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Published: April 2008

Protecting whistleblowers through the Sarbanes-Oxley Act

In a letter to Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, Consumer Action joined three other advocacy organizations in requesting continued protection for whistleblowers under the Sarbanes-Oxley Act.

We are writing on behalf of Fund Democracy, Consumer Federation of America, Consumer Action, and North American Securities Administrators Association to request that the Commission take the interpretive position that the whistleblower provision in the Sarbanes-Oxley Act of 2002 ( Sarbanes-Oxley ) generally applies to employees of a mutual fund's investment adviser.  It has come to our attention that, in at least two whistleblower cases, a mutual fund's investment adviser has argued that its employees are not covered by the whistleblower provision because the adviser is not a public company.  We are concerned that investment advisers may manufacture other arguments for exempting their employees from the whistleblower provision.  As discussed further below, excluding employees of mutual fund investment advisers from the whistleblower provision directly contradicts the text and the intent of the provision and threatens to undermine the protection of the securities laws for America s tens of millions of fund shareholders.

BACKGROUND

The impetus for Sarbanes-Oxley was a series of corporate scandals, the most prominent of which involved the collapse of two companies: Enron, Inc. and Worldcom.   The legislative history of the Act is replete with references to specific corporate scandals, and many of the Act s provisions can be traced directly to the conduct of the executives, accountants, and lawyers for the affected companies. Whistleblowers such as Enron's Sherron Watkins and Worldcom s Cynthia Cooper played a major role in exposing fraudulent conduct at their companies. 

In the aftermath of the Enron and Worldcom scandals, Congress was concerned that such corporate whistleblowers are left unprotected under current law.   Senator Patrick Leahy noted that  when sophisticated corporations set up complex fraud schemes, corporate insiders are often the only ones who can disclose what happened and why. Congress believed that the lack of protection for insiders when they attempt to prevent fraud was: 

a significant deficiency because often, in complex fraud prosecutions, these insiders are the only firsthand witnesses to the fraud. They are the only people who can testify as to  who knew what, and when,  crucial questions not only in the Enron matter but in all complex securities fraud investigations. Although current law protects many government employees who act in the public interest by reporting wrongdoing, there is no similar protection for employees of publicly traded companies who blow the whistle on fraud and protect investors. With one in every two Americans investing in public companies, this distinction fails to serve the public good.

Congress accordingly enacted Section 806 of Sarbanes-Oxley, which generally prohibits discrimination against employees of public companies (i.e., companies registered or reporting under the Securities Exchange Act) in retaliation for assisting in the investigation of a violation of the federal securities laws.  The whistleblower provision has been called  the single most effective measure possible to prevent recurrences of the Enron debacle and similar threats to the nation’s financial markets.  It is a crucial component of Sarbanes-Oxley's overall approach to combating corporate fraud. 

Soon after the scandals that led to the enactment of Sarbanes-Oxley, the mutual fund industry was engulfed in the biggest scandal in its long history. The abuses underlying the market timing scandal were brought to light by precisely the kind of whistleblowing that Sarbanes-Oxley was intended to protect.  The allegations contained in the complaint that launched the market timing scandal were brought to the New York Attorney General s attention by Noreen Harrington, an executive at Canary Capital Partners.  Peter Scannell, an employee of Putnam, reported to the staffs at the Securities and Exchange Commission and the Massachusetts Securities Division that, among other things, the investment adviser of the Putnam family of mutual funds and affiliates of the adviser were permitting trading in fund shares that violated fund disclosure documents.  In describing his experiences to a U.S. Senate subcommittee, Scannell specifically commended the Act s whistleblower provision.

There is no question that mutual funds are public companies to which the whistleblower provision applies.  The issue here is whether the whistleblower provision applies to employees of fund managers.  Fund managers that are not public companies have taken the position that the whistleblower provision does not apply to their employees, and fund managers that are public companies may argue that the whistleblower provision does not apply to them for other reasons.  These positions directly contradict the text and intent of the whistleblower provision.  

ANALYSIS

We believe that the whistleblower provision clearly applies to employees of fund managers to the extent that the employees are involved in ensuring a fund's compliance with the securities laws.  As discussed further in the attached memorandum, the only way that the whistleblower provision could apply with respect to fund compliance would be to apply the provision to the fund manager s employees.  A mutual fund typically has no employees because almost all mutual funds carry out all of their operations through third-party service providers, including activities necessary to ensure compliance with the federal securities laws.  As noted by the SEC staff,  although investment companies have officers, they usually are employed and compensated by the sponsor.  Thus, an investment company has no employees that are truly its own.  The only  employee  to whom the whistleblower provision could apply in relation to a fund's compliance with the federal securities laws therefore is an employee of the fund's investment adviser.  Congress intended that Sarbanes-Oxley apply to mutual funds (it expressly exempted them where appropriate), and the only logical interpretation of the whistleblower provision that would fulfill Congress's intent would be one that applied the provision to a mutual fund adviser s employees.

The logical necessity of applying the whistleblower provision to employees of a mutual fund's investment adviser is further illustrated by other considerations.  For example, the compliance structure mandated for mutual funds assumes that fund compliance will be effectuated by fund manager employees.  A mutual fund is required to appoint a chief compliance officer ( CCO ) who is typically employed by the fund's investment adviser.  The fund s CCO is primarily responsible for the fund's securities law compliance and therefore is the individual for whom protection under the whistleblower provision is most important.  It would be illogical for the application of the whistleblower provision to a fund s CCO that is, the key compliance officer for a public company that is clearly covered by the provision to depend on the happenstance of the direct employment of the CCO by the fund s investment adviser or the adviser's status as a public company.

The terms, structure and application of other provisions of Sarbanes-Oxley and rules thereunder also illustrate the logical necessity of applying the whistleblower provision to employees of a mutual fund's investment adviser.  Section 307 of Sarbanes-Oxley generally requires that lawyers representing public companies before the Commission report material securities law violations up the company's management chain.  As with other services, legal services are often provided to mutual funds by their investment advisers  attorneys.  The Commission specifically ruled that such attorneys are subject to Section 307 with respect to their representation of a fund even if the investment adviser who employs them is privately-held.  It would be illogical to hold that Section 307 applied to an employee of a privately-held investment adviser but that Section 806 did not, especially considering that the ultimate purpose of both provisions is to promote compliance with the securities laws through provisions specifically designed to affect the conduct of individuals who are involved in securities law compliance.  It also would be illogical for the Commission to take up the question of whether Section 307 applied to a privately-held adviser with respect to fund compliance matters if it had not assumed that Section 307, and therefore Section 806, also applied to attorneys employed by publicly held advisers.

Section 406 requires that the Commission adopt rules generally requiring that public companies provide disclosure regarding codes of ethics for certain officers of the company.  For operating companies, the Commission required disclosure of codes applicable to  principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions.  In contrast, the rules for mutual funds extended to codes applicable to  principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the registrant or a third party. Again, the Commission recognized that the unique structure of mutual funds necessitated expanding the scope of its rules to codes of ethics that apply to employees of entities other than the fund itself.  Interpreting Section 806 not to apply to employees of a fund's investment adviser would directly contradict the application of similar provisions of the Sarbanes-Oxley Act to these employees.

CONCLUSION

The mutual fund market timing scandal provided a stark reminder of the important role that whistleblowers can play in ensuring compliance with the federal securities laws.  Whistleblowers were directly responsible for drawing regulators  attention to the kind of fraudulent conduct that Sarbanes-Oxley intended to address.  It is inconceivable that Congress did not intend that mutual fund shareholders enjoy the benefits afforded to shareholders of other publicly traded companies with respect to whistleblowers.   

A recent SEC settlement illustrates the importance of the Commission's confirming that the whistleblower provision covers employees of fund managers.  In Heartland Advisers Inc., the Commission alleged that six executives of a mutual fund manager were responsible for the mispricing of two mutual funds  shares.  The mispricing led to a one-day decline of 69.4% and 44% in the value of the funds.  The settlement describes the executives as being responsible for the funds  day-to-day compliance with pricing rules under the securities laws.  The mispricing occurred in 2000, and one cannot help but wonder whether one of more of those executives would have chosen to correct the mispricing at its inception if the protections of the whistleblower provision had been available at that time.  If fund managers are able to escape application of the whistleblower provision, then employees who find themselves in the same position as the Heartland executives will have to choose between objecting to illegal conduct and getting fired, or remaining silent and ultimately finding themselves named defendants in an administrative proceeding.

We hope that the Commission will agree that clarifying that the whistleblower provision applies to fund manager employees is an appropriate and necessary step to protect mutual fund shareholders from the kinds of abuses that Sarbanes-Oxley was designed to address.

Lead Organization

Fund Democracy

Other Organizations

Consumer Federation of America | North American Securities Administrators Association

More Information

Section 806 of the Sarbanes-Oxley Act

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