The Securities Exchange Commission recently released its proposed rules for the handling of securities fraud whistleblower claims under the Dodd-Frank bill.

The reaction was predictable; lawyers who represent companies frequently charged with fraud think that the rules do too much to encourage whistleblowing.

Read that sentence again and let it sink in.

From a post by a trio of corporate defense lawyers at Wachtell over at The Harvard Law School Forum on Corporate Governance and Financial Regulation:

To be eligible for a bounty, a whistleblower must supply “original information” which the SEC has not otherwise already obtained.  This creates an incentive to race in to the SEC to stake the first claim, rather than report up through established corporate compliance channels.  The rules would allow a whistleblower’s report to the SEC to relate back to the date of the same person’s earlier internal corporate report, as long as the whistleblower contacts the SEC within 90 days of reporting internally.  While this provision would allow for internal reporting, it would do nothing to encourage it.  We propose that internal reporting should be a prerequisite to an SEC whistleblower report, absent extraordinary circumstances, and that up to 120 days should be permitted for the internal review to proceed.

Even Scott Greenfield, who now gets paid to say stuff that lawbreaking corporate officers like to hear, has jumped on the bandwagon:

What’s missing is a rational tipping point, a place where the incentives to work within the system are in balance with the incentives to give corporate impropriety a gentle push and then blow the whistle when things get bad.  It’s unclear whether there can be a single tipping point, since corporate employees differ in their degree of integrity and loyalty, some hating the person who signs their paycheck and waiting in the shadows for the opportunity to rat them out. 

But the incentive system in Dodd-Frank seems incredibly rich, so much so that it encourages even the most loyal employee to keep budding impropriety under his hat in the hope of a huge payday down the road.  Even the most ardent populist should recognize that too much greed presents a problem.

(Let’s pause to note some simple math: 1 Greenfield >= 3 Wachtells?)

I represent whistleblowers (you didn’t think anyone in this debate was unbiased, did you?) so let me respond.

Wachtell and Greenfield are wrong.

Let’s start with the obvious: whistleblowing suits — and there’s no reason to think Dodd-Frank suits will be any easier than, say, False Claims Act suits, the paradigm for most whistleblowing laws — are among the toughest, longest, and most expensive types of claims. The incentive system in Dodd-Frank isn’t "incredibly rich." You don’t just shoot an e-mail off to the government and collect a check. Your best case scenario is to spend years in costly, precarious, and hostile litigation against your current or former employer. Of course, spending all that time an effort doesn’t necessarily guarantee a victory: "you can be in a case for ten years and not get anything," says one practitioner, and he’s right, not least since you have to prove fraud. "Honest mistakes" don’t create liability.

Everybody knows that, employees included, and there’s not one shred of evidence that there are masses of disloyal employees thinking to themselves, "if I let something illegal go on without speaking up, then I could ruin my career and destroy my income for a shot at a risky and prolonged lawsuit." It’s just not how things work.

On the employee’s side, most whistleblowers — even those with the purest of motives — end up with nothing. They complain to their employer, get fired, and then either don’t pursue legal remedies, have their cases rejected by qui tam lawyers, have their cases dismissed by the government or the court, or lose at trial. There’s more than enough "disincentive" against whistleblowing in the absence of real fraud: odds are, it’ll cost you your job and you won’t get a penny.

On the lawyer’s side, every lawyer who represents whistleblower knows that those cases live and die by the relator themselves, and every qui tam lawyer has rejected their fair share of cases that looked good on the facts, good on the law, but bad on the whistleblower. Moreover, qui tam is a specialized world, where credibility with the government is key, and no whistleblower lawyer wants to be the dimwit who burned up all of his credibility wasting the U.S. Attorney’s time with some profit-seeking jerk who let wrongdoing go unchallenged so that they could build up a case against their employer.

It’s not like any of that is a secret. Most whistleblowers don’t set out to become whistleblowers — most people know that, if you keep complaining about wrongdoing at a company that everyone else wants to ignore, then you paint a target on your own back — but rather become whistleblowers either as a matter of principle after trying the normal channels or when they get fired for taking a stand against the wrongdoing.

Consider Cheryl D. Eckard at GlaxoSmithKline:

Ms. Eckard’s role in the case began in August 2002 when GlaxoSmithKline sent her to Cidra, south of San Juan, to lead a team of 100 quality experts to fix problems cited by an F.D.A. warning letter a month earlier.

This was GlaxoSmithKline’s premier manufacturing facility, producing $5.5 billion of product each year. But Ms. Eckard soon discovered that quality control was a mess: the water system was contaminated; the air system allowed for cross-contamination between products; the warehouse was so overcrowded that rented vans were used for storage; the plant could not ensure the sterility of intravenous drugs for cancer; and pills of differing strengths were sometimes mixed in the same bottles.

Although F.D.A. inspectors had spotted some problems, most were missed. And the company abandoned even the limited fixes it promised to conduct, the unsealed lawsuit says. Ms. Eckard complained repeatedly to senior managers; little was done. She recommended recalls of defective products; recalls were not authorized. In May 2003, she was terminated as a “redundancy.”

She complained to top company executives, but she was ignored even after warning that she would call the F.D.A. So she called the F.D.A. and sued.

She complained, and complained, and complained, using all the internal corporate channels, and it got her nowhere. GSK kept flooding the market with tainted drugs.

Fact is, for all the gnashing of teeth by corporate defense lawyers, there’s little evidence of these kinds of strategic whistleblowing complaints are even being filed, much less going anywhere.

Moreover, if we’re talking about the "balance" of a "rational tipping point," then consider the predicate underlying both Wachtell and Greenfield’s analysis: an assumption that the corporation has done something blatantly illegal — like, under Dodd-Frank, manipulating a security’s price, making a fraudulent sale of securities, setting up a Ponzi scheme, engaging in insider trading, stealing securities, stealing from municipalities or pensions, or bribing foreign officials — but should get a free pass if the employee either made a procedural misstep somewhere in the "internal reporting" bureaucracy designed by the corporation to squelch and to suppress whistleblowing, or if the employee knows that the "internal reporting" bureaucracy is also corrupt and will just try to cover up the crime or retaliate against the whistleblower.

Is that "rational," "balanced," or fair? Does it even make sense? Neither Wachtell nor Greenfield have identified any actual harm from the current proposed reporting scheme, and there isn’t any. To the extent these strategic whistleblowing cases exist at all, the only real damage is to the government, which had to waste time reviewing the complaints and rejecting them — which they do to the vast majority of complaints, good or bad. Most of the time, the company didn’t even know about the complaint, much less have to spend any money or time dealing with it, much less actually be held liable for it. (There’s that pesky fact again: the only way for a whistleblower to make any money is by revealing conduct proven to have been fraudulent.)

Indeed, even if we accept that "disloyal employees" — I’d call them good citizens for reporting fraud, rather than engaging in it — might go to the government first, I don’t think anyone can deny corporate fraud is endemic to our society, and that we need something like Dodd-Frank to stop it. As such, why not keep corporations on their toes with the possibility that a whistleblower will go to the government first? Is it so wrong to expect and to encourage corporations not only to refrain from fraud, but to establish effective compliance programs to detect and to prevent fraud in the first place? Why place the burden of fixing the corporation’s fraud — or, more properly stated, the burden of covering up the fraud that already happened — on the whistleblowing employee, an innocent whose very livelihood is at stake?