The SEC’s Secret Enforcement Weapon: Whistleblowers

GPs should take seriously the threat of whistleblower action on any questionable practices, writes Phillips & Cohen partner Stephen Hasegawa.

PUBLISHED: 06 AUGUST 2014

The Dodd-Frank Act brought greater regulation and greater Securities and Exchange Commission (SEC) scrutiny over the private equity industry. One of the lesser-known consequences of that legislation, however, is the increased likelihood that insiders will blow the whistle on any hidden practices or transactions that may violate SEC rules.

That's because of the incentives Dodd-Frank offers whistleblowers. While the examinations the SEC's Office of Compliance Inspections and Examinations is conducting in the private-equity industry are an important enforcement tool, the whistleblower incentives created by Dodd-Frank may prove to be just as valuable.

Whistleblowers can receive 10 percent to 30 percent of the money the government collects if more than $1 million is recovered as a result of information they have provided to the SEC. Dodd-Frank also offers whistleblowers confidentiality and job protection.

SEC officials realize that many illegal or questionable practices in the private equity industry - especially those involving the collection of fees and allocations of expenses- are nearly impossible for outsiders to figure out. As one SEC official told the NYT recently, "Much of what we're uncovering is undetectable by even the most sophisticated investor."

That's exactly why the SEC's Whistleblower Office actively seeks whistleblowers' assistance and has proven to be very responsive to investigating information it receives. Since the SEC Whistleblower Office opened in 2011, the SEC has received more than 6,200 reports of wrongdoing from whistleblowers.

So far, eight whistleblowers have received rewards totaling $15.2 million in the past three years. The number of whistleblower rewards and the size of the rewards are expected to increase significantly this year, which will grab the attention of more employees who are considering blowing the whistle.

The SEC is very careful to maintain whistleblowers' confidentiality. It hasn't revealed the identity of any whistleblower who has received a reward so far, nor has the SEC said which cases it has pursued or settled involve whistleblowers, with one exception. The SEC recognizes that robust whistleblower confidentiality will improve the amount and quality of information it receives.

SEC officials have shown that same commitment to protecting whistleblowers' livelihoods. They have been warning the financial world for months that the agency won't tolerate any job retaliation against SEC whistleblowers, and just recently for the first time settled charges against a firm for job retaliation. The Dodd-Frank Act states that "No employer may discharge, demote, suspend, threaten, harass . . . a whistleblower . . . in making disclosures that are required or protected" by the Sarbanes-Oxley Act or any law or regulations subject to SEC jurisdiction.

The SEC already has begun to take enforcement actions against private equity firms, although it's unknown whether whistleblowers had a role in them. The SEC filed an enforcement action in February against Clean Energy Capital LLC (CEC), alleging that CEC improperly allocated at least $3 million of employee compensation and other expenses to private equity funds that CEC was marketing under a partnership created and managed by CEC. In a separate case, the SEC charged a New York private equity manager and his firm with stealing $9 million by paying fake fees to a company controlled by a longtime acquaintance.

Wherever the law has provided meaningful incentives, whistleblowers have been tremendously effective in helping the government find and remedy fraud. The thousands of SEC whistleblower submissions show that this will be true of the SEC's whistleblower program as well. The private equity industry certainly will see enforcement actions triggered by whistleblower information - if it hasn't already.

Stephen Hasegawa is a San Francisco-based partner with law firm Phillips & Cohen. He has represented whistleblowers in qui tam cases and whistleblower submissions involving numerous industries.

This article originally appeared on www.privatefundsmanagement.net.