This Sunday, July 30, 2017, marks the 15th anniversary of the enactment of the Sarbanes-Oxley Act (“SOX”) of 2002. SOX emerged after the “smartest guys in the room” caused Enron to implode, and WorldCom magically erased billions in earnings overnight. The scandals shook the public’s confidence in the reliability of financial reporting and led to the demise of the venerable Arthur Andersen.
Before the collapse of both Enron and WorldCom, a handful of courageous employees – most notably, Sherron Watkins and Cynthia Cooper – tried to warn management of the frauds at their respective firms. Senior leadership at both companies disregarded the whistleblowers’ concerns and continued to perpetrate massive accounting fraud until December 2, 2001, and July 19, 2002, when Enron and WorldCom filed two of the largest bankruptcies in U.S. history.
After the companies had collapsed, many people questioned how these schemes went undetected for so many years. Where were the auditors? Why did employees not report the fraud? Congressional hearings about the Enron scandal later revealed the answers to these questions. Specifically, they revealed that “[i]n a variety of instances when corporate employees at both Enron and [Arthur] Andersen attempted to report or ‘blow the whistle’ on fraud,  they were discouraged at nearly every turn” by threatened retaliation. Indeed, after Sherron Watkins reported improper accounting practices, Enron “sought advice on the legality of discharging the whistleblower.”
The hearings also revealed massive conflicts in the accounting profession that perpetrated fraud. In particular, the legislative history of SOX found that:
- “professionals from accounting firms, law firms and business consulting firms, who were paid millions to advise Enron on these practices, assured others that Enron was a solid investment”;
- “Enron and Andersen were taking advantage of a system that allowed them to behave in an apparently fraudulent manner”; and
- Enron’s fraud partly attributable to “the well-paid professionals who helped create, carry out, and cover up the complicated corporate ruse when they should have been raising concerns.”
These hearings prompted Congress to include a whistleblower-protection provision in SOX to combat this “corporate code of silence.” A code that “discourage[d] employees from reporting fraudulent behavior not only to the proper authorities, such as the FBI and the SEC, but even internally.” Congress sought to empower whistleblowers to serve as an effective early warning system and help prevent corporate scandals. Fifteen years later, are whistleblowers in the accounting profession protected from retaliation and has SOX reduced accounting fraud?
SOX whistleblower protection for CPAs and auditors
Section 806 of SOX offers protection to employees of publicly-traded companies and employees of contractors and subcontractors of publicly-traded companies (including employees of accounting and audit firms), for disclosures about securities fraud, shareholder fraud, bank fraud, a violation of any SEC rule or regulation, mail fraud, or wire fraud. Notably, this includes disclosures about inadequate or deficient internal controls over financial reporting. Perhaps more importantly, if a whistleblower suffers retaliation for whistleblowing, SOX authorizes the whistleblower to recover:
- lost wages and benefits;
- reinstatement to their former position or front pay in lieu of reinstatement; and
- special damages, which could include emotional distress, impairment of reputation, personal humiliation, and other non-economic harm resulting from retaliation.
There is no cap on special damages under SOX. Recently, a jury awarded $11 million to a whistleblower in a SOX retaliation case.
Impact of SOX on corporate fraud
Since the enactment of SOX, several studies have assessed its effectiveness in combating corporate fraud. According to one study from the Center for Audit Quality, SOX led to a major decrease in “accounting mistakes” at large publicly-traded companies. The study looked at financial restatements filed with the SEC from 2003 to 2012 and found that after the enactment of SOX, the overall number of restatements has decreased, and the percentage of major restatements had declined. Another study found that SOX’s requirement that companies adopt a specific code of ethics for principal, financial, and accounting officers was effective at reducing financial fraud. According to the study, Fortune 500 public companies that had a specific code of ethics “caught misreporting earlier and saw significant declines in the number of financial restatements that were being made.”
Some critics have argued, however, that SOX whistleblower protections are not strong enough to incentivize many employees to blow the whistle. As seen in the Enron scandal, employees risk retaliation when raising concerns and may be terminated for their efforts. One scholar notes that after being terminated, whistleblowers may not have the financial means to fight against dishonest employers. As a result, many potential whistleblowers may remain silent because the risk of speaking up may not be worth the risk. According to a survey performed by the Ethics Resource Center in 2013, “41 percent of employees observed misconduct in their workplace, but out of the 41 percent of employees who observed misconduct, around 33 percent remained silent.” Scholars argue that whistleblower laws needed to provide additional incentives to employees to speak up.
Additional incentives – monetary rewards to whistleblowers
Congress enacted the Dodd-Frank Act on July 21, 2010, in response to the financial crisis of 2008. That recession was the worst financial crisis in the U.S. since the Great Depression. The stock market lost about $25 trillion in value, 23 million people lost their jobs, and the entire financial industry nearly collapsed. Once again, whistleblowers raised concerns before the crisis; however, their concerns fell on deaf ears.
In recognizing the value of whistleblowers as an early warning system to prevent another financial crisis, Congress required the SEC and the U.S. Commodity Futures Trading Commission to create whistleblower-reward programs. These programs offer CPAs and auditors an additional avenue to report fraud, and the potential to obtain significant monetary awards for doing so.
Since 2011, these programs, especially the SEC Whistleblower Program, have proven to be effective methods of discovering fraud, protecting investors, and preventing another financial crisis. To date, the SEC has paid more than $154 million in awards to whistleblowers, and collected nearly $1 billion from wrongdoers as a result of their tips. The largest SEC whistleblower award to date is more than $30 million.
SEC whistleblower awards for CPAs and auditors
The SEC Whistleblower Program offers awards to eligible whistleblowers who provide original information about violations of federal securities laws that leads to an enforcement action with total monetary sanctions over $1 million. Under the program, whistleblowers may receive an award of between 10-30 percent of the total monetary sanctions collected. The program also allows whistleblowers to report anonymously if represented by an attorney.
Generally, individuals who are integral to a company’s compliance are not eligible for awards, unless an exception applies. These individuals include most employees whose principal duties involve compliance, including internal auditors and employees of public accounting and audit firms.
The exceptions to this rule, found in Section 21F-4 of the Securities Exchange Act, allow these individuals to report violations and become eligible for an award in certain circumstances. Specifically, key compliance personnel may report to the SEC and qualify for awards under the program if:
- they reasonably believe the disclosure is necessary to prevent conduct that is likely to cause “substantial injury” to the financial interest or property of the entity or investors;
- they reasonably believe the entity is engaging in “conduct that will impede an investigation of the misconduct”; or
- at least 120 days have passed either since they properly disclosed the information internally, or since they obtained the information under circumstances indicating that the entity’s officers already knew of the information.
The analysis differs, however, for individuals who obtained the information during the audit of an issuer, such as an external auditor. The rules mandate that the 120-day exception — the third bullet above — does not apply. Instead, external auditors can immediately report to the SEC after they inform a superior in their firm about improper or illegal client activity and the firm fails to promptly report the securities law violation to the SEC. The rules also indicate that the first two exceptions will only apply to external auditors when the violation is “material.”
To date, the SEC has issued two whistleblower awards to key compliance personnel. In April 2015, the SEC announced an award of more than $1 million to a compliance professional who “had a reasonable basis to believe that disclosure to the SEC was necessary to prevent imminent misconduct from causing substantial financial harm to the company or investors.” In August 2014, the SEC announced an award of more than $300,000 to “a company employee who performed audit and compliance functions and reported wrongdoing to the SEC after the company failed to take action when the employee reported it internally.”
CPAs and auditors must speak up
The Wells Fargo fake accounts scandal, the Libor rate manipulation scandal, and other incidents demonstrate that fraud can go on for years with no one speaking up. But strong whistleblower protection coupled with whistleblower incentives makes it far more likely that fraud will be detected early, giving companies and regulators an opportunity to take corrective action before it causes a systemic crisis.
CPAs and auditors play an important role in protecting the public from corporate wrongdoing. As noted by the former Chief of the SEC’s Office of the Whistleblower:
Individuals who perform internal audit, compliance, and legal functions for companies are on the front lines in the battle against fraud and corruption. They often are privy to the very kinds of specific, timely, and credible information that can prevent an imminent fraud or stop an ongoing one.
The public needs these gatekeepers to speak up and stop the next “smartest guys in the room” from tanking the economy.
Jason Zuckerman is Principal of Zuckerman Law and litigates whistleblower retaliation, wrongful discharge, non-compete, and other employment-related claims. Prior to founding Zuckerman Law, Zuckerman served as Senior Legal Advisor to the Special Counsel at the U.S. Office of Special Counsel, the federal agency charged with protecting whistleblowers in the federal government. In 2012, the Secretary of Labor appointed Zuckerman to serve on the Whistleblower Protection Advisory Committee.
Matthew Stock is an associate at Zuckerman Law, where his practice focuses on representing whistleblowers in whistleblower rewards and whistleblower retaliation cases. He is also a Certified Public Accountant, Certified Fraud Examiner, and former KPMG external auditor.