Risk & Compliance

Whistle-blowers Face High Burden of Proof

A CFO lost his case based on the question of "reasonable belief," a measurement that employee advocates say the whistle-blower appeals board treats...
Sarah JohnsonJune 12, 2007

When the Sarbanes-Oxley Act created legal protection for employees who point out financial fraud, corporate lawyers feared the law would open the door to frivolous suits by disgruntled workers. The law said all an employee needed to trigger whistle-blower protection was simply “a reasonable belief” that the company was violating a securities law or harming shareholder value.

Considered employee-friendly, Sarbox’s whistle-blower provision was expected to provide the broadest, most comprehensive coverage of any other rule, says Richard Moberly, assistant law professor for the University of Nebraska.

But five years later, employee advocates say the law is interpreted too narrowly, leaving employees without recourse if they are indeed fired for reporting that their company has broken securities laws. In fact, if the lack of victories for employees seeking Sarbox protection is any indication, whistle-blowers have a very high burden of proof to make their case. While most of the nearly 1,000 Sarbox cases have been dismissed without merit or resulted in settlements between employees and companies, only six have passed the first level of appeal, according to a report compiled by attorneys at the law firm of Orrick, Herrington, & Sutcliffe LLP. None have passed the highest level of appeal within the Department of Labor — its Administrative Review Board (ARB).

On the other hand, such results could be an indication that the law is working as intended, suggests Lloyd Chinn, who has represented employers in whistle-blower cases as a partner with Proskauer Rose LLP. “The claim has to fit within the parameters of the statue,” he told CFO.com. “This is not just some general wrongful termination statue or a statute about elevating a dispute over office procedures. People who have real claims are complaining of activities that violate securities laws.”

In the latest case to be thrown out by the ARB, former CFO David Welch was told he could not have reasonably believed his company had over-inflated income in regulatory filings and neither would have someone else with his expertise or knowledge. The ARB dismissed Welch’s argument in part because he failed to draw a direct correlation between his former employer’s violation of generally accepted accounting principles and the specific areas to which the Sarbox whistle-blower provision applies: violations of federal fraud statutes, the Securities and Exchange Commission’s rules, and federal laws relating to shareholder fraud.

Employee advocates say the board members should concentrate on whether employers terminate employees in retaliation for their complaints. Instead, they have focused on whether employees’ suspicious of wrongdoing were correct. “The reasonable belief standard has turned more into an actual violation standard,” Moberly told CFO.com. “They’re requiring whistle-blowers almost to show that there was an actual violation of the law.”

But meeting that standard isn’t easy within the current timeframe for filing a claim. Employees have 90 days after they believe an employer has retaliated against them to file a complaint with the DOL’s Occupational Safety and Health Administration (which oversees whistle-blower violations because it handles similar provisions for 13 other laws). If they have been fired, they may not have time amid job searching to research their case and hire a lawyer. They may also not realize why they were let go or demoted until much later.

Few whistle-blowers even get to the stage where they can begin to show OSHA that they were the target of a retaliation, Moberly says. Instead, 95 percent of Sarbox cases fail to get past the administrative phase. At the investigative level, an employee’s odds improve, though not by much. At that level, the agency has historically found in the employee’s favor 10 percent of the time, he says.

These numbers do not include cases that are brought before a federal court, Chinn notes. If OSHA does not respond within 180 days to an employee’s complaint, the employee can bring his or her case to court. Many cases are also settled between the employee and employer. “Publicly traded companies are very worried about Sarbanes-Oxley whistle-blower claims because it’s not just about the claim [of retaliation but the] underlying claim of fraud,” Chinn says. “Employers will resolve these cases because of the spillover effect these cases have” into possible shareholder derivative litigation and Securities and Exchange Commission inquiries.

In Welch’s case against his former employer, Cardinal Bankshares Corp., the ARB ruled that he “could not have reasonably believed that Cardinal misstated its financial condition,” and was therefore not entitled to have Sarbox protection — and thus have his job reinstated. According to Welch, he was fired after questioning the bank holding company’s accounting policies and internal controls and later refusing to certify financial statements. The bank claimed Welch was let go because he refused to speak with an independent auditor and a company lawyer without his own attorney present.

Now considered the first whistle-blower under Sarbox to go to trial, Welch first filed a complaint with the Department of Labor in 2002 for reinstatement and back pay. DOL administrative law judge Stephen Purcell recommended that Cardinal reinstate Welch, but the bank refused. On May 31, the ARB said Purcell erred legally in his decision.

The ARB has presented an “awfully high standard” to meet, according to Welch’s attorney, D. Bruce Shine of Shine & Mason Law Office. To fall under the whistle-blower protection provision, Welch didn’t need to be right, Shine argues — “all he had to do is have a reasonable belief that the issues he raised were legitimate.” His opinion, Shine adds, was supported by his knowledge and experience as a CPA, MBA and two and a half years as Cardinal’s CFO.

In 2001, Welch disagreed with Cardinal’s chief executive, who often made ledger entries. Welch disputed that two loan recoveries worth a total of $195,000 should be accounted for in a loan reserve account and not income. By including the money as income, Welch believed the company had materially overstated its financial status, according to Purcell. The accounting error was later fixed by an external auditor.

In its defense, Cardinal acknowledged the company had made an accounting mistake but emphasized that the $195,000 was still disclosed on its financial statements. “Real money came into Cardinal’s door — money that was not there before,” the company’s lawyers said, adding that “a reasonable CFO” would not have concluded that net income had been overstated.

In its decision, the ARB also argued that Welch’s complaints about his access to Cardinal’s external audit firm and the integrity of its internal controls over financial reporting do not fall under Sarbox-protected activities. Welch could not convince the board of a direct link between federal securities laws and his claim of being cut off from communicating with the company’s auditor. According to Cardinal, Purcell “fails to point to a single statute, regulation, or case that holds that an external auditor’s preference for communicating with that company’s CEO rather than its CFO constitutes securities fraud.”

The DOL’s interpretations of Sarbox have been narrow and inconsistent between OSHA, the administrative law judges, and the ARB and could be discouraging whistle-blowers from coming forward, argues Moberly. Employees who are compelled to expose a company’s misdeeds need protection to offset the risk of losing their jobs and the cost of litigation, says Moberly. “You need to give extra incentive to reduce those costs in order to get people to follow through on their impulse to do the right thing,” he argues.

A National Bureau of Economic Research study released earlier this year similarly found that Sarbox has discouraged employees from coming forward and blowing the whistle on corporate fraud. From 1996 until Sarbox’s enactment, employees made up 21 percent of fraud detectors. Since then, that number has dropped to 16 percent.