Dealing with a whistleblower who remains an employee after going to the Government has always been something like traversing a mine field. When the Securities and Exchange Commission (“SEC”) adopted Rule 21F-2, defining a “whistleblower”1 and making a violation of the prohibition on retaliation that appears in Section 21F(h)(1) of the Exchange Act subject to an SEC enforcement proceeding,2 the path became even more treacherous. It has been only a question of time before the SEC viewed treatment of a whistleblower as retaliatory and sued. That time has come.3
The SEC recently initiated and settled the first enforcement proceeding alleging a violation of Section 21F(h).4 The respondents were Paradigm Capital Management (“Paradigm”), a registered investment adviser, and its principal (collectively, “Respondents”). As is typical in administrative proceedings and most judicial proceedings, the settlement is one in which Respondents neither admitted nor denied the allegations in the SEC’s administrative order (“Order”).
The Order, while fact intensive, certainly illustrates the challenges of having a whistleblower in a firm’s continued employ.
The Alleged Underlying Securities Law Violation
The Order alleged that Paradigm, an adviser with $1.7 billion under management, engaged in principal transactions without making the disclosures or obtaining the consent required by Section 206(3) of the Advisers Act.5 According to the Order, Paradigm’s principal, a senior portfolio manager, directed sales of securities from a private fund (“Fund”) that she managed and controlled through her ownership of the Fund’s general partner to a proprietary account at broker-dealer that she also controlled. Each transaction was done at the market price without markups or commissions; the objective was to realize losses for tax purposes while continuing to control the securities which the portfolio manager viewed favorably. The SEC alleged that Paradigm did not provide effective written disclosures, nor did it obtain consent of the Fund to enter into the principal transactions.
According to the Order, Paradigm’s head trader made a whistleblower submission to the SEC regarding Paradigm’s purported principal transactions in late March 2012 and disclosed his submission to Paradigm approximately four months later. During that period, the whistleblower’s trading and supervisory duties remain unchanged. After learning of his submission, Paradigm removed the whistleblower from the trading desk and relieved him of his trading and supervisory responsibilities, citing a need to investigate the whistleblower’s involvement in the trades he disclosed to the SEC. Paradigm instructed the whistleblower to prepare a report concerning the potential violations he reported to the SEC and required that he do this offsite. Paradigm also blocked the whistleblower’s access to his email and to trading accounts.
While the whistleblower was off-site, his counsel and that of Paradigm sought to negotiate the terms of his departure. When those negotiations were unsuccessful, the whistleblower advised that he wished to return to Paradigm but only in the same position that he had held previously.
Paradigm allowed the whistleblower to return, but not as the head trader. According to the Order, Paradigm had no legitimate reason for removing the Whistleblower from his position as head trader, tasking him with investigating the very conduct he had reported to the Commission, changing his job function from head trader to a full-time compliance assistant, stripping him of his supervisory responsibilities, and otherwise marginalizing him. Paradigm engaged in each of these adverse employment actions immediately after learning that the Whistleblower reported potential securities violations to the Commission.
The whistleblower resigned in August 2012.
Respondents consented to pay disgorgement of $1.7 million to Fund investors, an amount approximating “certain administrative fees the Fund paid in connection with the principal transactions.” They were also ordered to pay prejudgment interest of $181,771 and a civil penalty of $300,000, and to hire a compliance consultant to review and recommend changes to its policies and procedures surrounding principal transactions. In addition, Respondents agreed to cease and desist from future violations of Section 206(3) and Section 207 of the Advisers Act and Section 21F(h) of the Exchange Act.
This is clearly a “message” case, one that the SEC likely was eager to bring to signal its support for whistleblowers and as a warning to employers.6 But the “lessons,” beyond the obvious “tread with care” when you learn you have a whistleblower, are not as clear.
Formal Personnel Action. Paradigm did not take formal adverse personnel action to terminate or suspend the whistleblower. The SEC, however, viewed the whistleblower’s assignment to compliance as at least a de facto demotion. By its terms, Section 21F(h) prohibits not only these formal adverse actions, but also bars efforts to “harass, directly or indirectly, or in any other manner discriminate against a whistleblower.”7
Money Isn’t Everything. Paradigm did not change the whistleblower’s economics. He continued to be compensated at the same level as before in both salary and benefits. Presumably, this was a deliberate effort on Paradigm’s part to avoid a retaliation claim. Section 21F(h) does not make any express mention of compensation. It is clear from the Order that the SEC does not view an employer retaining a whistleblower’s salary and benefit levels to preclude a retaliation charge.
Can the Firm Do Anything? One reading of the Order is that any change in the workplace status of a known whistleblower is problematic and could result in a Section 21F(h) violation. But that should not be the case. In Paradigm, the firm’s principal was responsible for the underlying conduct that the whistleblower reported. She (and others), however, were not subjected to the same inquiry or actions taken against the whistleblower. This disparity in treatment made the SEC’s case more compelling.
If, in the next case, the employer made inquiry and took proportionate action against all wrongdoers, including a whistleblower, the analysis should be quite different. Indeed, it would be untenable if, because of a whistleblower, a firm were unable to investigate alleged wrongdoing and take proportionate action, including changing job responsibilities or even terminating employment of a wrongdoer who happened also to be a whistleblower. Particularly for registered entities, such as broker-dealers and investment advisers, supervisory obligation may demand no less.
Dealing with a whistleblower has been a daunting task for an employer. Dodd-Frank’s recently added prohibition on retaliation against whistleblowers, and SEC’s attendant rules, have increased the challenges. The Paradigm Order illustrates some of those challenges but does little to suggest a way through the mine field.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Timothy Burke
1 17 C.F.R. §§ 240.21F-2(a), 240.21F-2(b)(1) (2014).
2 Id. at § 240.21F-2(b)(2).
3 The question of whether an employee who reports a potential securities law violation internally to her employer, but not to the SEC, is protected under the anti-retaliation provisions of Section 21F(h) is an unsettled one. The SEC has taken the position that an employee who only reports internally is protected. See id. at § 240.21F-2(b)(1)(i); Brief for the Securities and Exchange Commission as Amicus Curae in Support of the Appellant, Liu v. Siemens AG, No. 13-4385 (2d Cir. Feb. 20, 2014). A number of district courts have upheld the SEC’s view that the definition of “whistleblower” is broader in the anti-retaliation context than in the context of a reward. See, e.g., Rosenblum v. Thomson Reuters (Mkts.) LLC, No. 13 Civ. 2219(SAS) (S.D.N.Y. Oct. 25, 2013); Ellington v. Giacoumakis, Civil Action No. 13-11791-RGS, 2013 WL 5631046, *3 (D. Mass. Oct. 16, 2013); Genberg v. Porter, No. 11-cv-02434-WYD-MEH, 2013 WL 12220586, *10 (D. Colo. Mar. 25, 2013); Nollner v. S. Baptist Convention, Inc., 852 F. Supp. 2d 986, 993-994 (M.D. Tenn. 2012); Kramer v. Trans-Lux Corp., No. 3:11-cv-01424 (SRU), 2012 WL 4444820, *3-*4 (D. Conn. Sept. 25, 2012); Egan v. TradingScreen, Inc., No. 10 Civ. 8202(LBS), 2011 WL 1672066, *4, *7 (S.D.N.Y. May 4, 2011). The Fifth Circuit has rejected this interpretation of Dodd-Frank’s anti-retaliation provisions and held that reporting solely internally is insufficient to trigger the anti-retaliation protection. See Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620, 630 (5th Cir. 2013); accord Englehart v. Career Educ. Corp., No. 8:14-cv-444-T-33EAJ, 2014 U.S. Dist. LEXIS 64994 (M.D. Fla. May 12, 2014). The Second Circuit could also rule on the issue in the near future. See Liu v. Siemens AG, No. 13-4385 (2d Cir. Feb. 20, 2014).
4 In the Matter of Paradigm Capital Mgmt., Inc., Exchange Act Release No. 72393 (June 16, 2014).
5 Obtaining a sufficient consent in the context of transactions between a fund and its general partner, managing member, or affiliates has been a thorny problem for fund managers. Under some circumstances a transaction between two funds, one of which has substantial general partner participation, may be subject to Section 206(3). Gardner Russo & Gardner, SEC No Action Letter [File No. 801-41357] 2006 WL 1594207 (June 7, 2006). The Paradigm Order criticized the workings on the conflict committee used by Paradigm to seek consent, asserting that the committee itself was conflicted. The Paradigm Order did not say that no internal committee could be sufficient but particularly in smaller firms, it likely would be difficult for members of an internal committee not to be conflicted in the eyes of the SEC staff.
6 Press Release, Sec. and Exch. Comm’n, SEC Charges Hedge Fund Adviser With Conducting Conflicted Transactions and Retaliating Against Whistleblower (June 16, 2014) (available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542096307) (“‘For whistleblowers to come forward, they must feel assured that they’re protected from retaliation and the law is on their side should it occur,’ said Sean McKessy, chief of the SEC’s Office of the Whistleblower. ‘We will continue to exercise our anti-retaliation authority in these and other types of situations where a whistleblower is wrongfully targeted for doing the right thing and reporting a possible securities law violation.’”); id. (according to Andrew J. Ceresney, director of the SEC’s Division of Enforcement, “Those who might consider punishing whistleblowers should realize that such retaliation, in any form, is unacceptable.”).
7 15 U.S.C. § 78u-6(h)(1)(A) (2012).
This article was originally published by Bingham McCutchen LLP.