the proposal.

The SLB also provides that the exclusion of a graph or an image would be appropriate under Rule 14a-8(d) if the total number of words in a proposal, including words in the graphics, exceeds 500 words.

ENDNOTES:

1Digital Realty Trust v. Somers, Docket No. 16-1276; 2017, U.S. Supreme Court.

2The SEC’s Office of the Whistleblower administers the whistleblower program established under the Dodd-Frank Act.

3See Sec. 922: Whistleblower Protections, available at https://www.sec.gov/about/offices/owb/dodd-f rank-sec-922.pdf.

4See “Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934” (May 25, 2011), available at https://www.se c.gov/rules/final/2011/34-64545.pdf.

5See “Interpretation of the SEC’s Whistleblower Rules under Section 21F of the Securities Exchange Act of 1934” (August 4, 2015), available at https://w ww.sec.gov/rules/interp/2015/34-75592.pdf.

6SEC Staff Legal Bulletin No. 141; Nov. 1, 2017; available at https://www.sec.gov/interps/legal/cfslb14 i.htm.

“SEC/SRO Update: Is Blowing the Whistle Internally Enough to Be Covered by the Anti-Retaliation Provisions of the Dodd-Frank Act? New SEC Guidance Related to excluding Shareholder Proposals,” by Yelena M. Barychev and Melissa Palat Murawsky was published in the November 2017 edition of Wall Street Lawyer (Vol. 21, 11). Reprinted with permission from the Wall Street Lawyer, a Thomson Reuters publication.