SEC Whistleblower Bait And Switch

March 10, 2014

This article updates and includes references to the previously published "SunTRUST or UNTRUSTWORTHY For SEC Chair Mary Jo White" (, April 14, 2013).

Molchatsky In-Discretion  

In Molchatsky, et al. v. United States (2nd Circuit, 11-2510 April 10, 2013), investors victimized by Bernard Madoff and Bernard L. Madoff Investment Securities LLC. sought to hold the United States liable for the failure of the United States Securities and Exchange Commission (the "SEC") to detect Bernard Madoff's Ponzi scheme over a 16-year period and for the financial losses sustained. In "Second Circuit Pounds Last Nail Into Madoff Plaintiffs' Coffin(, April 10, 2013), I reported that:

Pointedly, Plaintiffs asserted that the SEC had missed many opportunities to timely uncover the Madoff Ponzi fraud because of the SEC's:

    • repeated failure to alert other branch offices of ongoing investigations,
    • properly review complaints and staff subsequent inquiries, and
    • follow up on disputed facts elicited in interviews.

On April 10, 2013, the United States Court of Appeals for the Second Circuit ("2nd Circuit") found that the United States was effectively shielded from this lawsuit because the SEC retained complete discretion over when, whether and to what extent to investigate and bring an action against an individual or entity. The SEC's cited misconduct was similarly immunized from civil suit because the federal securities regulator was engaged in the allocation of time and resources based upon somewhat appropriate economic, social and policy considerations. 

Although the 2nd Circuit concluded that Plaintiffs' harm ultimately stemmed from the SEC's failure to investigate Madoff and uncover his Ponzi scheme, the appellate court affirmed the dismissal by the District Court for the Southern District of New York. Notwithstanding that ruling, the 2nd Circuit expressed its compassion for plaintiffs and its anger with the SEC's desultory conduct, as evidenced by this comment:

Despite our sympathy for Plaintiffs' predicament (and our antipathy for the SEC's conduct), Congress's intent to shield regulatory agencies' discretionary use of specific investigative powers via the DFE is fatal to Plaintiffs' claims.

The Gabelli Countdown

As noted in "Supreme Court Reverses SEC v. Gabelli On Discovery Rule Grounds" (, February 27, 2013), statute of limitations concerns in SEC cases became all the more pressing last year given the United States Supreme Court's Opinion in Gabelli et al. v. Securities And Exchange Commission (568 U. S. ____ (2013), February 27, 2013). In Gabelli, the Court considered an enforcement action brought  by the SEC under the Investment Adviser Act in April 2008, when the SEC filed a Complaint seeking civil penalties arising from allegations of illegal activity up to August 2002. The Investment Advisers Act makes it illegal for investment advisers to defraud their clients, and authorizes the SEC to seek civil penalties; however, under the general statute of limitations for civil penalty actions, the SEC has only five years to seek such penalties. In this case, the courts were faced with deciding whether the five-year clock begins to tick when the fraud is complete or when the fraud is discovered.

In 2008, the SEC brought the underlying civil enforcement action against Marc J. Gabelli, the portfolio manager of the mutual fund Gabelli Global Growth Fund ("GGGF" or the "Fund"), and Bruce Alpert, the chief operating officer for the Fund's adviser, Gabelli Funds, LLC ("Gabelli Funds" or the "Adviser") alleging that from 1999 until 2002 Alpert and Gabelli allowed one GGGF investor-Headstart Advisers, Ltd.-to engage in"market timing" in the fund. According to the SEC, Gabelli and Alpert did not disclose Headstart's market timing or the quid pro quo agreement, and, instead, banned others from engaging in market timing and made statements indicating that the practice would not be tolerated. In noting the impact of such disparate treatment, the Complaint asserted that during the relevant period, Headstart earned rates of return of up to 185%, while "the rate of return for long-term investors in GGGF was no more than negative 24.1 percent."

On August 17, 2010, the District Court dismissed the SEC's Complaint against Gabelli and Alpert as time barred. On August 1, 2011, the Second Circuit reversed accepting the SEC's argument that because the underlying violations sounded in fraud, the Discovery Rule applied and, accordingly, the statute of limitations did not begin to run until the SEC discovered or reasonably could have discovered the fraud. SEC v. Gabelli (2nd Circuit, 653 F. 3d 49, August 1, 2011). 

On appeal, the United States Supreme Court noted that it had never applied the Discovery Rule in a matter where the plaintiff is the government bringing an enforcement action for civil penalties, in contradistinction to a defrauded victim seeking recompense. In declining to extend the Discovery Rule to government civil penalty enforcement actions, the Supreme Court cast the government as a unique plaintiff often tasked with rooting out fraud and armed with many arrows in its quiver just for such an undertaking. 

Viewing the Discovery Rule as something of an equalizer designed to assist wronged parties seeking recompense, the Supreme Court was not compelled to offer such assistance to regulators seeking not compensation but punishment aimed at wrongdoers.  Further, the Supreme Court deemed that there were many motivating factors to avoid having courts attempt to parse through what the government knew or reasonably should have known about an alleged fraud. Accordingly, the Supreme Court reversed and remanded SEC v. Gabelli (2nd Circuit, 653 F. 3d 49, August 1, 2011). In Gabelli, the the Supreme Court noted, in part:

There are good reasons why the fraud discovery rule has not been extended to Government enforcement actions for civil penalties. The discovery rule exists in part to preserve the claims of victims who do not know they are injured and who reasonably do not inquire as to any injury. Usually when a private party is injured, he is immediately aware of that injury and put on notice that his time to sue is running. But when the injury is self-concealing, private parties may be unaware that they have been harmed. Most of us do not live in a state of constant investigation; absent any reason to think we have been injured, we do not typically spend our days looking for evidence that we were lied to or defrauded. And the law does not require that we do so. Instead, courts have developed the discovery rule, providing that the statute of limitations in fraud cases should typically begin to run only when the injury is or reasonably could have been discovered.

The same conclusion does not follow for the Government in the context of enforcement actions for civil penalties. The SEC, for example, is not like an individual victim who relies on apparent injury to learn of a wrong. Rather, a central "mission" of the Commission is to "investigat[e] potential violations of the federal securities laws." SEC, Enforcement Manual 1 (2012). Unlike the private party who has no reason to suspect fraud, the SEC's very purpose is to root it out, and it has many legal tools at hand to aid in that pursuit. It can demand that securities brokers and dealers submit detailed trading information. Id., at 44. It can require investment advisers to turn over their comprehensive books and records at any time. 15 U. S. C. §80b-4 (2006 ed. and Supp. V). And even without filing suit, it can subpoena any documents and witnesses it deems relevant or material to an investigation. See §§77s(c), 78u(b), 80a-41(b), 80b-9(b) (2006 ed.).

The SEC is also authorized to pay monetary awards to whistleblowers, who provide information relating to violations of the securities laws. §78u-6 (2006 ed., Supp. V). In addition, the SEC may offer "cooperation agreements" to violators to procure information about others in exchange for more lenient treatment. See Enforcement Manual, at 119-137. Charged with this mission and armed with these weapons, the SEC as enforcer is a far cry from the defrauded victim the discovery rule evolved to protect. . .

Page 7 - 8 of the Opinion.

NY Times Morgenson Warns Of Ticking Clock

Nearly a year ago, following Molchatsky and Gabelli, New York Times reporter Gretchen Morgenson raised her concern about a number of matters then on the SEC's plate that were nearing the expiration of their five-year statute of limitations - particularly involving cases arising from the mortgage bust of 2008. "Note to New S.E.C. Chief: The Clock Is Ticking" (New York Times, "Fair Game," April 13, 2013).

Morgenson's 2013 column warned about a then pending SEC whistleblower complaint involving tens of billions of dollars in transactions that may have been furthered by potentially misleading disclosures by SunTrust Banks, a regional bank holding company in Atlanta. Pointedly she asserted in her 2013 column that the matter was

[F]iled with the S.E.C. more than a year ago by a former SunTrust employee, it appears to be languishing even though time's a-wasting.

The SunTrust whistle-blower complaint, which I reviewed, contends that company financial filings of recent years misrepresented the bank's exposure to risky no-documentation mortgages that it underwrote from 2006 to 2008. Many were sold to Fannie Mae and Freddie Mac, the taxpayer-backed mortgage finance giants.

Shareholders have not been aware, the complaint says, that many mortgages SunTrust was selling to Fannie and Freddie in this period were so-called liar loans, with little to no documentation of borrowers' income or assets. The bank maintained that it had little exposure to low-documentation loans, the complaint says.

As with many whistle-blower complaints, the person filing this matter asked not to be identified. Aegis J. Frumento, a lawyer at Stern Tannenbaum & Bell who represents the whistle-blower, said the plaintiff is an experienced mortgage underwriter at SunTrust who was disturbed by dubious practices at the bank. . .

One Year Later

Morgenson has just reported in "A Whistle That's Lost In The Crowd" (New York Times, "Business Day," March 8, 2014) that although the Department of Justice is investigating mortgages that SunTrust underwrote and sold to Fannie Mae and Freddie Mac, the SEC whistleblower complaint "seemed to be languishing at the Securities and Exchange Commission since its submission in early 2012."

Although one wouldn't think that a whistleblower would suffer depending upon which agency runs with the ball that he passed, commonsense is often a casualty when it comes to federal regulatory organizations and prosecutors. As Morgenson warns:

[W]hat if the S.E.C. doesn't bring a successful case based on a whistle-blower's complaint but another law enforcement agency does, using the same information?

The answer appears to be this: The whistle-blower may get no award at all.

The rules of the S.E.C. program state that whistle-blower complaints brought to the agency can be shared with other law enforcers. That makes sense, especially if a matter involves potential criminal activity that the S.E.C. cannot pursue or if the facts outlined in a complaint fall outside the commission's enforcement mandate.

But the S.E.C. rules also state that a whistle-blower can receive an award only if the commission brings a successful case based on the information; success is defined as generating sanctions of more than $1 million. If another agency uses the complaint to generate fines and penalties but the S.E.C. declines to pursue it, the whistle-blower would appear to be out of luck under the S.E.C.'s program. . .

The Quagmire Of Related Actions

As set forth in § 240.21F-3:  Payment of awards.

(a) Commission actions: Subject to the eligibility requirements described in §§240.21F-2, 240.21F-8, and 240.21F-16 of this chapter, the Commission will pay an award or awards to one or more whistleblowers who:
(1) Voluntarily provide the Commission
(2) With original information
(3) That leads to the successful enforcement by the Commission of a federal court or administrative action
(4) In which the Commission obtains monetary sanctions totaling more than
$1,000,000. The terms voluntarily, original information, leads to successful enforcement, action, and monetary sanctions are defined in § 240.21F-4 of this chapter.

(b) Related actions: The Commission will also pay an award based on amounts collected in certain related actions.
(1) A related action is a judicial or administrative action that is brought by:
(i) The Attorney General of the United States;
(ii) An appropriate regulatory authority;
(iii) A self-regulatory organization; or
(iv) A state attorney general in a criminal case, and is based on the same original information that the whistleblower voluntarily provided to the Commission, and that led the Commission to obtain monetary sanctions totaling more than $1,000,000.
The terms appropriate regulatory authority and self-regulatory organization are defined in § 240.21F-4 of this chapter.

(2) In order for the Commission to make an award in connection with a related action, the Commission must determine that the same original information that the whistleblower gave to the Commission also led to the successful enforcement of the related action under the same criteria described in these rules for awards made in connection with Commission actions. The Commission may seek assistance and confirmation from the authority bringing the related action in making this determination. . .

In the absence of the SEC "anchoring" the matter in-house via the filing of its own action, a separate Department of Justice ("DOJ") action may not be deemed a "related" action under Dodd Frank but could, in fact, be deemed a separate and unrelated action?  As a consequence, if a whistleblower provided original information to the SEC that was subsequently passed on to DOJ (or another regulator/prosecutor) and that information resulted in a successful prosecution by DOJ (or an enforcement action by another regulator) but the SEC did not initiate its own action, then the whistleblower may well be left out in the cold.

In Whistleblowers Awarded Bounties In Related Criminal Action (, September 5, 2013), I reported about a "related matter" in which a whistleblower bounty was awarded to an individual. In the Order Determining Related Action Whistleblower Award Claims   we are confronted with the following caption:

In the Matter of the Claim for Related Action Award in connection with 
United States v. Andrey C. Hicks, 1:11-cr-10407-PBS (D. Mass. 2011) (Related Action)
SEC v. Andrey C. Hicks and Locust Offshore Management, LLC, 1:11-cv-11888-RGS (D. Mass. 2011) (SEC Action)

Note that the SEC's Order caption specifically characterizes the criminal action as the "related action" and the SEC's civil action as the "SEC Action."  All of which strongly suggests that there cannot be any "related" action in the absence of an anchored and separate "SEC Action." 

Bait And Switch

With the advent of 2014, the SEC was on notice of the consequences of Gabelli; namely, that, times' a tickin' and the federal regulator doesn't have the luxury of dawdling as the final seconds run off before a given statute of limitations is lost. Similarly, as admonished in Molchatsky, there were lessons for the SEC to learn from its disgraceful handling of tips about Madoff and from the organization's plodding response. The SEC is not entitled to dawdle until such time as the statutes of limitation have expired and the lights are turned out on any justified prosecution. One Harry Markopolous was more than enough for this generation. 

Notwithstanding Morgenson's columns and their concerns, SunTrust may or may not be guilty of whatever allegations have been presented by whistleblowers and possibly uncovered by the SEC's staff - as such, the bank is entitled to the presumption of innocence.  On the other hand, the investing public and SunTrust shareholders are similarly entitled to timely regulation and enforcement.  

As uneasily set forth in Morgenson's recent column, the much heralded Dodd Frank whistleblower initiative seems to be taking on the trappings of an unseemly "bait and switch." The goal should be to get timely, substantive tips that will either prevent fraud or bring about its quicker demise. And let's not be disingenuous here: The prospect of getting millions of dollars in whistleblower bounties may be the sole motivation for most folks coming forward with tips. Short-changing whistleblowers by shifting an action from one regulator/prosecutor to another is just not going to further the goals of the program. What we shouldn't be worrying about is the silliness of turf wars seeking credit for developing the tips at the expense of rewarding those who came forward with the information.

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