After repeated warnings over the last few years that it had both the authority and willingness to do so, on June 16, 2014, the SEC brought its first enforcement action for retaliation against a whistleblower under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The SEC charged a hedge fund advisor and its founder in In the Matter of Paradigm Capital Management, Inc. and Candace King Weir, Adm. Proc. File No. 3-15930 (June 16, 2014), with underlying violations of Sections 206(3) and 207 of the Investment Advisers Act of 1940, as well as Section 21F(h) of the Securities Exchange Act of 1934. The respondents settled, agreeing to pay disgorgement of $1.7 million and a civil penalty of $300,000.
Although Dodd-Frank does not expressly grant the SEC enforcement authority over Dodd-Frank’s anti-retaliation provisions, the SEC explained when promulgating its whistleblower rules that it has such enforcement power and has repeated that assertion publicly. (The CFTC, in contrast, does not assert that virtually identical provisions of Dodd-Frank granted it the same enforcement power.) The SEC’s action leaves no doubt that the SEC will, as threatened, bring cases to enforce Dodd-Frank’s anti-retaliation provisions. The case also highlights the extreme caution that a company must take when a known whistleblower is in its midst.
The substantive violations at issue in the Paradigm matter were relatively simple. The SEC alleged that Paradigm engaged in principal transactions with an affiliated broker-dealer, C.L. King & Associates, without providing effective disclosure to a hedge fund client advised by Paradigm. Because Candance King Weir controlled both Paradigm and C.L. King, the SEC alleged that the transactions were principal transactions that required Paradigm (1) to provide the fund with written disclosure of the transactions prior to their completion and (2) to obtain the fund’s consent to engage in the transactions. Paradigm tried to satisfy these requirements with a “Conflicts Committee” that would review principal trades, but the SEC found that the committee was conflicted and inadequate.
In March 2012, Paradigm’s head trader made a whistleblower submission to the SEC revealing numerous alleged securities laws violations. On July 16, 2012, he notified Weir and C.L. King that he had made such a submission. Paradigm immediately retained outside counsel to provide advice regarding the situation. The following occurred over the next four weeks:
- The day after revealing himself, the whistleblower was removed from the trading desk and relieved of his day-to-day trading and supervisory responsibilities because, Paradigm said, it needed to investigate his actions. It then directed him to work at a different facility and instructed him to prepare a report that would support the violations he reported to the SEC.
- At his counsel’s request, Paradigm allowed the whistleblower to prepare this report from his home. Paradigm, however, denied the whistleblower access to certain Paradigm trading and account systems while he was at home.
- Paradigm also denied the whistleblower access to his existing email account and redirected his trading and email accounts to another trader. The whistleblower received a different email account, which he used to submit the requested report.
- The whistleblower wanted to return to work, but Paradigm resisted, stating that the employment relationship had been “irreparably damaged.” Attempts to agree on severance terms, however, failed.
- The whistleblower was later allowed to return to work, but Paradigm said he could not return as head trader as he requested until its investigation was complete.
- When the whistleblower returned to work, he was not at the trading desk, but was placed in an office on a different floor. He was told his first assignment was to review 1,900 pages of hard-copy trading data to identify any potential wrongdoing by the firm to assist its internal investigation. The whistleblower requested electronic reports to assist this work, but those requests were denied.
- In response to the whistleblower’s allegations that its trading-related compliance policies were deficient, Paradigm tasked the whistleblower with consolidating procedure manuals and proposing revisions to enhance the firm’s policies and procedures.
- Despite having agreed to allow the whistleblower to use his personal email address for communications while he worked from home, Paradigm reprimanded the whistleblower for emailing a confidential report to his personal email address. Paradigm sent him a memorandum and an email accusing him of removing confidential and proprietary records in violation of the terms of his employment.
- The whistleblower resigned on August 17, 2012.
The SEC alleged that the actions taken against the whistleblower violated the anti-retaliation provisions of Section 21F(h) of the Exchange Act. In the SEC’s press release describing the action, Andrew J. Ceresney, director of the SEC’s Enforcement Division, said: “Those who might consider punishing whistleblowers should realize that such retaliation, in any form, is unacceptable.” Sean McKessy, chief of the SEC’s Office of the Whistleblower, added: “For whistleblowers to come forward, they must feel assured that they’re protected from retaliation and the law is on their side should it occur.”
The SEC’s action against Paradigm and its founder illustrates the no-win situation a company faces if it knows that a current employee has blown the whistle to the SEC. A company’s natural and understandable reaction is to try to figure out exactly what the whistleblower has disclosed. An equally understandable reaction is to limit the whistleblower from disclosing further potentially damaging information to the SEC. This enforcement action confirms that these goals may be unreachable in light of the SEC’s rules against taking any action against a whistleblower.
To its credit, Paradigm did not act rashly, but rather took the matter seriously and hired outside counsel to provide what was no doubt considered advice. The whistleblower also had counsel, and the lawyers tried repeatedly to devise a practical solution to the difficult employment situation presented. In its order, the SEC cited Paradigm’s changing the whistleblower’s job function and stripping him of supervisory responsibility. But leaving the whistleblower’s position and responsibilities unchanged would seem impracticable as Paradigm’s counsel conducted an internal investigation, no doubt leading to Paradigm’s conclusion that the employment relationship was “irreparably damaged.”
Recognizing the untenable situation, Paradigm and the whistleblower repeatedly tried to agree on a severance arrangement, but could not come to terms. This is not surprising given the incredible leverage that a whistleblower in this situation has over a company. But a severance agreement is fraught with danger as well because SEC Rule 21F-17 prohibits “any action to impede an individual from communicating directly with the Commission staff about a possible violation, including enforcing or threatening to enforce a confidentiality agreement.” SEC officials have stated repeatedly that they will review very carefully severance and separation agreements for any attempt to impede a whistleblower.
While this is the first enforcement action of its kind, it will not be the last. The SEC may soon bring additional enforcement actions under far different facts. For example, the SEC may bring a stand-alone enforcement action for violation of the anti-retaliation provision, including in cases in which the whistleblower incorrectly (but “reasonably”) thought there was a potential securities law violation. In addition, the SEC asserts that a whistleblower need not report to the SEC in order to be protected by the anti-retaliation provisions. Thus, the SEC’s enforcement of the anti-retaliation provisions could have far broader application in the future.
This case presents another reminder that companies must have a strong culture of compliance and a strong policy encouraging whistleblowers to report concerns internally if at all possible. Once the whistleblower has reported to the SEC, a company will be hamstrung to maintain status quo with respect to the whistleblower. The case also highlights the need to have plans in place to deal with whistleblowers promptly and effectively – while at all costs avoiding illegal retaliation. Training at all levels of an organization may be required to effectively educate employees to avoid taking actions that marginalize the whistleblower during an internal investigation.