MoneyGram Payment Systems. v. Citigroup, Inc.: Court Enforces Arbitration Provision

In MoneyGram Payment Sys. v. Citigroup, Inc., No. 27-CV-11-21348, 2013 WL 491527 (Minn. Ct. App. Feb. 11, 2013), the Minnesota Court of Appeals reversed judgment denying Citigroup, Inc.’s (“Citigroup”) motion to compel arbitration of claims brought by MoneyGram Payment Systems, Inc. (“MoneyGram”).

According to the allegations, MoneyGram operated its payment-services business by providing clients with money orders and check services.  In addition, MoneyGram managed a large investment portfolio that holds several billion dollars in mortgage-related securities (“MBS”) and collateralized debt obligations (“CDOs”).  From 2005 to 2007, MoneyGram purchased over $180 million in MBS and CDO investments via telephone and e-mail through its account with Citigroup’s broker-dealer subsidiary, Smith Barney.  In 2011, after the financial crisis led to a substantial decrease in MoneyGram’s investment value, MoneyGram brought fraud charges against Citigroup for purported fraud relating to the MBS and CDO investments.     

However, in 2008, subsequent to the security purchases at issue, MoneyGram executed a Client Services Agreement (“CSA”) that contained an arbitration agreement as part of the terms and conditions set to guide its continued relationship with Smith Barney.  Specifically, the agreement detailed that “all claims and controversies, including those prior to the execution of the CSA, concerning or arising from . . . any transaction involving Smith Barney or related business entities, must be resolved through arbitration.”  

The district court determined that language in the first paragraph of the CSA excluded transactions entered through “proprietary online order entry . . . or other systems,” and that MoneyGram’s orders were made through Smith Barney’s “other systems.”  The Appellate Court, however, held that such an interpretation would make the arbitration agreement unenforceable in every situation and would produce absurd results. The Court reasoned that if an order was not made through the proprietary online system then the order would have to have been made through an “other system,” rendering the arbitration provision pointless.  As a result, the Court reversed the trial court’s refusal to  grant Citigroup’s motion to compel arbitration.

The primary materials for this case may be found on the DU Corporate Governance website.


Bennett v. Sprint Nextel: Court Expands “Privileged” Information Subject to PCAOB Inspection 

In Bennett v. Sprint Nextel Corp., Case No. 11-9014-MC-W-ODS, 2012 U.S. Dist. LEXIS 145902 (W.D. Mo. Oct. 10, 2012), the plaintiffs, shareholders of Sprint Nextel Corp. (“Sprint”), filed a motion to compel KPMG, Inc. (“KPMG”), a non-party to the suit, to release certain documents presumed to support allegations of securities fraud in connection with Sprint’s acquisition of Nextel. The court granted, in part, the plaintiffs’ motion to compel on the ground that some of the information intentionally withheld by KPMG was privileged pursuant to 105 U.S.C. § 7215(b)(5)(A) (“Section 105(b)(5)(A)”), which protects information involved with Public Company Accounting Oversight Board (“PCAOB” or “Board”) inspections of registered accounting firms.

To maintain its administrative oversight authorized by the Sarbanes-Oxley Act, the PCAOB conducts regular inspections of accounting firms that perform independent audits of publicly traded companies. From 2004 to 2009, KPMG performed independent audit work for Sprint, and assisted with the accounting for Sprint’s acquisition of Nextel in 2005. In 2006, the PCAOB initiated a customary inspection of KPMG’s auditing practices. Of particular interest to the plaintiffs were aspects of the inspection that involved KMPG’s Sprint audit.

Section 105(b)(5)(A) protects against discovery “all documents and information prepared or received by or specifically for the Board, and deliberations of the Board.” This excludes from discovery such information “directed to targets of the Board’s investigations.”

First, the plaintiffs contested KPMG’s claim of privilege for internal communications not necessarily transmitted to the PCAOB but created for the sole purpose of responding to inquiries made during the course of the inspection. The plaintiffs argued that the privilege should not apply to information not “specifically for the Board.” However, the court reasoned that the internal “communications that discuss confidential questions or comments made by the Board or reflect KPMG’s development of responses to Board inquiries are also protected.” The court held that the internal information was “specifically for the Board,” because “absent the inspection, these documents and communications would not exist.”

Second, the plaintiffs challenged KPMG’s assertion that the statutory privilege covered internal documentation that could potentially divulge information regarding the PCAOB’s deliberations. The plaintiffs maintained that the deliberations privilege should not apply since KPMG was not involved with the PCAOB’s actual deliberations. The court agreed that the deliberations privilege was intended to protect the PCAOB and its “consideration and analysis of the evidence,” not the evidence itself. As a result, the deliberative privilege did not extend to the documents submitted to the PCAOB.  

Finally, the plaintiffs contended that KPMG specifically waived its statutory privilege by informing Sprint’s CEO of the upcoming inspection and by sharing a presentation used to organize preparations for the inspection with Sprint personnel. Analogizing to other privileges, the court reasoned that the partial disclosure of privileged documents does not destroy the protection of other privileged documents. The court held that KPMG never revealed the “details or substance of the investigation,” and that the limited amount of detail disclosed was not enough to warrant a complete waiver of privileged information.

Accordingly, the court granted, in part, the plaintiffs’ motion to compel and denied the plaintiffs’ contentions of waiver. We have previously discussed the underlying suit here.

The primary materials for this case may be found on the DU Corporate Governance website.


Vannoy v. Celanese Corp.: Administrative Review Board Interprets Less Stringent Requirements for Sarbanes-Oxley Whistleblower Protections 

In Vannoy v. Celanese Corp., ARB Case No. 09-118, the Administrative Review Board (“ARB”) reversed an Administrative Law Judge’s (“ALJ”) decision that Matthew Vannoy (“Vannoy”) had not alleged shareholder fraud and therefore could not rely on the whistleblower protections contained in § 806 of Sarbanes-Oxley (“SOX”).  The ARB found that a claimant need only have a reasonable belief, alleged with sufficient facts, that the company was  violating SOX.  The ARB also dismissed the limitations that the ALJ read into the term “federal regulatory agency” in § 1514A of SOX and relaxed certain elements of a whistleblower action in order to more align them with Congressional intent.

According to the decision, Vannoy began working for Celanese Corporation in 2004 and became the program administrator of the company’s expense reimbursement program in early 2005.  After finding what he viewed as misuse of company credit cards, Vannoy filed an internal complaint for violations of the business conduct policy on February 15, 2007.  Shortly after, Vannoy received a performance bonus for a good review but was informed that his entire department was being outsourced.  

In March, he filed an IRS complaint through its whistleblower rewards program.  Vannoy secured Celanese Corporation proprietary and confidential documents in order to aid in the investigation.  In October, Vannoy was suspended with pay for allegedly disregarding direction from his boss by confronting an employee about expense reimbursements.  A subsequent examination of his company laptop revealed that Vannoy had emailed documents containing personal information, including social security numbers, of 1,600 Celanese employees to his personal email address, a violation of company policy.  On November 5, 2007, Vannoy was suspended without pay. Vannoy filed a complaint with OSHA alleging a violation of the whistleblower provision of SOX.  

To seek protection as a whistleblower under SOX, the plaintiff must establish that he or she "(1) engaged in activity or conduct that § 1514A protects; (2) the respondent took an unfavorable personnel action against him; and (3) the protected activity was a contributing factor in the adverse personnel action.”  Vannoy v. Celanese Corp., ARB Case No. 09-118, at 9 (Sep. 28, 2011)

The ALJ dismissed the complaint, finding that Vannoy failed to allege either a “specific and definitive” violation of law by Celanese or conduct by Celanese that “amounted to actual fraud on shareholders.”  In addition, The ALJ found that the IRS is not a “federal regulatory or law enforcement agency” as contemplated by §1514A and that Vannoy did not “suffer an unfavorable personnel action due to protected activity.”

The ARB reversed this determination.  The ARB found Vannoy’s reasonable belief that the accounting discrepancies he uncovered were in “noncompliance with federal securities laws and fraud generally” was adequate.  The ARB also reversed the ALJ’s determination that the IRS was not a “federal regulatory agency” under SOX finding no such limitation in the statutory language.  It was enough that Vannoy reported the allegations to individuals who had the authority to investigate the misconduct.  

The ARB found that Vannoy suffered an adverse employment action.  In defining this element, the ARB stated “an adverse action… is simply an unfavorable employment action, not necessarily retaliatory or illegal.”  This broad definition can include being put on paid administrative leave as well as non-tangible activity such as harassment or threats.  The case was remanded to determine whether Vannoy suffered an adverse personnel action due to his engaging in protected activity.

The ARB noted that a temporal connection between the protected activity and the adverse action would be adequate.  Further evidentiary hearings were also necessary to determine whether Vannoy’s sending of sensitive documents to his personal email was protected activity under SOX and whether the information was “the kind of ‘original information’ that Congress intended to be protected under either the IRS or SEC whistleblower programs.”  

The primary materials for this case may be found on the DU Corporate Governance website.


Sharkey v. J.P. Morgan Chase & Co.: SOX Whistleblower Complaint Hits the Right Notes without Identifying Specific Statutes Violated

In Sharkey v. J.P. Morgan Chase & Co., 10 CIV. 3824, 2011 WL 3663401 (S.D.N.Y. Aug. 19, 2011), the court denied the defendants’ motion to dismiss a Sarbanes-Oxley whistleblower complaint for lack of subject matter jurisdiction and failure to state a claim, holding that such complaints do not require the identification of the specific statutes alleged to have been violated by defendants or third parties.

According to the allegations, in early 2009 personnel from J.P. Morgan’s Compliance and Risk Management departments alerted Jennifer Sharkey, an employee in the company’s Private Wealth Management Group, to  suspicious activities by one of her clients (the “Suspect Client.”)  After attempting to gather additional information on these activities, Sharkey came to believe the Suspect Client was violating federal securities laws, laundering money, and engaging in mail and bank fraud.  She communicated her concerns about the Suspect Client’s activities to defendants Joe Kenney, Adam Green, and Leslie Lassiter, all J.P. Morgan employees.

On Oct. 22, 2009, Sharkey filed a complaint with the Occupational Safety and Health Administration (“OSHA”) alleging that J.P. Morgan had violated the Sarbanes-Oxley Act of 2002 (“SOX.”)  After OSHA issued a preliminary order dismissing the complaint, Sharkey filed suit in federal district court.  The defendants moved to dismiss the suit for lack of subject matter jurisdiction under Federal Rule of Civil Procedure (“F.R.C.P.”) 12(b)(1) and failure to state a claim under F.R.C.P 12(b)(6).

Under F.R.C.P. 12(b)(1), a federal court must have statutory or constitutional jurisdiction over a case.  Although SOX grants such statutory jurisdiction, a plaintiff must present a SOX claim to OSHA prior to bringing any action in federal court.  

The defendants argued that the court lacked jurisdiction over Sharkey’s amended complaint because the complaint presented new allegations that first had to be presented to OSHA.   The court held that although new claims would have to be presented to OSHA, the amended complaint had merely presented new details regarding existing claims; thus the court had proper jurisdiction over the case.

Under F.R.C.P. 12(b)(6), a complaint must state a claim that is plausible.  A prima facie SOX whistleblower claim must allege that an employee engaged in a SOX-protected activity the employer had knowledge of and that the protected activity contributed to an unfavorable action by the employer toward the employee. 

The defendants argued that in order to establish that Sharkey’s whistleblowing was a protected activity, her complaint had to specify exactly which statutes the Suspect Client violated.  The court disagreed, holding that Sharkey need only plead that she had information leading to a reasonable belief that the Suspect Client violated securities regulations or other federal anti-fraud provisions; her “myriad of allegations” met this standard.

The defendants also argued that to establish employer knowledge, a complaint must demonstrate that communications from the whistleblower referred to the specific code sections being violated.  The court held that a whistleblower need only communicate the conduct believed to be illegal, not the code section that the conduct violated.  Sharkey’s complaint alleged that she communicated to the defendants a number of different activities she believed to be illegal, so it properly alleged employer knowledge.

Because the court had subject matter jurisdiction under F.R.C.P. 12(b)(1), and because Sharkey’s complaint stated a claim under F.R.C.P. 12(b)(6), the court denied the defendants motion to dismiss.       

A previous post on Sharkey, discussing the trial court’s dismissal with leave to amend, is here

The Primary materials for this case may be found on the DU Corporate Governance website.


Sylvester v. Parexel International LLC: Civil Pleading Requirements Do Not Apply to SOX Whistleblower Claims 

In Sylvester v. Parexel, ARB Case No. 07-123, the Administrative Review Board (“ARB”) held that an administrative law judge could not dismiss a Sarbanes-Oxley Act (“SOX”) whistleblower claim because it did not have the specificity required by Twombly and Iqbal. Ashcroft v. Iqbal, 129 S. Ct. 1937 (2009); Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007).  

 Plaintiffs Kathy Sylvester (“Sylvester”) and Theresa Neuschafer (“Neuschafer”) both worked for Parexel International LLC (“Parexel”) in Baltimore, Maryland.  In March 2006, Sylvester and Neuschafer separately reported allegedly false recording of clinical data by employees to Parexel upper management. In the same month, Parexel issued letters of warning to both women.  In May 2006, Sylvester again reported allegedly fraudulent documentation to management.  On June 15, 2006, the Director of Business Operations discharged Sylvester for not being a “team player.”  The Director then fired Neuschafer on August 10, 2006, claiming that her “personality did not fit in.”

In September and October 2006, Sylvester and Neuschafer filed separate whistleblower complaints against Parexel with the Occupational Safety and Health Administration (“OSHA”).  These complaints alleged that Parexel violated SOX by firing them in retaliation for reporting fraudulent acts by Parexel employees.  OSHA dismissed their complaints and the women requested a hearing before an Administrative Law Judge (“ALJ”). Before the hearing, Parexel filed Motions to Dismiss the Complaints pursuant to Fed. R. Civ. P. 12(b)(1), alleging that the women’s allegations did not “fall within the closely prescribed subject matter jurisdiction authorized by Congress for the Department of Labor to hear SOX complaints.” 

In August 2007, the ALJ dismissed the women’s complaints pursuant to Fed. R. Civ. P. 12(b)(1) because the women had not engaged in SOX-protected activities.  More specifically, the ALJ held that the women failed to establish that their actions: “(1) ‘definitely and specifically’ related to a violation of any of the laws covered by SOX Section 806, (2) involved an actual violation by Parexel of any of the laws enumerated in Section 806, (3) involved shareholder fraud, fraud generally, or were otherwise adverse to shareholders’ interests, or (4) constituted reasonable concerns about SOX violations.”  The women then appealed to the Administrative Review Board (“ARB”).

The ARB overturned the ALJ’s decision.  The ARB held that the ALJ had erred in finding that the women had not established subject matter jurisdiction and that the women had provided sufficient allegations of SOX-protected activity to proceed with their complaints.  A whistleblower claim does not require a particular form of complaint, except that it must be in writing and contain a full statement of the acts and omissions, with pertinent dates, which are believed to constitute the violations.  29 C.F.R. § 1980.103(b).  While Twombly and Iqbal require that factual allegations “raise a right to relief above the speculative level” and allow the court “to draw the reasonable inference that the defendant is liable for the misconduct alleged,” the ARB pointed out that these requirements do not apply to SOX allegations.  The complainant need only show that he or she had a subjective belief that the complained-of conduct constituted a violation of relevant law, and that this belief is objectively reasonable.  The court must consider the knowledge available to a reasonable person in the same factual circumstances with the same training and experience as the grieved employee.  Because the ALJ dismissed the claims before an evidentiary hearing, the women did not have the opportunity to present evidence of the reasonableness of their alleged SOX-protected activities.

The ARB explained that the protected activity does not need to describe an actual violation of the law and a SOX complaint does not have to relate to fraud against shareholders.  As a result, the ARB held that Neuschafer and Sylvester had sufficiently pled that they had engaged in protected activity under SOX whistleblower provisions and reversed and remanded the case.

The primary materials for this case may be found on the DU Corporate Governance website.


Stock Exchanges, IPOs and A Misguided Attack on SOX

We don't often write about the editorials in the WSJ but a recent one caught our eye.  The WSJ apparently conducted an interview with Duncan Niederauer, the CEO of NYSE Euronext and transformed some of the discussion into an editorial

The editorial essentially argued that the decline in the number of IPOs in the US was a result of the costs associated with Sarbanes-Oxley.  The basis?  Everyone just knows.  Or, as the WSJ put it:  "It's clear to most stock-exchange watchers that no business combination can relieve the burden that the 2002 Sarbanes-Oxley (Sarbox) law places on firms seeking to join the public markets."  In legal writing, the general rule of thumb is that if you have to say its clear, its not. 

Did Mr. Niederauer actually make this argument?  Despite talking with him, the WSJ can only assert that "[t]his is no doubt one of the reasons that Mr. Niederauer sees advantages in a merger with a foreign partner that has most of its business overseas."  In other words, they are guessing which is an odd thing to do when he was there and they could have asked. 

The only example of some aspect of SOX that explains the decline in IPOs was the requirement that companies get an opinion from their accounting firm on their internal controls, the so called Section 404(b) Report.  Only this is tough to criticize because Congress just exempted companies below $75 million in public float from the requirement.  This is not good enough, according to the WSJ, because "every company aspires to rise above $75 million".

The unfortunate thing about the editorial is that a discussion on facilitating public offerings is certainly a worthy topic but it cannot be reduced to a simplified attack on regulation, particularly when it comes down to one provision of one act. 

One potential explanation for the decline in the number (besides the obvious one, the economy), is the lack of competition among underwriters.  The last financial crisis essentially saw the loss of Merrill, Bear and Lehman as significant players in the underwriting market.  The business has been captured by commercial banks which, with their lending operations, have a potential conflict of interest.  Lending relationships are likely more lucrative than underwriting ones. (This is discussed in The "Great Fall": The Consequences of Repealing the Glass-Steagall Act). 

As a result, fees in the United States are higher than those overseas.  As one article (admittedly from 2006) described:

  • U.S. investment banks charge underwriting fees—the percentage of the offering that investment banks keep for themselves—that are the highest in the world. Examining IPOs from Jan. 1, 2003, through June 30, 2005, Oxera found that average fees paid by companies going public on the NYSE and the NASDAQ were 6.5 percent and 7 percent, respectively. By contrast, the median fee for companies on the LSE's Main Market and the Alternative Investment Market were 3.25 percent and 4 percent, respectively.

Whatever the costs of SOX, certainly the millions taken off the top in additional fees in the US probably make those amounts pale by comparison.  If anything might force an IPO overseas, certainly a far less expenisve underwriting process ought to be one of them.  Moreover, with the continued decline in competition among underwriters, this is only likely to get worse.

For a more balanced analysis of the issue, take a look at Is Going Public Going Out of Style? in CFO magazine.  As for the role of SOX in any decline, the article noted that "there is little clear evidence that Sarbox is the true culprit." 

The debate on making IPOs easier is a good one that ought to occur.  To the extent used as a singular attack on corporate governance regulation, however, it will get nowhere. 


Coppinger-Martin v. Solis: 90-Day Whistleblower Time Limit Begins at Firing

In Coppinger-Martin v. Solis, No. 09-73725 (9th Cir. Nov. 30, 2010), the Ninth Circuit Court of Appeals dismissed an employee’s whistleblower claim under the Sarbanes-Oxley Act of 2002 (“SOX”) as untimely filed. 

Carole Coppinger-Martin (“Coppinger-Martin”) was Chief Technical Architect of Nordstrom’s Business Information Systems Strategic Planning Group. During the summer of 2005, she alerted her immediate supervisor that security vulnerabilities in Nordstrom’s information systems exposed the company to potential SEC violations.  Soon after, Coppinger-Martin received an unfavorable work-performance review.  In November 2005, Coppinger-Martin’s supervisor informed her that her job would be eliminated.  She continued working for the company until April 2006. 

On October 13, 2006, Coppinger-Martin filed a whistle-blower action under SOX with the Occupational Safety and Health Administration (“OSHA”), alleging that Nordstrom had fired her in retaliation for reporting possible SEC violations.  The whistleblower provision in Sarbanes-Oxley (SOX) required the filing of an administrative complaint with OSHA “not later than 90 days after the date on which the violation occurs.”  18 U.S.C. §1514A(b)(2)(D).  The violation occurs “when the discriminatory decision has been both made and communicated to the complainant.”

After OSHA denied her relief, Coppinger-Martin requested a hearing before an Administrative Law Judge. In March 2007, Nordstrom moved to dismiss Coppinger-Martin’s complaint as untimely. The Administrative Law Judge granted Nordstrom’s motion to dismiss, and Coppinger-Martin petitioned for review with the Department of Labor’s Administrative Review Board (“ARB”). The ARB also held that the complaint was untimely filed. 

The Ninth Circuit held that the ARB properly dismissed Coppinger-Martin’s complaint as untimely and denied her petition for review.  In support of its decision, the court held that a claim accrues when the plaintiff learns of the actual injury, “i.e., an adverse employment action, and not when the plaintiff suspects a ‘legal wrong,’ i.e., that the employer acted with a discriminatory intent."  As a result, the latest possible accrual date was Coppinger-Martin's last day of work, April 21, 2006.  Because Coppinger-Martin filed her complaint on October 13, 2006, more than 90 days after her final day of work, the court held that it had been filed untimely under SOX.

Coppinger-Martin argued that even if her complaint was not filed in time under the 90-day whistleblower doctrine, she should receive an extension of time under the doctrines of equitable tolling and equitable estoppel. The court held that neither of these equitable doctrines applied in Coppinger-Martin’s case.

The primary materials for this post can be found on the DU Corporate Governance website. 


SOX Whistleblower Protections Extend Beyond the Employer-Employee Relationship

In Sharkey v. J.P. Morgan Chase & Co., No. 10 Civ. 3824, 2011 WL 135026 (S.D.N.Y. Jan. 14, 2011), the Southern District of New York held the Sarbanes-Oxley Act of 2002 (“SOX”) protects not only whistleblowers who report the illegal conduct of their employers, but also those who report the illegal conduct of their clients.  

In March of 2010, Plaintiff Jennifer Sharkey (“Sharkey”) filed a complaint against J.P. Morgan Chase & Co. (“JPMC”) alleging an assortment of claims, including one for breach of contract and another for violation of the whistleblower protection provision in SOX.  According to the complaint, Sharkey worked as a vice president and wealth manager in JPMC’s Private Wealth Management Department.  There, she managed more than 75 “high net worth client” relationships and was the second highest producer in her department.  In January 2009, management assigned Sharkey to a long-term client of JPMC.  The client had been with JPMC for more than 20 years and brought in approximately $150,000 in quarterly returns for the company.

Soon thereafter, JPMC’s compliance and risk management team contacted Sharkey to express concern regarding the client’s involvement in illegal activities.  Sharkey conducted her own investigation, ultimately concluding that the client was engaged in illegal activities and recommended that JPMC terminate the client relationship. 

When Sharkey conveyed these concerns to the individual defendants, they dismissed the concerns both because they disagreed and because they potentially exposed weakness in JPMC’s risk processing procedures.  When Sharkey refused to condone the client’s behavior, the individual defendants allegedly began to retaliate against her by removing her from several client accounts, excluding her from important meetings with her own clients, refusing to pay her a bonus for 2009, and ultimately terminating her employment with JPMC in August of 2009.

To state a claim under the SOX whistleblower provision, the plaintiff must make a prima facie showing that: (a) she engaged in a protected activity; (b) JPMC or the individual defendants knew or suspected that plaintiff engaged in a protected activity; (c) plaintiff suffered an unfavorable employment action; and (d) the circumstances are sufficient to raise an inference that the protected activity contributed to the unfavorable employment action.

The defendants first claimed that because Sharkey reported the illegal activities of a JPMC client, rather than the illegal activities of JPMC, her actions do not constitute “protected activity” under SOX. Put another way, JPMC claimed that SOX protects Sharkey only if it was JPMC engaging in the illegal conduct. The court disagreed, however, holding that because SOX promotes corporate ethics by protecting whistleblowers from retaliation, it should not be read narrowly.  Specifically, the court stated that the statute did not require that fraudulent conduct be committed directly by the employer that took the retaliatory action.  The court, therefore, held Sharkey properly pled that she engaged in protected conduct under SOX.

The court, however, found the complaint inadequate because it failed to state specifically or definitively how the client allegedly violated SOX.  Specifically, in order for SOX to protect a whistleblower, the reported information must have a certain degree of specificity and must state particular concerns that reasonably identify a respondent’s purportedly illegal conduct.  Because Sharkey failed to identify the allegedly illegal conduct that formed the basis of her whistleblower complaint, the court dismissed the claim, granting Sharkey leave to re-plead within 20 days.

Finally, the court dismissed Sharkey’s breach of contract claim with prejudice. Sharkey claimed JPMC’s Code of Conduct, which included an anti-retaliation policy, created an implied contract of employment.  The court held that the complaint contained no allegation that Sharkey relied on the anti-retaliation provision in deciding to report unspecified illegal activities of the JPMC client.  Further, the court stated that even if the Plaintiff properly alleged the elements of a breach of an implied contract claim, she cannot negate the express disclaimer of contractual rights contained on the first page and in the first section of the Code of Conduct.

The primary materials for this case may be found on the DU Corporate Governance website.


The Benefits of Regulation and the Benefits of Sarbanes Oxley

By now, the big news out of the Supreme Court's decision in FEF v. PCAOB is that SOX survived essentially untouched.  It was always farfetched that even if the Court struck down the PCAOB it would somehow invalidate the rest of the law. 

But what is more amazing is that the opposition to SOX, something that was far more virulent when the case was filed (for a discussion of the unfounded criticism, go here), continued in what can only be described as an often myopic view that refuses to take into account the benefits of the Act.  In the current era, its clear that sometimes prudent regulation makes the markets work better.  There is considerable doubt that removal of the regulatory barrier imposed by Glass-Steagall was a good thing for the markets.  SOX has likewise generated advantages. 

So with that in mind, we turn to the editorial in the Wall Street Journal today titled "Sarbox Survives."  It is a lament to the Supreme Court's failure to strike down SOX.  It contains, however, this disingenuous statement:

  • At least until ObamaCare, few laws have cost so much to so little good end as Sarbox. The law has imposed hundreds of billions of dollars in costs on business with no noticeable decline in financial scandals (Madoff, Stanford). Congress is about to exempt small public companies from Sarbox's rules as part of the financial reform, and we can only hope that Members use this opening provided by the Supreme Court to ease it further.

There are several things to point out about the statement.  First, SOX reformed governance among public companies.  Stanford and Madoff were essentially investment advisors, an entirely different type of market participant untouched by the Act.  The fact that the most important frauds came in areas not regulated by SOX supports rather than detracts from the Act.

Second, the data in fact shows that SOX has had a positive effect.  As the Stanford Securities Site illustrates, the number of class action fraud suits has continued to decline since the adoption of SOX.  Last year was the lowest number filed, with one exception (2006) since the statistics were first compiled in 1997.  This year looks to be even lower.  And these low numbers are even more remarkable because they come at a time when the markets were convulsed by the financial crisis. 

In short, financial fraud, at least measured by law suits, is down.  This has to be attributed at least in part to SOX.  SOX, after all, did seek to prevent financial reform (rather than regulate investment advisors).  In what SOX tried to do, it was a success.  While one can still try to argue that the costs outweigh the success, it is ideological rather than analytical to not recognize the benefits.  


Sarbanes-Oxley Whistleblower Protections Cover Employees of Mutual Fund Firms

Last week, Massachusetts federal district court judge, Douglas P. Woodlock ruled that whistleblower protections of the Corporate and Criminal Fraud Accountability Act of 2002 (“Sarbanes-Oxley”) apply to employees of private firms that operate and advise mutual funds (“Mutual Fund Firms”). According to an attorney for one of the plaintiffs, this was the first time the Sarbanes-Oxley whistleblower provisions were applied to mutual fund firms.


Woodlock’s memorandum and order addressed motions to dismiss in two separate cases. In the first case, plaintiff, Jackie Hosang Lawson sued FMR LLC, FMR Corp. and Fidelity Brokerage Services. In the second case, Jonathan M. Zang sued Fidelity Management & Research Company, FMR Co., Inc., and FMR LLC.  The defendants are referred to hereafter as “Fidelity.”

According to the decision, Lawson worked at Fidelity for more than a decade, most recently as Senior Director of Finance. Lawson claimed that she had questioned the firm’s financial methodology. For example, she believed that internet expenses were not properly allocated and that 12b-1 fees (fees paid out of the fund assets to support sales of fund shares) were being improperly retained by the firm. She allegedly reached out to various management personnel and also contacted OSHA. In response, Fidelity allegedly retaliated by lowering her performance evaluations, reducing her bonus, subjecting her to verbal abuse and ultimately making it impossible for her to continue working there.

Zang, according to the decision, worked for Fidelity for approximately eight years, most recently as a mutual fund portfolio manager. Zang allegedly objected to what he saw as inaccurate disclosure of portfolio manager compensation. Zang contended that in response, Fidelity retaliated by giving him poor performance ratings and ultimately firing him without severance.

 Whistleblower Protection under Sarbanes-Oxley

Sarbanes-Oxley protects certain employees who blow the whistle on publicly held companies. Under the law, whistle-blowing includes helping to investigate conduct the employee reasonably believes violates federal laws designed to protect shareholders. Whistle-blowing also includes assisting in a legal proceeding related to a violation of such a federal law.

Sarbanes-Oxley forbids retaliation against covered employees. The language provides that no publicly held company:

 “or any officer, employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee in the terms and conditions of employment” when that employee blows the whistle.

Dispute Concerning Which Employees are Covered

Fidelity argued that the Sarbanes-Oxley whistleblower protections only apply to “an employee of a publicly traded company.”  Lawson and Zang worked for the Fidelity entities, all of which are private companies. Although the mutual funds themselves are publicly held, Larson and Zang were not employees of the funds themselves. Indeed, the funds have no employees whatsoever. Instead, the funds (with the guidance of the board of trustees) “hire” a variety of contractors to perform services, including money management. Therefore, in Fidelity’s view, the whistleblower claims should be dismissed.

In contrast, the plaintiffs supported a more expansive reading of the statute, claiming that the law prevents retaliation against employees of “any officer, employee, contractor, subcontractor, or agent of” a publicly traded company. “Lawson and Zang argue that the statute encompasses not only employees of public companies but also employees of private companies, particularlythose that act as investment advisers to public investment companies.”

 The Ruling

In the memorandum and order, the judge denied Fidelity’s motions to dismiss the Sarbanes-Oxley claims, but granted the motions to dismiss the state law wrongful discharge claims. He seemed to reject both the narrow and expansive reading, finding “that both of the opposing interpretations suggest somewhat awkward applications to various business relationships.”

Woodlock  first determined that the provisions covered “employees of any related entity of a public company.” Then, he went on to interpret the law to apply to Lawson and Zang.  He wrote that:

“For the goals of SOX to be met, contractors and subcontractors, when performing tasks essential to insuring that no fraud is committed against shareholders, must not be permitted to retaliate against whistleblowers. These concerns are especially strong for mutual funds, which have no employees and implement the funds’ management through contractual arrangements with investment advisers. If Section 806 only protected employees of public companies, then any reporting of fraud involving a mutual fund’s shareholders would go unprotected, for the very simple reason that no “employee” exists for this particular type of public company.”


In arriving at the decision, the judge distinguished related decisions, such as a decision by the New York Federal District Court, Brady v. Calyon Sec. (USA) Inc., 406, F. Supp. 2d 307 (S.D.N.Y. 2005). In that case, the court decided that the whistleblower provisions of Sarbanes-Oxley “did not cover an employee of a privately held broker-dealer that allegedly acted as an “agent and/or underwriter” for public companies.”


The Board of Directors and a Review of Corporate Disclosure

When the Commission inked the settlement with Bank of America (yet to be approved by Judge Rakoff), it included some corporate governance reforms.  One of them was to require the audit committee to retain disclosure counsel who would review the company's disclosure and report to the audit committee.  As the settlement disclosed:

  • IT IS HEREBY FURTHER ORDERED, ADJUDGED, AND DECREED that within forty-five (45) days of the entry of this Final Judgment, the Audit Committee of BAC's Board of Directors ("Audit Committee") shall retain disclosure counsel with expertise in disclosure issues ("Disclosure Counsel") for a period of three (3) years after entry of this Final Judgment. The Disclosure Counsel shall report solely to the Audit Committee. BAC shall require that the Disclosure Counsel: (i) review drafts of all of BAC's public disclosure statements, including all quarterly reports, annual reports, proxy statements, and current reports containing financial information; and (ii) confer, in executive session, with members of the Audit Committee at all regularly scheduled meetings of the Audit Committee, separate and apart from the nonindependent members of BAC's Board of Directors, to discuss the adequacy of BAC's disclosures in its public disclosure statements. BAC shall also require that the Disclosure Counsel, for the period of engagement, not enter into, directly or indirectly, any other employment, consulting, or other professional relationship with BAC or its affiliates, directors, officers, employees, or agents without obtaining the consent of the Commission's staff.

The approach is an interesting one.  SOX substantially beefed up the obligations of the audit committee, at least for Exchange traded companies.  See Section 301 of SOX.  The committee was given the direct authority to supervise and to hire/fire the outside auditor.  The committee was also given the authority to hire counsel without full board approval.  The approach essentially amounted to the preemption of state law by redefining the duties of the audit committee (taking them away from the full board) and by treating a sub-category of the board (a single committee) as a separate entity with its own jurisdiction and funding authority.  The approach has raised interesting ethical questions, particularly whether the privilege rests with the board or with the committee.

In the proposed settlement with BofA, the SEC is seeking to augment the authority of the audit committee one more time.  The Commission is giving to the audit committee (not the full board) the authority to hire counsel.  Counsel must not only review filings but must discuss possible deficiencies with the audit committee in executive session, without the presence of the non-indpendent directors.  The latter restriction is significant. 

While the three committees required by the exchanges (nominating, compensation, and audit) must consist entirely of independent directors, there is no requirement that they meet in executive session or otherwise exclude the non-independent directors.  Indeed, one would say that the compensation committee usually consults actively with the CEO over compensation issues.

To the extent approved by Rakoff, the change can be characterized as another example of the SEC dipping into the corporate governance debate and setting out what it thinks are good governance principals.  

The primary materials, including the proposed settlement, can be found at the DU Corporate Governance web site.


Stone v. Instrumentation Laboratory: SOX, Whistleblowing, and the Plain Language of the Statute

In Stone v. Instrumentation Laboratory Co., No. 08-2196, 2009 WL 5173765 (4th Cir. Dec. 31, 2009), the Fourth Circuit reversed the district court’s determination that a Sarbanes-Oxley Act (“SOX”) whistleblower suit was precluded under the doctrine of collateral estoppel by a decision of an Administrative Law Judge (“ALJ”).  The Fourth Circuit recognized policy considerations in utilizing preclusion principles, but held that the language of 18 U.S.C. § 1514A(b)(1)(B) unambiguously established the right of a whistleblower under SOX to de novo review in federal district court if the Department of Labor (“DOL”) had not issued a final decision within the statutorily prescribed 180 day time frame.  

Appellant David Stone (“Stone”) worked for appellee Instrumentation Laboratory Co. (“ILC”) from 1999 to 2006.  As Director of National Accounts, Stone regularly worked with Group Purchasing Organizations (“GPOs”), which concentrated the buying power of many hospitals.  GPO’s were the major purchasers of ILC products and GPO contracts mandated that ILC pay administrative fees to GPOs equal to three percent of sales revenue generated from the purchases.  Soon after promotion to Director of National Accounts in 2005, Stone learned that his superiors were not honoring their obligations under the GPO contracts.  ILC owed over $500,000 to various GPOs.  Stone repeatedly voiced his concern to superiors and, when he was subsequently dismissed, filed a claim pursuant to SOX alleging retaliation for his whistleblowing activities.  

In June, OSHA found against Stone, but the preliminary findings were not issued within 180 days after he had filed his complaint.  Stone objected to OSHA’s findings and sought a hearing before an ALJ.  On September 6, the ALJ granted ILC’s motion for summary judgment.  Stone petitioned for review of the ALJ’s decision with the Administrative Review Board (“ARB”).  Approximately one month later, Stone notified the ARB that he was utilizing his right under SOX to bring a de novo action in federal district court.  The ARB determined that they had lost jurisdiction over the matter, and dismissed Stone’s administrative appeal. 

The U.S. District Court of Maryland dismissed the case on collateral estoppel grounds, finding that the ALJ’s ruling was a final judgment on the merits.  Stone appealed to the U.S. Court of Appeals for the 4th Circuit, contending the district court did not have authority to dismiss Stone’s complaint by applying preclusion principles.

SOX provides protection for whistleblowers of publicly traded companies.  See 18 U.S.C. § 1514A(b)(1).  The provision provided a whistleblower with the right to seek relief by “filing a complaint with the Secretary of Labor,” and if the Secretary (or OSHA on behalf of the Secretary) does not “issue a final decision within 180 days of the filing of the complaint” the aggrieved can bring an action “for de novo review” in federal district court.  Although the ALJ had ruled on the matter, OSHA had not not issued a final decision within 180 days.  Stone argued that under the plain language of the statute he had a right of de novo review. 

This provision was a matter of first impression among all circuit courts. The Fourth Circuit looked to the canons of statutory interpretation for guidance.  The court noted that if the plain language of the statute is unambiguous, and if a literal interpretation does not lead to an “absurd result,” then the intent of Congress is clear and judicial inquiry stops.  Only if the language is unambiguous should courts defer to an administrative agency’s interpretation.           

The appellate court reasoned that the Secretary did not issue a final decision within 180 days and that the plain language of SOX unambiguously gave Stone the right to de novo review in federal court.  The court rejected ILC’s contention that SOX could not abrogate a district court’s power to apply collateral estoppel, stating that “Congress unquestionably has the right to create a complainant-friendly statutory scheme that affords no deference to non-final agency findings.” 

Furthermore, the court was unpersuaded by ILC’s argument that a literal interpretation leads to an absurd result, and thus deference should be given to the Secretary of Labor’s belief that abrogating a district court’s preclusion power is a waste of resources.  The court determined that precluding collateral estoppel in this situation was not absurd, and reasoned that Congress intended for whistleblower claims to be resolved quickly, and thus specified an alternative process to resolve the conflict should the DOL not act within 180 days.

In summary, the Fourth Circuit held that when a whistleblower does not receive a final decision from the DOL within 180 days of filing a complaint, SOX gives the complainant a right to de novo review in federal district court.  An ALJ’s decision between the end of the 180-day period and the filing of suit in district court cannot preclude, on the basis of collateral estoppel, the complainant’s right to de novo review.  

The primary materials for this case may be found on the DU Corporate Governance Website.


Reinstating Glass-Steagall: The Harm of Inaction (Part 4)

Is the decline in the number of independent investment banking firms already having an impact on the IPO market? 

The Economist reported on a study by Grant Thornton about a decline in the competitiveness of US securities markets.  The study, A wake-up call for America, looks to the decline in the number of listed companies since the 1990s. From 1991 through 2008, the number of listings fell from 6,943 to 5,401, or a decline of 22%.  The study puts the decline at 52.8% when adjusted for GDP growth.  The statistics mask considerable difference among the exchanges.  While the NYSE fell only 1.3%, Nasdaq dipped by 27.9% and Amex by 43.5%.

What is the culprit?  The decline in the IPO market.  While the US needs 360 new listings a year just to replace departing companies, the number of IPOs has averaged only 166 since 2001, with 54 in 2008.  As the Economist noted:

  • For all the talk of a revival in initial public offerings (IPOs), domestic markets are on track to add a mere 50 or so new companies this year, one-seventh of the level needed to offset the average annual loss of listed companies in recent years.

And, in turn, what caused the decline in IPOs?  Not SOX.

  • Grant Thornton argues that the root cause of “The Great Depression in Listings” is not Sarbanes-Oxley, as some will suggest. Rather, it is what we call “The Great Delisting Machine,” an array of regulatory changes that were meant to advance low-cost trading, but have had the unintended consequence of stripping economic support for the value components (quality sell-side research, capital commitment and sales) that are needed to support markets, especially for smaller capitalization companies.

In other words, much like the harm flowing from the repeal of Glass Steagall, the decline in listings is a product of deregulation, not the governance reforms contained in SOX.

But, as the Economist notes, there are other explanations for the dearth of IPOs.  US underwriters charge excessive fees, much higher than those imposed by foreign underwriters.  This no doubt reflects at least in part a lack of serious competition for underwriting business.  Yet as bad as things have been, they will now likely get worse.  The class of independent banking firms has largely ceased to exist, a consequence of this ongoing financial crisis. 

This affect has eliminated the one class of financial intermediaries that profited from robust securities markets.  This will, as predicted, harm the securities markets.  Unlike traditional commercial banks, investment banks had every incentive to encourage public offerings.  Moreover, they had the capacity to accept higher levels of risk.  Without these institutions, the number of companies going public may well decline.  In other words, deregulation (particularly the repeal of Glass Steagall) likely resulted in long term structural damage to the US securities markets.  It remains to be seen whether or not they can be fixed.

Putting Glass Steagall back in place will allow for the return of a class of intermediaries committed to robust securities markets.

For more on this topic, see Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets.


Reinstating Glass-Steagall: A Brief History in the United States (Part 3)

Until the 1920s, private investment firms dominated the underwriting process. Because they lacked the economic clout of  commercial banks, however, the advantage shifted immediately once commercial banks decided to aggressively pursue underwriting activities.  Banks did so once the remaining legal limitations on underwriting activities were eliminated. 

Commercial banks entered the underwriting business with a number of advantages.  Commercial banks in the principal money centers had long-standing relationships with large corporations.  They also had an existing base of clients already using their services for financial matters. The existence of a network of branches facilitated sales at little additional cost. Banks were thus able to develop a strong and immediate presence in the retail distribution market.

By the time of the Great Depression, commercial banks threatened to monopolize the industry. In a relatively brief time, eight commercial banks -- Guaranty Trust, National City (Citibank), Chase, Bankers Trust, Equitable Trust, Continental Illinois, First National Bank of Boston, and Union Bank of Detroit -- had a significant amount of underwriting business.  These and other commercial banks accounted for more than half of all underwriting business.

Domination by the commercial banks ended only because of direct intervention by Congress. During the Depression, Congress concluded that the involvement of banks in securities activities was at least partially responsible for the nation's economic collapse. In response it enacted the Glass-Steagall,  which, among other things, prohibited banks from dealing in, underwriting, and purchasing securities for their own accounts. The law further prohibited commercial banks from affiliating with firms engaged in underwriting activities. Securities firms, in turn, were prohibited from accepting deposits. The net effect was a separation of commercial and investment banking.

This development disrupted existing banking relationships. Companies that were accustomed to having all of their financial needs met by a single firm were compelled to find new sources of funding. The result was vigorous competition among new and existing firms for a share of the business.

Moreover, by requiring divestiture or dissolution of the securities subsidiaries of some of the country's largest commercial banks, Glass-Steagall essentially ensured the creation of a class of investment banking firms with considerable skill, prominence, and access to the highest levels of corporate America. First Boston arose from the securities division of the First National Bank of Boston; Morgan Stanley from the remnants of J.P. Morgan; and Brown Harriman & Co. from National City Co.  Formed from established banks, these new firms enjoyed instant name recognition and credibility. During the post-war period, they became the principal advisors to corporate America in regard to its capital needs.

As a result, banks and securities firms pursued different roles in the capital markets. Banks preferred arm's length relationships based on the provision of short-term funding. Securities firms, specifically investment banks, became the primary providers of long-term capital to American corporations.

Absent Glass Steagall, therefore, the United States was in the process of becoming bank dominated.  Only with a legal separation in the two categories of financial institutions did this process stop.  Once Glass Steagall was implemented, an independent and powerful set of investment banking firms developed.  At the same time, the US developed vibrant and deep securities markets.

For more on this topic, see Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets


Reinstating Glass-Steagall: The Problem with Bank Dominated Securities Markets (Part 2)

Bank dominated securities markets are those where banks control the primary distribution process.  This is the situation for example in Germany.  It was the situation in the United States before the adoption of Glass Steagall (we will explore the history in another post). 

Bank dominated systems involve an inherent conflict of interest: The same entities providing companies with short-term credit also give advice on long-term capital needs.  Consequently, the risk exists that the advice provided by banks will be motivated by their own self-interest rather than the best interests of the company. Moreover, banks have a reputation for conservative decision-making and risk aversion, attitudes which conflict at times with corporate interests.

The risk is that bank-dominated systems will provide access to fewer sources of capital.  Given the conflict of interest and the attitude towards risk, one can predict that bank dominated systems will engage in fewer IPOs. 

Any significant reduction in the availability of equity markets will have a disproportionate affect on companies that lack the traditional attributes sought by lenders.  Bank lending depends primarily upon indicia of the ability to repay, particularly collateral and cash flow. Many companies, however, lack these attributes, and even those that can obtain some bank funding will often not be able to borrow additional amounts to expand.  Biotechnology companies in the 1980s, Internet companies in the 1990s, and software companies in the New Millenium likely fall into this category.  

In systems with active and accessible securities markets, start up companies can sidestep banks and seek funds directly from the capital markets. In so doing, they need not meet the same standards applicable to bank loans. Instead of focusing almost entirely on indicia of repayment, securities firms must look at investor demand for shares.  The different standards allow companies with minimal track records to gain access to the capital markets, so long as they can convince an investment bank that investors will buy the shares. 

Investment banks, unlike commercial banks, profit almost entirely from the securities markets.  They lack the same conflict of interest possessed by commercial banks.  Investment banks also have an incentive to encourage companies to engage in public offierings.

For more on this topic, see Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets.


Reinstating Glass Steagall: Part 1

We on this Blog opposed the repeal of Glass Steagall, predicting that it would result in the demise of independent investment banking firms.  The case was made in: The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.  It seems that the sentiment for bringing back Glass Steagall has continued to grow.  Steny Hoyer in the House indicated support.   So has Senators McCain and Cantwell

Glass-Steagall is of course Depression era legislation that separated investment and commercial banks.  Those taking deposits were prohibited from engaging in securities activities; those engaging in securities activities were prohibited from taking deposits. 

There are a number of reasons why renewed consideration of the separation makes sense.  Over the next few posts, however, we will discuss one of them.  As a matter of international practice and history in the United States, the absence of a separation of commercial and investment banking with respect to primary offerings results in commercial banks eventually controlling the market.  This is because they are more conservatively managed and have inherent funding advantages (particularly deposits). 

This risk aversion and the inherent conflict of interest by commercial banks (they favor debt relationships over the sale of securities) will likely harm the securities markets.  We are already seeing a decline in IPOs, something that may be explained at least in part by an absence of any significant number of independent investment banking firms.  We will look at some of the supporting evidence over the next few posts. 

For more on this topic, see Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets


Congress and the Assault on SOX: Commissioner Aguilar Speaks

The efforts to exempt public companies with a market cap of less than $75 million brought a quick reaction from Commissioner Aguilar:

  • The Investor Protection Act of 2009 in its current form would repeal this important requirement of an independent audit for public companies with a market cap under $75 million. Some are describing this repeal of Sarbanes-Oxley as relief for "small businesses." I think people are confused when they hear the words "small business." The companies that would be exempted are not mom and pop neighborhood stores. These are publicly traded companies that offer their shares to all types of investors. And just so you know, this repeal has wide-ranging ramifications and would appear to affect the majority of public companies. Although the SEC generally does not track companies based on market cap, the SEC does have data on companies that generally have $75 million or less in public float, and our staff estimates that over 6,000 public companies may fall under that threshold.
  • To repeal this part of Sarbanes-Oxley now is to throw away a substantial amount of work done by regulators, companies, and private organizations to make compliance with 404(b) more cost-effective. Since the passage of Sarbanes-Oxley, the SEC has repeatedly deferred smaller public company compliance with the independent internal control audit requirement. During the period of the SEC deferrals, the SEC and the Public Company Accounting Oversight Board (PCAOB) were active in developing rules and guidance to allow 404(b) to be implemented in a manner that would work for both large and small public companies. A central goal of this work focused on making sure that costs for smaller public company were not overly burdensome.

We could not have said it better.  Nice to see that the defense of SOX is not limited to the ivory tower.


Congress and the Assault on SOX

What is clear by now is that if there was a problem with SOX, it was that the legislation did not go far enough.  The law only addressed one compensation issue, loans to executive officers.  SOX dealt with the concern by prohibiting them, leaving the matter otherwise untouched.  Likewise, SOX never addressed the responsibility of the directors for risk assessment, something the Delaware courts suggest is not their responsibility at all.   

So it is a bit startling to see that the House Financial Services Committee, over the objection of its Chair and, apparently, the chair of the SEC, voted in favor of a bill that would weaken rather than strengthen SOX.  The so called "Investor Protection Act of 2009" (HR 3817) was amended to exempt companies with less than $75 million in market capitalization from Section 404(b), the provision that requires outside auditors to "attest" to management's assessment of the internal controls and procedures.  The amendment was approved by a 37-32 vote before the entire Act was approved by the Committee by a vote of 45-28.

And the reason?

  • The "one size fits all" regulatory approach to implementing section 404 of Sarbanes Oxley has had a disproportionately negative impact on small and medium sized companies. The current and pending compliance burden has sent many companies to market overseas or dissuaded them from going public here in America.

This is devoid of any real content and harks back to the era when SOX was attacked by all manner of made up statistics, that it reduced foreign listings, that it caused companies to go dark, most of which proved incorrect.  For a discussion of these arguments, see Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance

There is no evidence that suggests that small US companies have been dissuaded from conducting IPOs by Section 404(b).  Indeed, the statement was made just when the IPO pipeline seems to be opening up and the evidence (developed in an SEC Study) indicates that the costs of complying with Section 404(b) are coming down. 

It is not a bad idea to take cost into account when addressing smaller businesses.  But there is no evidence that this is what is taking place in these circumstances.  The amendment not only exempted these businesses but required the Commission to conduct a study of methods of reducing "the burden" of complying with Section 404(b) for companies with a market capitalization between $75 and $250 million. 

The importance of Section 404(b) is to require another set of eyes, outside the company, to assess what management has done in developing internal procedures and controls.  With Delaware and the Delaware courts imposing few real obligations on management and the board to protect the interests of shareholders, the internal governance system is not sufficiently robust to ensure that adequate internal procedures are put in place.  Like the pay czar, to fix governance problems increasingly requires a solution outside the corporate governance process. 


Protecting the Whistleblower under SOX: Van Asdale v. International Game Technology 

In Van Asdale v. International Game Technology (IGT), plaintiffs sued defendant for retaliatory discharges under the Whistleblower protection provision in the Sarbanes  Oxley Act (SOX) and Nevada state law.  IGT moved for summary judgment.  The U.S. District Court for the District of Nevada granted IGT’s motion.  In reversing, vacating and remanding the lower court’s decision, the Ninth Circuit Court of Appeals held that (1) professional ethics rules did not preclude plaintiffs’ claims under SOX; (2) the attorney-client privilege did not require dismissal of the case; (3) the plaintiffs’ claim of shareholder fraud was protected; (4) the use of the sham affidavit rule was unjustified; (5) a genuine issue of material fact existed regarding fraud disclosures contributing to the plaintiffs’ terminations.
Shawn and Lena Van Asdale began work with IGT in 2001.  That year, defendant began merger talks with Anchor Gaming (Anchor).  Concomitantly, one of Anchor’s competitors, Bally Gaming (Bally), marketed a new slot machine.  Anchor’s IP department alleged Bally’s new machine used technology that infringed on a valuable patent owned by Anchor.  After the merger, Shawn Van Asdale found material evidence supporting Bally’s defense claim that had been left out of Anchor’s due diligence.  This evidence invalidated Anchor’s patent and undermined the ongoing lawsuit between Anchor and Bally.  Plantiffs suspected the merger had purposely been overvalued by Anchor. 

Plaintiffs alleged they brought the matter to the attention of their original superiors at IGT.  They met later with IGT’s General Counsel, formerly of Anchor.  Plaintiffs alleged they suggested the failure to disclose Bally’s defense materials was conduct that related to shareholder fraud.  Within approximately three months of these allegations, IGT fired the Van Asdales.

This court found that the district court could hear testimony regarding plaintiffs meeting with defendant’s senior executives as long as the court avoided hearing testimony relating to attorney-client privilege in the Bally litigation.  It also concluded that Section 1514(A) of SOX expressly authorized any “person” to allege discrimination based on protected conduct and to file a complaint.  This included in-house attorneys, such as the plaintiffs.  

This case was an issue of first impression. The court looked to Section 1514(A) of the SOX whistleblower statute, which requires that the plaintiffs have a reasonable belief that their employer violated a listed law.  The court found the plaintiffs met this minimum threshold requirement. 

Next, it found Shawn Van Asdale’s meetings with IGT supervisors were protected whistleblower activities.  The court also found that the plaintiffs made a prima-facie case of retaliatory termination.  Thus, the court concluded that the defendant did not establish by clear and convincing evidence that plaintiffs would have been fired if they had not been whistleblowers, preventing the defendant from prevailing on summary judgment.  Based on this finding of error in summary judgment, the Court also vacated the dismissal of all of plaintiffs’ state law claims and remanded them for reconsideration.

The primary materials for this post are available on the DU Corporate Governance website.


The SEC and the Costs of SOX: A Section 404 Survey

SOX was adopted in the aftermath of Enron and Worldcom.  When the law came out, the knives were unsheathed and the criticism rampant.  Plenty of pundits and academics purported to quantify the costs of SOX and find that the costs more than outweighed the benefits.  Most of these purported attacks were at best premature and at worst wrong.  For an analysis of this critics, see Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance

There was no provision that received more vituperative criticism than Section 404(b).  Section 404(b) required the outside auditors to "attest" to the assessment by management (required by 404(a)) of the company's internal controls.  Section 404 essentially required outsiders to assess the system of internal controls implemented by management.  This did not make managers happy.  In addition, however, the provision coincided with an increase in auditor fees.  As a result, it was a relatively easy matter to quantify increases in fees and lay them at the doorstep of SOX. 

The attempts to attribute increases in auditor costs to Section 404(b) were way off the mark.  Auditor fees increased in part because of the changed environment after Enron and the heightened risk of liability.  In other words, some of the increase had nothing to do with SOX and would have happened anyway.  They also increased because auditing fees in a pre-SOX era were subsidized by consulting fees.  Once SOX essentially separated auditing and consulting functions, the auditing fees increased to reflect the lost subsidy.  In that case, the increase may have been related to SOX but had nothing to do with Section 404.

Section 404 did increase costs.  It was an extra service that had to be paid for.  In addition, there was a concern that auditing firms took the opportunity to bulk up on hours (and fees) in performing the service, a matter of opportunity rather than necessity.  Nonetheless, those criticizing the Act rarely noted that Section 404(b) was at best responsible for only a portion of the increase.  

We don't hear much about Section 404(b) anymore.  The SEC took some of the pressure off by exempting for a time smaller companies (non-accelerated filers).  Moreover, accounting firms got better (and presumably more efficient) at performing the service.  Anecdotal evidence also suggests that software and other forms of increased efficiency have been utilized.  Mostly, though, with the current financial crisis taking place, critics have a much harder time taking the position that whatever the costs, they outweigh the benefits.  This crisis has emphasized that there is a need for greater oversight by gatekeepers, not less.

We give all of this background because we noted that the SEC is conducting a survey on the costs associated with Section 404.  The survey can be found here.  The survey notes that all "companies with experience in complying with 404 rules are invited to participate."  Perhaps the SEC would also like to hear from non-companies about the perceived benefits of the attestation.  In any event, whatever the costs, we have little doubt that under this Commission, the benefits of the provision will outweigh the costs.