<b>BREAKING NEWS:</b> SEC Proposed Rule 21F-13: A Hidden Whistleblower Tax?

Among the Proposed Rules is Proposed Rule 21F-13, which provides the procedures applicable to the payment of the whistleblower awards. Rule 21F-13(a) provides that all whistleblower awards made pursuant to Rule 21F must be paid from the Securities and Exchange Commission Investor Protection Fund (the 'Fund'), which is established by Section 21F(g) of the Exchange Act. Rule 21F-13(d) sets out the rules governing the timing of payment in the situation in which the Fund lacks a sufficient amount to satisfy the payment of a whistleblower award. At this point, it is natural to wonder how the Fund ' the main purpose of which is to satisfy whistleblower awards 'c ould ever possess an insufficient amount to pay a whistleblower. The mechanism for adding money to the Fund offers the answer. [Note that the Fund can also be used by the SEC for 'funding the activities of the Inspector General of the Commission.' Section 21F(g)(2)(B) of the Exchange Act.]

Section 308 of SOX

Under section 308 of the Sarbanes-Oxley Act (SOX), the SEC has the power to add disgorged funds to a disgorgement fund for the benefit of the victims of an underlying securities violation. Now, section 21F(g)(3)(A) of the Exchange Act will provide the mechanism for allocating sanctions to the Fund. Under this section, the Fund receives 'any monetary sanction collected by the Commission in any judicial or administrative action brought by the Commission under the securities laws that is not added to a disgorgement fund or other fund under section 308 of the Sarbanes-Oxley Act of 2002 or otherwise distributed to victims of a violation of the securities laws.' (Emphasis added.) The emphasized portion of section 21F(g)(3)(A) is the key. Its application means that only the excess amount of a monetary sanction ' that amount not added to a disgorgement fund or otherwise given to victims ' is actually added to the Fund. Since a whistleblower's award represents 10% to 30% of the entire amount of the monetary sanction, a situation may arise in which more money is being withdrawn from the Fund than deposited. See Section 21(F)(b)(1) of the Exchange Act.

A Hypothetical

To illustrate this situation, consider the following hypothetical. Whistleblower, an employee of Company, provides original information to the SEC that leads to a $100 million sanction against Company. Under the terms of the sanction, $90 million is to be distributed to the victims of Company's securities violations. The SEC also determines that, based on the importance of the information provided by Whistleblower, a 30% whistleblower award is appropriate. Thus, Whistleblower is awarded 30% of $100 million, or $30 million. However, because $90 million is already being distributed to the victims, only $10 million remains to be added to the Fund. Thus, once Whistleblower is paid the $30 million award from the Fund and the excess $10 million is deposited to the Fund, the net result is that the Fund decreases by $20 million. Over time, therefore, it is hypothetically possible that the combination of large awards to victims and large awards to whistleblowers could deplete the Fund's reserves.

Section 21(F)(g)(3)(B) of the Exchange Act addresses the situation by providing that if the Fund contains an insufficient amount to satisfy a whistleblower award, an amount equal to the unsatisfied portion must be added to the Fund from the total monetary sanctions collected in the action. In other words, in this situation, the whistleblower's interests outweigh the victims' interests, and the whistleblower award is satisfied at the expense of the victims' disgorgement fund. In the Proposing Release, the SEC acknowledges this situation and requests comments on how to resolve the 'tension between the competing interests of paying an award to a whistleblower (as provided in Section 21F) and compensating victims with monies collected from wrongdoers (as recognized in Section 308 of the Sarbanes-Oxley Act).' See Proposing Release, p. 82. The SEC's concern in this area is also evidenced by its initial funding of the Fund with $450 million, an amount that exceeds the $300 million minimum required by Section 21F(g)(3)(A)(i) of the Exchange Act.

A Potential Solution

One potential solution is foreclosed by the Dodd-Frank Act itself. Section 21F(c)(1)(B)(ii) of the Exchange Act (as added by Dodd-Frank) states that the SEC may not consider the balance of the Fund when determining the amount of a whistleblower award. Therefore, if the SEC determines that circumstances warrant a thirty percent whistleblower award, the fact that the Fund currently lacks sufficient funds to satisfy the award is not a relevant concern, and the whistleblower must receive the 30% award. Consequently, the whistleblower sits in the best position: the amount of the award granted cannot be reduced due to a lack of funds, and the payment of the award takes precedence over the victims of the securities violations.

The concern for companies, however, is the extent to which the SEC will attempt to shift the burden from the victims to the companies. The SEC possesses wide discretion in the assessment of monetary sanctions, and it is conceivable that the SEC could solve the tension between the whistleblowers and the victims by assessing larger sanctions generally in order to keep the Fund solvent. This would allow the SEC to continue to distribute large amounts to the victims of securities violations, while maintaining enough excess sanction money to deposit in the Fund to satisfy whistleblower awards.

With this in mind, reconsider the previous hypothetical with the SEC assessing an initial sanction of $150 million instead of $100 million. The victims are still distributed $90 million. The whistleblower is still granted a 30% award, but this time the award is $45 million (30% of $150 million). The Fund, however, does not lose money in this instance since the excess ($150 million minus $90 million) added to the fund totals $60 million. Thus, after payment to the whistleblower, the Fund gains $15 million in this instance and the SEC's incentive to increase sanctions is exemplified.

Such a step would be unfair in that companies would be forced to pay larger sanctions based on SEC administrative needs ' factors entirely extraneous and unrelated to their conduct or offense ' and particularly troubling to a company that faces sanctions stemming from an action that does not involve a whistleblower. Since the Fund collects the excess sanctions 'collected by the Commission in any judicial or administrative action brought by the Commission under the securities laws,' the SEC's incentive to increase sanctions will be present regardless of whether the action is based on information provided by a whistleblower. See Section 21F(g)(3)(A)(i) (emphasis added). Every action offers an opportunity to add money to the Fund. Therefore, a company facing SEC-imposed sanctions might legitimately worry that it will be required to pay an inflated amount to help pay other companies' whistleblowers. In essence, Section 21F(g)(3) of the Exchange Act and Proposed Rule 21F-13 may be providing the SEC with the opportunity to institute a 'Whistleblowers Tax.' The Dodd-Frank Act makes one thing clear: whistleblowers must be paid. The troublesome question now is who will be required to bear that cost.

Christine Edwards ([email protected]) is a partner in Chicago office of Winston & Strawn's corporate practice group. She focuses on the regulation of the financial services industry ' particularly the securities and banking industries ' as well as corporate governance and public and regulatory policy issues. Edward Johnsen ([email protected]) is a partner in the firm's financial services practice group, resident in New York. He concentrates on regulatory matters relating to broker-dealers and other financial institutions. Jerry Loeser ([email protected]) is of counsel in the firm's Chicago office whose practice focuses on banking regulation. He was previously chief regulatory and compliance counsel for Comerica Bank, where he also served earlier as general counsel of its retail bank division and senior vice president and deputy general counsel.

Corporate Counsel take note: on Nov. 3, the Securities and Exchange Commission (the 'SEC') published proposed Regulation 21F (the 'Proposed Rules'), establishing a program designed to reward individuals who provide the SEC with information leading to successful enforcement actions. See Securities Exchange Act Release No. 63237 (Nov. 3, 2010) (the 'Proposing Release'). The proposal was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act ('Dodd-Frank') and sets out procedures under which potential informants ('whistleblowers') could qualify for significant monetary awards by providing information to the SEC regarding violations of the federal securities laws. The deadline for comment on the Proposed Rules is Dec. 17, 2010.

Key Questions

The question that should be on everyone's mind is how will the Fund ' out of which money will be dispensed to successful whistleblowers ' work? Will every institution that is sanctioned by the SEC pay ' and pay even though their institution had no whistleblower? The likely answer to this is yes ' every institution will pay. Under Section 922 of Dodd-Frank, Section 21F was added to the Securities Exchange Act of 1934, as amended (the 'Exchange Act'), authorizing the SEC to pay awards to certain individuals who provide original information that leads to successful SEC enforcement actions and certain related actions. If a whistleblower qualifies, the SEC has the discretion to determine the amount of the award, subject to a statutory minimum and maximum of between ten to thirty percent of the total sanctions collected in the action stemming from the whistleblower's information. See Section 21F(b)(1) of the Exchange Act.

Among the Proposed Rules is Proposed Rule 21F-13, which provides the procedures applicable to the payment of the whistleblower awards. Rule 21F-13(a) provides that all whistleblower awards made pursuant to Rule 21F must be paid from the Securities and Exchange Commission Investor Protection Fund (the 'Fund'), which is established by Section 21F(g) of the Exchange Act. Rule 21F-13(d) sets out the rules governing the timing of payment in the situation in which the Fund lacks a sufficient amount to satisfy the payment of a whistleblower award. At this point, it is natural to wonder how the Fund ' the main purpose of which is to satisfy whistleblower awards 'c ould ever possess an insufficient amount to pay a whistleblower. The mechanism for adding money to the Fund offers the answer. [Note that the Fund can also be used by the SEC for 'funding the activities of the Inspector General of the Commission.' Section 21F(g)(2)(B) of the Exchange Act.]

Section 308 of SOX

Under section 308 of the Sarbanes-Oxley Act (SOX), the SEC has the power to add disgorged funds to a disgorgement fund for the benefit of the victims of an underlying securities violation. Now, section 21F(g)(3)(A) of the Exchange Act will provide the mechanism for allocating sanctions to the Fund. Under this section, the Fund receives 'any monetary sanction collected by the Commission in any judicial or administrative action brought by the Commission under the securities laws that is not added to a disgorgement fund or other fund under section 308 of the Sarbanes-Oxley Act of 2002 or otherwise distributed to victims of a violation of the securities laws.' (Emphasis added.) The emphasized portion of section 21F(g)(3)(A) is the key. Its application means that only the excess amount of a monetary sanction ' that amount not added to a disgorgement fund or otherwise given to victims ' is actually added to the Fund. Since a whistleblower's award represents 10% to 30% of the entire amount of the monetary sanction, a situation may arise in which more money is being withdrawn from the Fund than deposited. See Section 21(F)(b)(1) of the Exchange Act.

A Hypothetical

To illustrate this situation, consider the following hypothetical. Whistleblower, an employee of Company, provides original information to the SEC that leads to a $100 million sanction against Company. Under the terms of the sanction, $90 million is to be distributed to the victims of Company's securities violations. The SEC also determines that, based on the importance of the information provided by Whistleblower, a 30% whistleblower award is appropriate. Thus, Whistleblower is awarded 30% of $100 million, or $30 million. However, because $90 million is already being distributed to the victims, only $10 million remains to be added to the Fund. Thus, once Whistleblower is paid the $30 million award from the Fund and the excess $10 million is deposited to the Fund, the net result is that the Fund decreases by $20 million. Over time, therefore, it is hypothetically possible that the combination of large awards to victims and large awards to whistleblowers could deplete the Fund's reserves.

Section 21(F)(g)(3)(B) of the Exchange Act addresses the situation by providing that if the Fund contains an insufficient amount to satisfy a whistleblower award, an amount equal to the unsatisfied portion must be added to the Fund from the total monetary sanctions collected in the action. In other words, in this situation, the whistleblower's interests outweigh the victims' interests, and the whistleblower award is satisfied at the expense of the victims' disgorgement fund. In the Proposing Release, the SEC acknowledges this situation and requests comments on how to resolve the 'tension between the competing interests of paying an award to a whistleblower (as provided in Section 21F) and compensating victims with monies collected from wrongdoers (as recognized in Section 308 of the Sarbanes-Oxley Act).' See Proposing Release, p. 82. The SEC's concern in this area is also evidenced by its initial funding of the Fund with $450 million, an amount that exceeds the $300 million minimum required by Section 21F(g)(3)(A)(i) of the Exchange Act.

A Potential Solution

One potential solution is foreclosed by the Dodd-Frank Act itself. Section 21F(c)(1)(B)(ii) of the Exchange Act (as added by Dodd-Frank) states that the SEC may not consider the balance of the Fund when determining the amount of a whistleblower award. Therefore, if the SEC determines that circumstances warrant a thirty percent whistleblower award, the fact that the Fund currently lacks sufficient funds to satisfy the award is not a relevant concern, and the whistleblower must receive the 30% award. Consequently, the whistleblower sits in the best position: the amount of the award granted cannot be reduced due to a lack of funds, and the payment of the award takes precedence over the victims of the securities violations.

The concern for companies, however, is the extent to which the SEC will attempt to shift the burden from the victims to the companies. The SEC possesses wide discretion in the assessment of monetary sanctions, and it is conceivable that the SEC could solve the tension between the whistleblowers and the victims by assessing larger sanctions generally in order to keep the Fund solvent. This would allow the SEC to continue to distribute large amounts to the victims of securities violations, while maintaining enough excess sanction money to deposit in the Fund to satisfy whistleblower awards.

With this in mind, reconsider the previous hypothetical with the SEC assessing an initial sanction of $150 million instead of $100 million. The victims are still distributed $90 million. The whistleblower is still granted a 30% award, but this time the award is $45 million (30% of $150 million). The Fund, however, does not lose money in this instance since the excess ($150 million minus $90 million) added to the fund totals $60 million. Thus, after payment to the whistleblower, the Fund gains $15 million in this instance and the SEC's incentive to increase sanctions is exemplified.

Such a step would be unfair in that companies would be forced to pay larger sanctions based on SEC administrative needs ' factors entirely extraneous and unrelated to their conduct or offense ' and particularly troubling to a company that faces sanctions stemming from an action that does not involve a whistleblower. Since the Fund collects the excess sanctions 'collected by the Commission in any judicial or administrative action brought by the Commission under the securities laws,' the SEC's incentive to increase sanctions will be present regardless of whether the action is based on information provided by a whistleblower. See Section 21F(g)(3)(A)(i) (emphasis added). Every action offers an opportunity to add money to the Fund. Therefore, a company facing SEC-imposed sanctions might legitimately worry that it will be required to pay an inflated amount to help pay other companies' whistleblowers. In essence, Section 21F(g)(3) of the Exchange Act and Proposed Rule 21F-13 may be providing the SEC with the opportunity to institute a 'Whistleblowers Tax.' The Dodd-Frank Act makes one thing clear: whistleblowers must be paid. The troublesome question now is who will be required to bear that cost.

Christine Edwards ([email protected]) is a partner in Chicago office of Winston & Strawn's corporate practice group. She focuses on the regulation of the financial services industry ' particularly the securities and banking industries ' as well as corporate governance and public and regulatory policy issues. Edward Johnsen ([email protected]) is a partner in the firm's financial services practice group, resident in New York. He concentrates on regulatory matters relating to broker-dealers and other financial institutions. Jerry Loeser ([email protected]) is of counsel in the firm's Chicago office whose practice focuses on banking regulation. He was previously chief regulatory and compliance counsel for Comerica Bank, where he also served earlier as general counsel of its retail bank division and senior vice president and deputy general counsel.