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Second Circuit Limits Scope Of SEC Whistleblower Incentives – Securities



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A recent decision by the U.S. Court of Appeals
for the Second Circuit
 has implications for whistleblowers
under the Dodd-Frank Wall Street Reform and Consumer Protection Act
(“Dodd-Frank Act” or “The Act”). In 
Hong v. SEC
, No. 21-529 (2d Cir. July 21, 2022), the
Court held that a person who provides the Securities and Exchange
Commission
 (“SEC”) with information about
potential securities laws violations is entitled to receive a
whistleblower award under 
Section 21F of the Securities Exchange Act
 (15 U.S.C.
§ 78u-6)if the SEC itself brings a qualifying action, but not
when the SEC shares the whistleblower’s information to other
agencies who then bring an action in partial reliance upon it. The
decision sets definitive limits on the reach of the Dodd-Frank
Act’s whistleblower incentives and may affect the calculus
for individuals considering whether to risk their personal and
professional careers to come forward with information of
wrongdoing.

Victor Hong worked at a bank for six weeks in the fall of 2007
before resigning, prompted by what he believed to be unlawful
practices engaged in by the bank in connection with its portfolio
of residential mortgage-backed securities (“RMBS”).
After his resignation, he formally submitted information to the SEC
about the bank’s perceived misconduct. The SEC itself took no
action against the bank but shared the information with the
Department of Justice (“DOJ”) and the Federal Housing
Finance Agency (“FHFA”) (together, the
“Agencies”), each of which had already begun
RMBS-related investigations into the bank. The Agencies then
obtained additional information and documents from Hong by subpoena
and later entered into settlements with the bank requiring it to
pay over $10 billion.

Hong applied to the SEC for an award under Section 21F of the
Securities Exchange Act, the SEC’s whistleblower program (the
“Program”) established by the Dodd-Frank Act to
motivate those with inside knowledge of securities law violations
to share information with the government despite the risks that
speaking out could pose to the whistleblower’s reputation and
career. Hong asserted that the statute entitled him to between 10%
and 30% of the total amounts collected. Hong’s application
was denied on the grounds that he had identified no action brought
by the Commission under the securities laws based on his
information. The Commission also rejected Hong’s alternative
theory of recovery that the DOJ and FHFA settlements qualified as
“related actions,” reasoning that an
“action” that was “brought by the SEC” was
still a necessary predicate for an action brought
by another  agency to qualify as a
“related action.” Hong petitioned the Second Circuit
for judicial review.

The Court reviewed the SEC’s decision to deny Hong an
award under the standard set forth in Section 706 of the
Administrative Procedure Act (“APA”), which allows the
Court to “set aside agency action, findings, and conclusions
found to be . . . arbitrary, capricious, an abuse of discretion, or
otherwise not in accordance with law.” Section 21F(f) of the
Exchange Act also provides that “any determination . . .
including whether, to whom, or in what amount to make awards, shall
be in the discretion of the commission.”

When evaluating an APA challenge to an agency’s
interpretation of a statute it administers, courts apply a two-step
analysis known as the Chevron  framework, which
considers: (1) whether the statutory language at issue is
ambiguous, and, if it is, (2) whether the agency’s
interpretation is reasonable and, thus, to be accorded
deference.

The Court first applied this framework to the two interrelated
elements of the statutory definition of a covered action: first,
the phrase “judicial or administrative action,” and
second, the phrase “brought by the Commission.” As to
the former, the Court concluded that while the concept was not
entirely free from ambiguity, a conclusive determination was
unnecessary because the SEC’s interpretation that an
“judicial or administrative action” generally means a
single captioned judicial or administrative proceeding as well as
limited types of settlement and non-prosecution agreements was
reasonable and, thus, to be accorded deference. After considering
the Black’s Law definition of “action,” its
common usage by courts, and the statutory text, the Court found
that it was reasonable for the SEC to conclude that the concept did
not extend to the full range of investigative or
information-sharing activities the SEC may undertake with respect
to a tip. The Court briefly addressed the phrase “brought by
the Commission,” concluding that the SEC’s
interpretation that this contemplated a leading enforcement role by
the SEC was “not arbitrary, capricious, or otherwise not in
accordance with law.”

The Court then considered whether the DOJ and FHFA settlements
qualified as “related actions” under the Program,
making Hong eligible for the award. It held that to the extent the
statutory definition of “related action” is ambiguous,
the SEC reasonably interpreted the provision to require a predicate
action brought by the SEC. The Court found this conclusion
logically flowed from the contextual statutory language, which
requires the non-SEC action to be “based upon the original
information” that the “successful” SEC action
relied upon, presupposing an SEC action that could be
“enforce[d].” Accordingly, the Court held that an
award-eligible “related action” must be predicated upon
a covered judicial or administrative SEC action, which the DOJ and
FHFA settlements were not.

The decision in Hong demonstrates that
despite the broad goals underlying the Dodd-Frank Act’s
whistleblower program aimed at preventing the kind of misconduct
that led to the financial crisis of 2008, it has its limits. The
Second Circuit concluded that its provisions do not leave the SEC
on the hook for whistleblower awards where other agencies reached
settlements based in part upon tips the SEC received and shared
with those agencies. The ruling has important implications for
prospective whistleblowers considering whether to risk their
personal and professional reputations in bringing information of
wrongdoing to light.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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