New SEC Whistleblower Program & Hedge Fund Investor Protections On Way, to Supplement IRS Whistleblower Program? Congress & SEC Consider Changes After Madoff, Stanford Schemes

Could a meaningful SEC “whistleblower” program prevent the next Madoff or Stanford debacle? The SEC and legislators are now seriously considering that question. That Madoff managed to defraud investors for so long proves that the current system is inadequate.

Past experience proves that incentives to whistleblowers to report illegal acts work. The nation’s primary “anti-fraud” statute that protects federal funds, the False Claims Act, has been extremely successful in encouraging whistleblowers to come forward by allowing them to share in the government’s recovery.

As we have written about extensively on this whistleblower lawyer blog, based on the successes of the False Claims Act in fighting and deterring fraud, Congress has encouraged states to enact their own similar state false claims acts with incentives for whistleblowers to expose fraud (and almost half of the states now have such laws).

Likewise, in December 2006 Congress created the first meaningful IRS Whistleblower Program, which we regularly follow here. At present, the IRS Whistleblower Program created in December 2006 may help ferret out some SEC violations when the violator also has significant tax liability to the IRS.

Hedge fund abuses with tax consequences are already the subject of some IRS Whistleblower claims, and more will follow as the IRS Whistleblower Program gains notoriety. Based on our dealings with the IRS in pursuing these claims, this IRS Whistleblower Program has great promise.

But the IRS provisions simply do not cover all of the wrongdoing that goes on. Thus, the SEC desperately needs its own “whistleblower” program, with meaningful incentives to encourage citizens who report wrongdoing.

The SEC’s existing “whistleblower” provisions are too limited to be effective. 15 U.S.C. § 78U-1(e) authorizes a “bounty” to whistleblowers of what is effectively 0-10% of civil penalties paid in insider trading cases. (See full text here.) Thus, the SEC’s existing incentives are limited to insider trading cases, and do not address any other securities laws violations.

Like the “old” IRS Whistleblower rewards, very few awards have been made by the SEC, even in insider trading cases. Moreover, there is no “right” to a reward even if the whistleblower’s information causes the government to recover money from wrongdoers. A system of small, discretionary, and infrequent payments is simply ineffective to cause whistleblowers to come forward.

We understand that the SEC has been looking to correct this gap in protecting investors. This week, Rep.Paul E. Kanjorski (D-PA), the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, released a letter from U.S. Securities and Exchange Commission (SEC) Inspector General H. David Kotz. The IG seems to understand the need to modernize the SEC’s incentives to whistleblowers, in his recommendations below:

Bounty programs are an effective tool to encourage whistleblowers to come forward and would provide necessary incentives for outside entities to bring complaints about possible illegal activity. There is some evidence that the bounty program implemented by the Department of Justice (DOJ) has played a role in the increase of civil recoveries obtained by the DOJ over a 10-year period. The Internal Revenue Service (IRS) also has a system in place where it provides a bounty to individuals who present the IRS with information leading to the collection of federal taxes.

Although the bounty system has been in place at the SEC for more than 20 years, there have been relatively few awards made. The SEC program is limited to insider trading cases, and the stated criteria for judging bounty applications are broad, somewhat vague and not subject to judicial review.

Currently, Section 21A(e) of the Securities Exchange Act of 1934 (Exchange Act) [15 U.S.C. 78u-l(e)] authorizes the SEC to award a bounty to a person who provides information leading to the recovery of a civil penalty from an insider trader, from a person who “tipped” information to an insider trader, or from a person who directly or indirectly controlled an insider trader. All bounty determinations, including whether, to whom, or in what amount to make payments, are within the sole discretion of the SEC, however, the total bounty may not currently exceed 10% of the amount “actually recovered” from a civil penalty pursuant to a court order.

We would recommend that the Exchange Act be amended to authorize the SEC to award a bounty for information leading to the recovery of a civil penalty from any violator of the federal securities laws, not simply insider trading violations. We would also suggest that the Exchange Act be amended to provide specific criteria for awarding bounties, including a provision that where a whistleblower relies upon public information, such reliance does not constitute an absolute bar to recovering a bounty. The statute should also require that the whistleblower be provided with status reports at certain milestones during the investigation or examination that was based on the tip.

We look forward to watching the development of new whistleblower incentives to make the next would-be Madoff think twice.
The full text of SEC Inspector General Kotz’s letter to Chairman Kanjorski from June 30 follows:

Dear Chairman Kanjorski:

Thank you for your June 16, 2009 letter regarding the Securities and Exchange Commission (SEC) Office of Inspector General’s (OIG) investigation into allegations regarding Bernard L. Madoff (Madoff) and Bernard L. Madoff Investment Securities, LLP and for meeting with me on June 23, 2009 at your offices to discuss our ongoing investigation.

I am glad that you are generally pleased with our progress in connection with our investigations and audits of these important and complex matters. As I indicated to you during our meeting, we are committed to producing, in an expeditious manner, thorough and comprehensive investigative and audit reports analyzing the reasons that the SEC did not uncover the Madoff Ponzi scheme notwithstanding examinations and investigations conducted over a period of nearly 20 years, as well as providing recommendations to improve the operations of the pertinent SEC divisions and offices. I appreciated the opportunity to brief you on developments in our investigation at your offices last week and am happy that you felt the meeting was productive.

While we have not yet completed the investigation, we are able to provide to you, at your request, several legislative suggestions that have arisen out of our Madoff investigatory work, which we believe will strengthen the ability of investors and the regulatory agencies to uncover frauds such as Ponzi schemes in the future. We understand that the SEC is also recommending to the Subcommittee the legislative suggestions numbered 1 and 4 below. These suggestions are as follows:

(1) Extend the regulatory jurisdiction of the Public Company Accounting Oversight Board (PCAOB) to audit reports prepared by a domestic registered or foreign public accounting firm regarding issuers, broker-dealers, investment advisers and any companies subject to U.S. securities laws. The PCAOB’s current responsibilities include the following: (a) registering public accounting firms; (b) establishing auditing, quality control, ethics, independence, and other standards relating to public company audits; (c) conducting inspections, investigations, and disciplinary proceedings of registered accounting firms; and (d) enforcing compliance with the Sarbanes-Oxley Act of 2002. The PCAOB is able to address many auditing problems through a combination of inspections and standards-setting. The PCAOB’s supervisory model uses several tools to improve audit quality, correct audit deficiencies, and promote compliance with applicable standards and laws. Where necessary, the PCAOB exercises its enforcement authority.

Extending the regulatory jurisdiction of the PCAOB would allow for increased oversight of these accounting firms and reduce the risks associated with unknown accounting firms that have been able to avoid scrutiny. We believe that H.R. 1212, as currently introduced, accomplishes many of these same goals, except that we would recommend that the legislation clarify that the PCAOB oversight be extended to audit reports prepared by a registered accounting firm which provides reports for investment advisers, investment companies and other registered entities, as well as registered broker dealers.

(2) Amending the Investment Advisers Act of 1940 (Investment Advisers Act) to require the use of independent custodians in a manner similar to Section 17(f) of the Investment Company Act of 1940 (Investment Company Act), which requires the use of an independent custodian by mutual funds. Section 17(f) of the Investment Company Act requires a registered management company to “place and maintain its securities and similar investments in the custody of” a bank or a dealer admitted to a national securities exchange, subject to such rules and regulations as the Commission may from time to time prescribe for the protection of investors. See 15 U.S.c. § 80a-17(f)(1). In addition, Rule 17f-2(b) of the Rules and Regulations promulgated under the Investment Company Act requires that all such securities and similar investments be deposited in the safekeeping of, or in a vault or other depository maintained by, a bank or other company whose functions and physical facilities are supervised by Federal or State authority. The Rule further provides that investments so deposited shall be physically segregated at all times from those of any other person and shall be withdrawn only in connection with transactions of the character described in the Rule. This custodian requirement essentially removes the ability of an investment adviser to fraudulently use the proceeds invested by new investors to make payments to old investors.

Hedge funds are currently exempt from the Investment Company Act and are not subject to the independent custodian requirement. In addition, investment advisers who are also registered broker-dealers are currently permitted to clear their trades through their own broker-dealer firm. Thus, both investment advisers and hedge funds should be required to use an independent custodian.

We are aware that the SEC is currently proposing amendments to its custody rule under the Investment Advisers Act to require a written report from an independent public accountant that includes an opinion regarding the custodian’s controls relating to custody of client assets if the client accounts are not maintained by an independent qualified custodian. However, we believe that a more direct way to remedy this statutory loophole would be to amend the Investment Advisers Act in conformity with the Investment Company Act.

(3) The Sarbanes-Oxley Act of2002 requires ongoing certifications of certain reports by chief executive officers and chief financial officers of public reporting companies. Executives who knowingly file noncompliant reports face possible criminal prosecution including substantial fines and imprisonment.

Certifications have been determined to be effective controls to ensure compliance with particular requirements or guidelines. We would recommend imposing a requirement of certification by senior officers of registered investment advisers that shows they conducted adequate due diligence in connection with investments. This certification requirement should apply to all funds of hedge funds. The adequate level of due diligence required in accordance with the certification may be defined pursuant to a particular model of best practices, such as the Managed Fund Association (MFA) model or the Alternative Investment Management Association (AlMA) model, or could be developed by the SEC. Enforcing an adequate level of due diligence would ensure that investors have adequate information when investing through intermediaries.

(4) Bounty programs are an effective tool to encourage whistleblowers to come forward and would provide necessary incentives for outside entities to bring complaints about possible illegal activity. There is some evidence that the bounty program implemented by the Department of Justice (DOJ) has played a role in the increase of civil recoveries obtained by the DOJ over a 10-year period. The Internal Revenue Service (IRS) also has a system in place where it provides a bounty to individuals who present the IRS with information leading to the collection of federal taxes.

Although the bounty system has been in place at the SEC for more than 20 years, there have been relatively few awards made. The SEC program is limited to insider trading cases, and the stated criteria for judging bounty applications are broad, somewhat vague and not subject to judicial review.

Currently, Section 21A(e) of the Securities Exchange Act of 1934 (Exchange Act) [15 U.S.C. 78u-l(e)] authorizes the SEC to award a bounty to a person who provides information leading to the recovery of a civil penalty from an insider trader, from a person who “tipped” information to an insider trader, or from a person who directly or indirectly controlled an insider trader. All bounty determinations, including whether, to whom, or in what amount to make payments, are within the sole discretion of the SEC, however, the total bounty may not currently exceed 10% of the amount “actually recovered” from a civil penalty pursuant to a court order.

We would recommend that the Exchange Act be amended to authorize the SEC to award a bounty for information leading to the recovery of a civil penalty from any violator of the federal securities laws, not simply insider trading violations. We would also suggest that the Exchange Act be amended to provide specific criteria for awarding bounties, including a provision that where a whistleblower relies upon public information, such reliance does not constitute an absolute bar to recovering a bounty. The statute should also require that the whistleblower be provided with status reports at certain milestones during the investigation or examination that was based on the tip.

We would be happy to discuss any of the above legislative suggestions with you or the Subcommittee at your convenience. If, as we conclude our investigation, we determine that there are any further legislative recommendations that would be appropriate for your Subcommittee, we will share them with you at that time.

Thank you again for your continued interest in our work.

Sincerely,

H. David Kotz

Inspector General

cc: The Honorable Mary L. Schapiro

Chairman, Securities and Exchange Commission