April 22, 2013

Whistleblowing and Sarbanes-Oxley

Posted in Corporate Litigation, Employment Law by Gene Killian |

Suppose you’re the chief financial officer or general counsel of a public company.  Suppose that someone in the accounting department makes some inquiries about proper accounting for corporate entertainment expenses.  Has the bookkeeper just engaged in “protected activity” under Sarbanes-Oxley, 18 U.S.C. §1514A (known as Section 806 of the law)?  Or is Section 806 triggered only when the bookkeeper makes specific allegations of one of the prohibited activities listed in that section, such as securities fraud?  That was the issue recently addressed in a 2-1 precedential Third Circuit decision, and the answer is not good for management.

Jeffrey Wiest had worked for Tyco as accountant for 31 years.  Beginning in 2007, Wiest questioned certain Tyco expenses that did not seem to satisfy proper accounting standards.  As an example, Wiest was unhappy about an event that Tyco intended to hold at the Atlantis Resort in the Bahamas, which seemed to him akin to the lavish (and improperly-accounted for) events organized by Tyco’s previous CEO, Dennis Kozlowski, currently a guest of the state.  Expenses for the $350,000 Atlantis event included “Mermaid Greeters” and “Costumed Pirates/Wenches” at a cost of $3000; a tattoo artist and events called “Limbo” and “Fire” at a cost of $2350; chair decorations at a cost of $2500; and hotel room rentals ranging from $475 to $1000 per night.  (Full disclosure:  Last December I took my entire staff out for a holiday lunch at a local steakhouse and spent $850.)

Leaving aside the wisdom of this particular company hosting such sybaritic events (given its recent past), Wiest told his supervisor that the costs were being charged improperly as advertising expenses.  Wiest felt that the costs needed to be detailed and charged as income to attending employees, and that the expenses needed to be reviewed for potential disallowance by the IRS because they were extravagant.  In response, Tyco’s management determined that the five-day event included only a single one-and-a-half hour business meeting.  Therefore, management determined that processing the payment would have resulted in a misstatement of accounting records and a fraudulent tax deduction.  Tyco went forward with the event, but compensated the attendees for their additional tax liability by increasing their bonus.

After a few similar episodes of Wiest objecting to improperly supported expenses, Tyco’s human resources department told Wiest that he was under investigation for (1) incorrectly reporting the receipt of two basketball game tickets; (2) having a sexual relationship with a co-worker 10 years earlier; and (3) making sexually-oriented comments to co-workers.  After Wiest learned of the investigation, his health declined and he went on medical leave.  Seven months later, he was fired.

Based solely upon the court’s description of the facts, this sure sounds like a case in which Wiest’s “overdedication” wore thin with Tyco’s management, and that the reasons for investigating him may have been pretextual.  Wiest sued under Section 806, claiming that his firing was in retaliation for his reports of improper expenditures.

The problem with Wiest’s suit was that Section 806 prohibits retaliation against an employee for reporting specifically enumerated offenses under federal law, such as mail fraud, wire fraud, bank fraud and securities fraud.  What happened here seems to have involved a failure to follow internal accounting procedures, and there’s evidence that Tyco’s management considered and acted upon Wiest’s complaints.  Is that enough to constitute a violation?

Yes, said the appeals court, writing:  “An employee must establish not only a subjective, good faith belief that his or her employer violated a provision listed in SOX, but also that his or her belied was objectively reasonable. A belief is objectively reasonable when a reasonable person with the same training and experience as the employee would believe that the conduct implicated in the employee’s communication could rise to the level of a violation of one of the enumerated provisions in section 806…That employee should not be unprotected from reprisal because she did not have access to information sufficient to form an objectively reasonable belief that there was an intent to defraud or the information communicated to her supervisor was material to a shareholder’s investment decision.”  (Emphasis added.)

The majority opinion brought a strong response from Judge Jordan, dissenting, who wrote:  “If it is unnecessary to measure a SOX complainant’s reasonable belief against at least some of the elements of securities fraud, like materiality, then virtually any internal questioning of an accounting mistake or judgment call turns the questioner into a SOX whistleblower, and that cannot be right.”

Like Judge Jordan, I think that this decision creates an unwise “slippery slope.”  What happens, for example, if an employee tells a supervisor about a suspected (but ultimately nonexistent) product defect, and is later fired?  Does the firing violate Section 806?   After all, if the defect actually existed, it could have affected the company’s share price, which could have led to securities fraud.  Another disturbing aspect of the Wiest case, already mentioned above, is that the employee’s complaints were not ignored; they were properly investigated, and management took corrective action.

Some lessons here from a human resources standpoint:  Be very careful when firing the gadfly.  Make sure any history of poor performance is properly documented.  And don’t keep underperformers around.  (I’ll leave for another day the “optics” of throwing lavish corporate parties in the current economic environment.)

You can read the complete Wiest decision here.

- Gene Killian