As we have previously observed, private fund advisers face a difficult challenge when SEC guidance (in the form of a speech or a public enforcement order) indicates that certain long-standing practices may be contrary to the securities laws. What does an adviser do when its past practices appear, in hindsight, to have fallen short?
While there are a number of potential “fixes”, including rebating fees, amending the fund documents, amending the Form ADV, and changing prospective practices, doing nothing is a particularly bad strategy. These situations are potential whistleblower events, even if the adviser is not yet aware of any whistleblower. Advisers must recognize that their personnel might be motivated (economically and otherwise) to bypass internal reporting and report directly to the SEC. Similarly, investors and others may go directly to the SEC. When management becomes aware of a potential violation, there is usually a short time window to address the issue before it becomes a bigger problem. Over the past two months, the SEC has issued over $26 million in whistleblower awards, including a $17 million award. And the SEC is actively pursuing cases against investment advisers relating to improper fees and inadequate disclosures, including a number of cases filed in the past month.
Letting an issue linger is not an option, because—chances are—the regulators will eventually examine the issue. Below are some key mistakes to avoid when addressing issues relating to the SEC’s whistleblower program.
- Failing to Encourage Internal Reporting. In addition to fostering a culture of compliance, private fund advisers should establish a mechanism for internal reporting, encourage employees to use it, and assure employees that no retaliation will occur. Internal reports serve as an important mechanism to quickly identify problems, investigate the underlying issues, and address and remediate misconduct if any is found. Doing so also serves as an important reminder to employees that the company takes compliance very seriously. This not only ensures that the company sets the right “tone from the top” but it also deters employees from engaging in inappropriate behavior.
- Ignoring the Internal Complaint. When an entity becomes aware of a potential violation, the clock starts ticking. After an employee reports an issue internally, Rule 21F-4 holds that employee’s place in line as an SEC whistleblower for 120 days. If the employee then reports to the SEC within that 120-day period, the whistleblower also gets additional credit for the company’s internal investigation. This dynamic forces the entity to act quickly if it wants to obtain credit for proactively recognizing and dealing with the problem. Otherwise, there is little benefit if the SEC learns about the issue from the individual’s follow-on tip rather than from the fund or its adviser.
- Failing to Address Suspected Past Violations. Even if there is no employee complaint, the clock starts ticking as soon as management becomes aware of a potential securities violation, because after 120 days, the universe of potential whistleblowers grows. Officers, directors, trustees, or partners who learn about a violation through internal reporting channels generally are not eligible for a whistleblower award. However, if the entity’s chief legal officer, audit committee or other compliance personnel possess relevant information and fail to adequately address the issue for at least 120 days, then officers, directors, and other employees can potentially become eligible to report information to the SEC and claim an award. See Exchange Act Rule 21F-4(c).
- Inadequately Investigating. The SEC will not look favorably upon an entity that it believes conducted an inadequate internal review. The entity should investigate thoroughly, address the misconduct (if any) and decide whether to self-report. It should also gather facts relating to misconduct by individual employees, keeping in mind the SEC’s focus on individuals and the DOJ’s Individual Accountability Policy (the “Yates Memo”). If the SEC later determines that the internal investigation was insufficient, then (1) the firm has lost the time and resources put into the review, (2) it may not get credit for its investigation, and (3) the fact of the investigation may be viewed by the SEC as having put the entity on notice of the violations.
- Forgetting External Whistleblowers. Whistleblower complaints can come from anywhere, not just from disgruntled employees. In fact, according to the SEC’s most recent report on the program (at p.16-17), over half of its whistleblower awards have gone to non-employees. These company “outsiders” include defrauded investors, “professionals working in a related industry,” and individuals who had a “personal relationship with the alleged wrongdoer.” Even outsiders who had no contact with the entity could potentially qualify as whistleblowers. For example, on January 15, 2016, the SEC announced a $700,000 award to a “company outsider who conducted a detailed analysis that led to a successful SEC enforcement action.”
- Taking Retaliatory Action. Managers must take care to avoid any actions that might be considered retaliatory. Section 21F(h)(1) of the Exchange Act, promulgated by Dodd-Frank, prohibits employers from retaliating against individuals when they engage in whistleblowing activities, such as reporting an issue to the SEC. The first anti-retaliation case brought by the SEC was against a private fund adviser. Although caselaw is mixed on the topic, the SEC takes the position that the anti-retaliation provisions apply to any individual public company employee who reports internally, regardless of whether the employee reports information to the SEC.
- Discouraging Reporting. Entities should also avoid any action that might be seen as hindering current or former employees from reporting information to the government, which could be viewed as a violation of the SEC’s Rule 21F-17. That rule prohibits any person from taking “any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation.” This concern is particularly acute in the context of confidentiality agreements. See In re KBR, Inc., A.P. File No. 3-16466 (Apr. 1, 2015).
Based on recent statements by senior SEC officials, the importance of the whistleblower program to the SEC’s enforcement efforts cannot be overstated. It has become a key component of the SEC’s enforcement efforts. The SEC is receiving at least 3000-4000 tips per year, according to the SEC’s most recent report on the program (at p.21), and those numbers continue to grow. As the program matures, we expect greater exposure in the private fund space, especially as the SEC has increased its focus on previously-unregistered and unexamined advisers. Given the compressed time frames resulting from the statutory regime, fund managers should proactively retain counsel to investigate and address problems as soon as they arise.
 According to the memo: “In order for a company to receive any consideration for cooperation . . . the company must completely disclose to the Department all relevant facts about individual misconduct.”
 Private fund employees might have less incentive to report internally because certain anti-retaliation provisions of Dodd-Frank do not generally prohibit retaliation for internal reporting by employees of private companies, but do protect employees who report directly to the SEC. According to the SEC’s August 2011 adopting release, “the retaliation protections for internal reporting afforded by Section 21F(h)(1)(A) do not broadly apply to employees of entities other than public companies.” In general, the anti-retaliation protection for internal reporting derives from the catchall language of Section 21F(h)(1)(A)(iii), for disclosures that are “required or protected” under other provisions of the securities laws—generally applicable to public companies, not private entities.