On July 31, 2012, the United States District Court for the Central District of California dismissed without prejudice a shareholder derivative suit against American Apparel and its individual directors. The complaint alleged that the individual directors breached their fiduciary duty by, inter alia, failing to institute controls to ensure American Apparel’s compliance with immigration laws governing work authorization for employees. The complaint also alleged that American Apparel misrepresented its compliance with those laws in filings with the Securities and Exchange Commission; and that a subsequent audit by Immigrations and Customs Enforcement (“ICE”) unearthed at least 1,800 undocumented employees who were subsequently terminated. As a result of a tremendous loss in production, American Apparel’s stock price plummeted. The court dismissed the complaint on the grounds that it failed to plead the requisite scienter and bad faith on the part of the individual directors necessary to maintain a shareholder derivative suit under Delaware law. With this dismissal of the derivative action against it, American Apparel, at least temporarily, dodged a bullet.
The court’s dismissal of the complaint was grounded in the rigorous standards necessary to maintain a derivative action. As the court noted throughout its opinion, under Delaware law, even conduct amounting to gross negligence is insufficient to support a claim of bad faith. But what if, instead of a shareholder derivative action, an American Apparel employee blew the whistle on American Apparel’s alleged lack of compliance with immigration laws? Under the standard announced by the Administrative Review Board (“ARB”) in Sylvester v. Parexel Int’l LLC, ARB No. 07-123, ALJ Nos. 2007-SOX-039, 2007-SOX-042 (ARB May 25, 2011), an employee’s disclosures alleging the same conduct as that alleged in the derivative suit would most likely invoke the Sarbanes-Oxley Act’s whistleblower protections.
II. THE SYLVESTER STANDARD
Section 806 of the Sarbanes-Oxley Act confers legal protection upon employees of public companies who report suspected violations of a range of federal offenses—including violations of any rule or regulation of the Securities and Exchange Commission and any provision of federal law relating to fraud against shareholders. A whistleblower who makes such a report is considered to have engaged in “protected activity” which protects him from retaliation by the company. Prior to the ARB’s Sylvester decision, whistleblowers had to allege conduct “definitively and specifically” related to one of the categories of law enumerated in Section 806. Thus, for example, a whistleblower reporting violations of wage and hour laws would not be protected under the Sarbanes-Oxley Act.
In Sylvester, however, the ARB significantly lowered a whistleblower’s burden of demonstrating that he engaged in a “protected activity” under the Sarbanes-Oxley Act. In that case, the ARB held that complaints reporting clinical research fraud and failure to adhere to Food and Drug Administration practice standards were protected under the Sarbanes-Oxley Act where the company regularly filed reports to shareholders stating that it strictly adhered to FDA “good clinical practice.” Thus, under Sylvester, a whistleblower does not have to report conduct “definitively and specifically” related to one or more of the categories of law listed in Section 806. Rather, any complaint challenging the accuracy of the company’s representations in its public disclosure statements—or in management response to dissident shareholders—sufficiently constitutes a “protected activity.”
III. IF AN EMPLOYEE BLEW THE WHISTLE…
A Sarbanes-Oxley Act whistleblower disclosure making the same allegations regarding American Apparel’s compliance (or lack thereof) with immigration laws would likely constitute “protected activity”. Even though, on their face, the allegations against American Apparel are unrelated to securities fraud or other categories of law listed in Section 806, Sylvester provides for broad whistleblower protections under the Sarbanes-Oxley Act. The shareholders alleged that, despite failing to institute proper controls to ensure compliance with immigration laws, American Apparel frequently touted in its public filings its diligent efforts to comply with all employment and labor regulations, including immigration laws. In addition, the company stated that its policy was to comply fully with its obligations to establish the employment eligibility of prospective employees under immigration laws, even though it refused to implement E-verify and other Department of Homeland Security recommended best practices. Certainly, under Sylvester, an employee’s report of these and other allegedly misleading statements made in American Apparel’s public filings would have been sufficient to trigger the Sarbanes-Oxley Act’s whistleblower protections.
IV. SO WHAT?
In the derivative suit, allegations of widespread violations of immigration laws, ICE investigations, misleading public filings, and the resulting plunge in the price of shares were not sufficient to avoid dismissal. The dismissal of this complaint highlights the high hurdles that shareholders must jump over in order to maintain a derivative action. Whistleblowers, on the other hand, do not have any such hurdles to leap. Under Sylvester, in order to have engaged in “protected activity,” whistleblowers need only challenge the accuracy of a company’s public disclosures—whether that challenge pertains to fraud against shareholders is irrelevant. The Sylvester decision opened the door to complaints challenging public representations relating to corporate compliance with myriad laws and regulations—including those relating to immigration. In essence, Sylvester opened the proverbial floodgates. Even though American Apparel may have dodged a bullet this time, it would not have been so “lucky” had the same allegations been made by an aggrieved employee as opposed to a shareholder.
Companies need to be careful when dealing with employees who raise concerns about public filings and disclosures—even when those concerns have nothing to do with fraud. A supposed “troublemaker” can easily become a whistleblower. As Sylvester demonstrates, the world of the Sarbanes-Oxley Act’s whistleblower protections is far bigger than most companies anticipate. Where shareholders have no cause of action, an aggrieved employee might.