New Study Confirms Efficacy of SOX-Mandated Internal Whistleblower Systems

February 19, 2019
Jessica L. Westerman

Late last year, financial researchers Stephen Stubben and Kyle Welch published a first-of-its kind study analyzing the use of internal whistleblowing systems at over 900 publicly-traded companies in the United States. The study, “Evidence on the Use and Efficacy of Internal Whistleblowing Systems,” found wide variation in the use of internal whistleblower systems across companies and across industries but observed trends and characteristics common to companies with robust, heavily utilized systems. The report offers insights that should inform federal financial policy in the future.

In conducting the study, Stubben and Welch analyzed the relationship between a company’s use of its internal whistleblower system and subsequent whistleblower-related litigation. They found that the more actively a firm used its internal whistleblower system, the fewer material lawsuits were filed against it in subsequent years. Stubben and Welch concluded that internal whistleblower systems provide “relevant and actionable information” to company management regarding employee concerns about accounting problems, employee harassment, workplace safety, and other topics. Indeed, active internal whistleblower systems allow employees to improve their day-to-day working conditions without resort to costly litigation, and allow companies to address problems before they become more severe and/or become known to outside entities, such as financial regulators. For two major federal statutes that regulate financial fraud, the Sarbanes-Oxley Act of 2002 (“SOX”) and the Dodd-Frank Act Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), the study’s findings have implications that cut in opposite directions for whistleblowers.

Protection for Whistleblowers under the Sarbanes-Oxley Act

As the study notes, Congress passed SOX in response to the high-profile investigations of companies like Enron and WorldCom, which revealed that whistleblowers had raised concerns internally about the problems that eventually brought these companies down, but were ignored. In an effort to encourage whistleblowers to report fraud internally – and to ensure that companies take those reports seriously – SOX (1) mandated that all publicly-traded companies establish internal compliance systems and (2) prohibited retaliation against whistleblowers who report wrongdoing to their supervisors.

Under Section 301 of SOX, audit committees of publicly-traded companies must establish internal procedures for

(A) the receipt, retention, and treatment of complaints received by the issuer regarding accounting, internal accounting controls, or auditing matters; and

(B) the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.

15 U.S.C.A. § 78j-1(m). Although the SEC declined to require “one-size-fits-all” reporting procedures for all publicly-traded companies, these internal procedures typically come in the form of a toll-free whistleblower hotline or web-based submission form, and often are operated by a third-party provider in order to preserve both the confidentiality of the report and the anonymity of the whistleblower.

Anti-Retaliation Provisions under Sarbanes-Oxley

Under Section 806 of SOX, companies are prohibited from retaliating against whistleblowers who report suspected violations of federal financial rules or regulations to “a person with supervisory authority over the employee (or such other person working for the employer who has the authority to investigate, discover, or terminate misconduct).” 18 U.S.C. § 1514A(a)(1). This includes individuals who have reported concerns through the procedures mandated under Section 301, but whose identity has been compromised. (SOX also protects those who report suspected violations to a federal law enforcement or regulatory agency, or to Congress.) If an employee nevertheless faces retaliation for making an internal complaint, he or she can seek damages in the form of reinstatement, back pay, compensation for emotional distress, and attorneys’ fees. 18 U.S.C. § 1514A(c). Taken together, these provisions create important incentives for employees to use internal complaint procedures before, or in place of, external ones to remedy serious problems at publicly-traded companies.

Anti-Retaliation Provisions under Dodd-Frank

The Dodd-Frank Act, however, creates opposite incentives. Signed into law in 2010, the Act focused on the root causes of the 2008 financial crisis, including the lack of oversight for banking institutions and inadequate consumer protections, and created the SEC Whistleblower Program. The Program provides monetary incentives for employees to report suspected violations of federal securities laws to the SEC. Under Section 922 of the Dodd-Frank Act, eligible whistleblowers are entitled to an award between 10 percent and 30 percent of monetary sanctions in excess of $1 million collected by the SEC and certain other law enforcement or regulatory authorities.15 U.S.C. § 78u-6(a), (b). Like SOX, the Dodd-Frank Act also contains anti-retaliation provisions 15 U.S.C. § 78u-6(h).

Unlike SOX, however, and under the Supreme Court’s recent decision in Digital Realty Trust Inc. v. Somers, 583 U.S. ___ (2018), only those employees who report their concerns externally to the SEC are entitled to protection from retaliation. This means that employees who avail themselves only of internal reporting systems, giving their employers the opportunity to address serious problems without facing consequences from law enforcement or regulatory agencies, are left without recourse if they subsequently are subject to retaliation at work.

As Stubben and Welch suggest, the potential value of internal whistleblower systems for addressing regulatory and workplace issues before they become more severe “may be lost” as a result of the increasing incentives under the Dodd-Frank Act for employees to report their concerns directly to the SEC. Given that internal whistleblower systems enable companies to identify and address workplace problems sooner and to avoid both penalties and costly litigation down the line, policymakers should consider providing more incentives for whistleblowers to at least initiate their efforts at meaningful change by making an internal complaint.

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