The SEC has issued its second-ever whistleblower award.  The award went to three anonymous individuals, each of whom will receive 5 percent of the monetary sanctions ultimately collected in a case against hedge fund manager Locust Offshore Management LLC and its CEO, Andrey Hicks, who allegedly defrauded investors of US$2.7 million, and who have been ordered to pay US$7.5 million in disgorgement and penalties.

Prior to the June 12 announcement, the whistleblower program had yielded only one far more modest award, in 2012, for US$50,000 in connection with a Ponzi-scheme in Texas.  However, Stephen Cohen, Associate Director of the SEC’s Division of Enforcement, was recently quoted saying that in the next few months, the program would produce “incredibly impactful cases” with “some extremely significant whistleblower awards.” 

The Hicks award may signal the first of many whistleblower awards involving investment managers of hedge funds and private equity firms.

About the Hicks award

In October 2011, the SEC filed an enforcement action against Hicks and Locust Management for fraud in connection with the offer and sale of shares in the Locust Offshore Fund, Ltd., an investment fund purportedly incorporated in the British Virgin Islands.  In March 2012, the US District Court for the District of Massachusetts entered default judgments against Locust and Hicks, ordering US$7.5 million in disgorgement and penalties.  Hicks also pled guilty to criminal fraud charges in 2012 and received a 40-month prison sentence.

As with the SEC’s first whistleblower award announced in 2012, the whistleblower order in Hicksdoes not identify the bounty recipients.  However, the order states that two of them provided information prompting the SEC to investigate and stop the fraud before more investors were harmed.  The third whistleblower confirmed information provided by the others and identified key witnesses.  The SEC denied a fourth whistleblower’s claim, which it deemed too vague or insubstantial.

SEC is focusing on hedge fund and private equity firms

In its 2012 annual report, the SEC touted the Hicks case as one of the most significant actions related to investment advisers brought by the SEC’s Enforcement Division’s Asset Management Unit.  The SEC further noted:  “With over 11,000 registered investment advisers managing more than $40 trillion in assets, investment advisers and the funds they manage continued to be a key focus of the [Enforcement] Division.  The SEC filed 147 investment adviser-related cases in FY 2012, one more than with the previous year’s record performance.”[i]

As Bruce Karpati, the former head of the AMU, warned in January this year at a private equity forum, “it’s not unreasonable to think that the number of cases involving private equity will increase.”  The Hicks award demonstrates that the AMU’s central focus on hedge funds, private equity funds and investment advisers to alternative investments will likely benefit from the whistleblower program.  In its 2012 annual report, the SEC Office of the Whistleblower reported receiving tips in a wide number of subject areas that could impact investment advisers, including insider trading (190 tips), trading and pricing (144 tips), manipulation (457 tips), offering fraud (465 tips) and Foreign Corrupt Practices Act issues (115 tips).[ii]  Many of those tips will undoubtedly find their way to the AMU.

About the SEC whistleblower program 

The SEC whistleblower program, launched in August 2011 pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, encourages individuals to report financial wrongdoing internally and to the SEC.

Under the whistleblower program, the SEC may pay rewards to individuals who provide the SEC with “original information” about a possible violation of the federal securities laws at companies required to report to the SEC when such information leads to a successful SEC enforcement action resulting in sanctions exceeding US$1 million.  With some restrictions, individuals who voluntarily report original information may receive between 10 and 30 percent of the amount collected in the SEC action, or in a related action brought by the Department of Justice, certain regulatory agencies, self-regulatory organizations, or state attorneys general in criminal cases.

Dodd-Frank encourages internal reporting first

These are critical aspects of the whistleblower program:

  • The program encourages whistleblowers to report possible violations to internal company compliance departments. 

  • Interference with internal reporting and compliance systems may cause the SEC to decrease a reward. 

  • The SEC considers as reward-eligible any whistleblower who reports original information through a company’s internal whistleblower, legal, or compliance procedures before or simultaneously with reporting to the SEC. 

  • Finally, the Dodd-Frank regulations provide a 120 day-window for a whistleblower to report original information to the SEC after first reporting internally.

Anti-retaliation provisions

The program protects whistleblowers from employers who would retaliate against individuals reporting to the SEC.  Under Dodd-Frank, individuals may bring a federal legal action for relief, including reinstatement of the whistleblower’s position, twice the back pay otherwise owed the individual with interest, and attorneys’ fees and costs for bringing suit.  At least one hedge fund trader has already brought retaliation claims against his employer under these provisions, alleging “a campaign of retaliation” against him after he reported “trading violations” and a “deliberate disregard for compliance rules” and cooperated with the SEC.  He alleged in his complaint that he was isolated in a “room with little ventilation,” removed from the trading desk and subsequently “demoted.”

Key takeaways

The Hicks award and related statements by SEC Enforcement personnel highlight the need for hedge fund and private equity managers to prepare for increased whistleblower activity.  Useful steps may include a strong compliance training program; implementing internal controls to ensure that complaints are reported and addressed properly (internally and with the SEC); and making sure that careful consideration precedes any adverse action against purported whistleblowers.