Court Decision Could Advance Compliance at Private Companies

A U.S. Supreme Court decision earlier this month has significantly expanded whistleblower protections under the Sarbanes-Oxley Act, effectively creating new compliance headaches for private companies that perform services for publicly traded companies.

The Supreme Court ruled that Sarbanes-Oxley prohibits not just public companies from retaliating against their employees for engaging in protected whistleblower activities, but also the private contractors of those public companies. The decision means that many private companies are now subject to Sarbanes-Oxley whistleblower claims, which could be problematic since most don't have proper anti-retaliation compliance controls in place.

“This is a landmark decision of sweeping importance for a whole new category of companies that likely expected they weren't covered in the first place,” says Steven Pearlman, a partner in the labor and employment law department with law firm Seyfarth Shaw.

Congress passed Sarbanes-Oxley in 2002 in response to the Enron scandal and other corporate frauds to protect employees who report corporate wrongdoing from retaliation and encourage the reporting of securities fraud. The Supreme Court wrote that SOX states, in part, “no [public] company …, or any … contractor [or] sub-contractor…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 because of [whistleblowing or other protected activity].”

The case, Lawson v. FMR, gives validity to two separate whistleblower retaliation complaints filed by Jackie Lawson and Jonathan Zang, two former employees of private firms that provide investment advising services to Fidelity mutual funds. Zang and Lawson each alleged they were fired in retaliation for raising concerns about potential shareholder fraud at the mutual funds.

Until the Supreme Court's ruling in Lawson, most people had interpreted SOX to mean that whistleblower protections applied only to employees of U.S. publicly traded companies. “People always assumed there was a limit,” says Randy Stephens, vice president of advisory services for Navex Global. The court's decision changes that mindset entirely.

The U.S. District Court for the District of Massachusetts, which decided the original cases jointly, found that Section 1514A of Sarbanes-Oxley protects employees of “private agents, contractors, and sub-contractors” of publicly traded companies. The U.S. Court of Appeals for the First Circuit disagreed.

In a 6-3 decision on March 4, the court reversed the First Circuit, reasoning that both the statutory text and “common sense” support the plaintiffs' argument that the reading of the SOX means, “no contractor may discriminate against its own employee for whistleblowing,” Justice Ruth Bader Ginsburg wrote for the court.

Since contractors are “not ordinarily positioned to take adverse actions against employees of the public company with whom they contract,” a contrary interpretation of the statute would “shrink to insignificance the provision's ban on retaliation by contractors,” Ginsburg wrote. The court said its decision further protects employees of independent investment advisers, “who are often the only firsthand witnesses to shareholder fraud involving mutual funds.”

“This is a landmark decision of sweeping importance for a whole new category of companies that likely expected they weren't covered in the first place.”

—Steven Pearlman,

Partner,

Seyfarth Shaw

Chief Justice John Roberts and Justices Stephen Breyer and Elena Kagan joined in the majority opinion. Justices Antonin Scalia and Clarence Thomas concurred.

In a dissenting opinion, Justices Sonia Sotomeyer, Anthony Kennedy, and Samuel Alito criticized the “stunning reach” of the court's decision. “By interpreting a statute that already protects an expansive class of conduct also to cover a large class of employees, [the] opinion threatens to subject private companies to a costly new front of employment litigation,” wrote Sotomeyer.

As a result of Lawson, the court has “expanded the universe of companies regulated by the Sarbanes-Oxley whistleblower provision from roughly 5,000 public companies to potentially six million private ones,” says Lloyd Chinn, a partner and co-head of the whistleblowing and retaliation group of law firm Proskauer.

Even though it's difficult to say how many private companies are providing services to public companies at any given time, Chinn adds, “at least theoretically, any of these roughly six million private companies, provided they are a contractor to a public company, are now captured within this provision.”

Compliance Obligations

The ruling could force private companies of every size that engage in contracts with public companies to put in place internal compliance policies and procedures for investigating and handling whistleblower complaints. Shanti Atkins, president and chief strategy officer for NAVEX Global, says Lawson is a watershed case that imposes a “shift in the maturation of compliance programs for private companies."

“Private companies might have felt like they had a free pass in the past where they could treat employees, and operate, in a slightly different manner than public companies that have more external regulatory pressure,” says Stephens. “They may have felt like, ‘I'm not going to have to worry about having a full-blown compliance program.' This decision clearly ends that misconception.”

Contractors covered under Sarbanes-Oxley, for example, now include those that provide legal, accounting, or financial consulting services to publicly traded companies, as well as those involved in securities law compliance, and investigative and forensic services.

The first step private companies will want to take is to perform an audit to determine which of their existing contractual relationships are with publically traded companies, says Connie Bertram, a partner in the labor and employment department of Proskauer. “Who do you work with regularly? What types of services are you providing to them?”

Private companies will also need to decide “whether they want to set up at least an investigation protocol—a hotline, for example—so that they can become aware more quickly of problems that arise within their organization,” says Edward Ellis, co-chair of the whistleblowing and retaliation practice of law firm Littler Mendelson.

SUPREME COURT RULING

What follows is a brief excerpt from the Supreme Court's opinion in Lawson v. FMR:

Our reading of §1514A avoids insulating the entire mutual fund industry from §1514A, as FMR's and the dissent's “narrower construction” would do. As companies “required to file reports under section 15(d) of the Securities Exchange Act of 1934,” mutual funds unquestionably are governed by §1514A. Because mutual funds figure prominently among such report-filing companies, Congress presumably had them in mind when it added to “publicly traded companies” the discrete category of companies “required to file reports under section 15(d).”

Virtually all mutual funds are structured so that they have no employees of their own; they are managed, instead, by independent investment advisers. The United States investment advising industry manages $14.7 trillion on behalf of nearly 94 million investors. These investment advisers, under our reading of §1514A, are contractors prohibited from retaliating against their own employees for engaging in whistleblowing activity. This construction protects the “insiders [who] are the only firsthand witnesses to the [shareholder] fraud.”

Under FMR's and the dissent's reading, in contrast, §1514A has no application to mutual funds, for all of the potential whistleblowers are employed by the privately held investment management companies, not by the mutual funds themselves.

The Court of Appeals found exclusion of the mutual fund industry from §1514A tenable because mutual funds and their investment advisers are separately regulated under the Investment Company Act of 1940, the Investment Advisers Act of 1940, and elsewhere in Sarbanes-Oxley. But this separate regulation does not remove the problem, for nowhere else in these legislative measures are investment management employees afforded whistleblower protection. Section 1514A alone shields them from retaliation for bringing fraud to light.

Indeed, affording whistleblower protection to mutual fund investment advisers is crucial to Sarbanes-Oxley's endeavor to “protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.”

Source: Lawson v. FMR.

Private companies will now have to consider adopting an effective compliance programs that fosters a speak-up culture, where employees have a means to report potential misconduct without fear of retaliation, and one in which the company immediately investigates and remediates the problem. “These are really basic concepts that just make for good governance that aren't limited to publicly traded companies,” says Atkins.

Stephens says the decision could also push public companies to look more carefully at the compliance programs of the private companies in which they do business with. “You may see more of a synergy between the employer and the contracted company being required to share and prove the quality of their compliance program in order to maintain and retain the work,” he says.

In light of Lawson, public companies should consider whether to start requiring their contractors and sub-contractors to abide by the public company's own anti-retaliation policy, and further require that contractors certify compliance with the policy, says Bertram.

The decision is expected to increase litigation as well. “By forcing private companies to comply with the Sarbanes-Oxley Act, the court is downplaying the reality that this decision gives plaintiff's attorneys additional incentives to pursue aggressive litigation against independent companies,” Karen Harned, executive director of the National Federation of Independent Businesses, said in a statement in response to the ruling.

Whether the courts will place any limitations on the types of anti-retaliation complaints that may be filed under the whistleblower provisions of Sarbanes-Oxley only time will tell, says Ellis, “but right now, there doesn't appear to be any at all.”