I’m writing on the flight returning from the XIIth International CIFA Forum in Monaco. CIFA is an NGO. It is a confederation of independent financial advisor organizations that works with the UN in promoting the protection of investors. This means that their clients are often very wealthy and that many of the participants are speakers are very conservative or libertarians (or an admixture). One of the speakers, Dr. Hans Geiger, gave an impassioned denunciation of “bureaucrats” (which turned out to mean anyone who worked for the government) and the imposition of a duty on bankers to file criminal referrals when they had a “reasonable suspicion” that their clients had committed certain crimes. The official U.S. jargon for a criminal referral is “Suspicious Activity Reports” (SARS). Geiger was particularly distressed that the banker would not be allowed to inform his client that he was making the criminal referral (which FATF terms “Suspicious Transaction Reports” (STRs)) under the standard 21 proposed by the Financial Action Task Force in 2012.
21. Tipping-off and confidentiality
Financial institutions, their directors, officers and employees should be:
(b) prohibited by law from disclosing (“tipping-off”) the fact that a suspicious transaction report (STR) or related information is being filed….
The new requirement for criminal referrals will arise as nations adopt the FATF recommendations for financial policies. A number of nations have already done so. Geiger is a leader of the effort to convince the Swiss government not to adopt these provisions. He is part of an organization that encourages “tax competition” among nations. The goal is to minimize taxes and governmental spending by denying governments revenues. The aim is to encourage the wealthiest people to move that wealth and income to nations with the lowest taxes on wealth and income. Geiger is also a fierce austerian. The next day when I responded I wore my special austerian repellant tie – it’s resplendent with images of defaulted German bonds – the equivalent of wearing a garlic garland to ward off vampires.
In this first installment of my written response prompted by Geiger’s remarks I make only one point that I do not believe was made in a related context. FATF not only forbids the bank that makes the criminal referral against the client to inform the client, it labels such an act “tipping” – tipping off the suspect to the potential criminal investigation so that the client can destroy documents and avoid making future incriminating statements and requests. FATF’s language prohibiting tipping off the subject of the criminal referral comes from the federal banking agencies’ rules that require banks that they regulate to make such referrals and forbids them to inform the subject of the referrals.
12 CFR 390.355 – SUSPICIOUS ACTIVITY REPORTS AND OTHER REPORTS AND STATEMENTS.
(d) (9) Notification to board of directors—
(ii) Suspect is a director or executive officer. If the State savings association files a SAR pursuant to this paragraph (d) and the suspect is a director or executive officer, the State savings association may not notify the suspect, pursuant to 31 U.S.C. 5318(g)(2), but shall notify all directors who are not suspects.
The Dodd-Frank Act has provisions designed to encourage whistleblowers. The Chamber of Commerce, Financial Services Roundtable (FSR), and the American Bankers Association (ABA) hated the provision and made exceptional efforts to prevent the SEC from adopting a rule that would allow the whistleblower to notify the government of his corporation’s misconduct without first notifying the corporation.
This was rather obviously nuts for all the reasons that have long led us to ban banks from informing their clients of criminal referrals and which were leading FATF to propose recommendations that every nation adopt a similar ban. The ABA and the FSR know full well about criminal referrals and why the bank is forbidden to tip off the customer (even if the customer is a corporation with a system of internal controls) about the criminal referral. The opponents of the SEC rule, however, were not treated by the media as if they were trying to reverse a long-standing policy that made eminent sense given the reality of what the controlling officers leading a corporate control fraud would do to thwart an investigation if the whistleblower were required to notify the people leading the felony that he wished to alert the government that he had detected a likely crime.
Indeed, the policy argument is far stronger in the whistleblower context because the leading manner in which the controlling officers leading a control fraud seek to thwart investigations is to retaliate against the whistleblower. The goal is to intimidate and harm the whistleblower, but the reprisal also allows the officers to label him “a disgruntled employee who was fired for his incompetence and lack of integrity.” The “disgruntled employee” label is the favorite tactic of fraudulent officers seeking to discredit the whistleblower. The SEC rejected the demand that whistleblowers be required to tip off the alleged perpetrators of the crime, but that demand was overwhelmingly endorsed by the business community and by the SEC members who are Republicans. Their claim was based on the (implicit) assumption that control fraud does not exist and that the virtuous CEO needs to know of the crimes committed by his corporation’s officers and employees that were spotted by the whistleblower so that the CEO could remedy the crimes.
The Oxymoron that is Modern Legal Ethics
Michael E. Clark, Special Counsel to the Duane Morris law firm of Houston, Texas did us all the favor of revealing a bit too much of the basis for the CEOs’ rage against whistleblowers. The hostility is evident in the title he chose for his article: “The Dodd-Frank Act’s Bounty Hunter Provisions.”
The Review of Securities and Commodities Regulation, Vol. 44 No.3 (February 9, 2011).
“Although turning workers into informants by realigning their loyalties seemed fundamentally wrong to me, both then and now, Congress has recently decided to move in this direction [in Dodd-Frank].
As a result, publicly traded companies can expect higher compliance costs, added enforcement activities, and more follow-on civil litigation.
These new bounty provisions promise to be a “game-changer” for financial fraud enforcement. Not only will whistleblowers now have strong incentives to put their personal interests ahead of loyalties to their employers, but they will have ample opportunities to do….”
The argument that whistleblowers betray their “loyalty” to the corporation when they alert authorities to the actions of officers and employees who are likely to be violating the law and harming the corporation in order to make the CEO wealthy never made sense. CEOs leading control frauds use executive compensation and the power to hire, fire, promote, and bully to create perverse incentives to induce employees to act on their own behalf by harming the corporation. It is true that Dodd-Frank’s whistleblower provisions will increase enforcement actions and civil suits, but that would be a very good thing for corporations (and shareholders) if it clawed back fraud proceeds from the controlling officers. In the longer run, more effective deterrence could reduce civil suits and enforcement actions.
It is bizarre that an attorney, who must deal constantly with officers and directors’ fiduciary duties and the absolute necessity of complying with the law, would assert that employees who blow the whistle on fraud are “disloyal” to the corporation and morally degenerate “informers” while employees who say nothing and aid frauds by controlling officers are “loyal” to the corporation and morally superior. (The not very hidden truth is that the senior corporate officers decide whether lawyers are hired, fired, and paid, so lawyers are eager to conflate the CEO with the client even when the CEO is looting the client.) Clark’s discussion of fiduciary duties makes clear his all too common conception of legal “ethics.”
“Both agencies’ analyses appear to be markedly incomplete. For one thing, they do not address the duties of care, loyalty, and good faith that such key corporate officials [who are members of the control group], as fiduciaries, owe to an entity as its decision-makers.”
I think it is Clark who misses the concept of fiduciary duties. The most likely scenario is that the CFO learns that the CEO is leading a control fraud. The typical situation is that the CEO dominates the board of directors. The CFO cannot stop the fraud. If he aids the fraud he will be committing a felony. If he confronts the CEO he will be fired and the fraud will continue, harming the client to which he owes these fiduciary duties. The only way he can fulfill his fiduciary duties effectively is to blow the whistle to the SEC (which should promptly make a criminal referral). If the CFO blows the whistle to the SEC and continues to operate as CFO and while refusing to aid the fraud he can provide the SEC with constantly updated information and place the CEO in a dilemma about whether to fire him. Conversely, if the CFO were to blow the whistle only within the organization the CEO can learn exactly what the CFO knows – and doesn’t know – about the fraud schemes and take steps to make it far more difficult for the government to sanction him for his crimes.
Fish and Corporations Rot from the Head
The obvious question, which the opponents of whistleblowers studiously ignored was how common is it that the senior officers lead securities fraud. COSO’s (Treadway’s) 2010 study gave an answer to that question – and the question of whether securities frauds helps a corporation or harms it. The passage below is from COSO’s May 20, 2010 press release announcing the key findings of their study.
“The COSO study, which examined financial statement fraud allegations investigated by the U.S. Securities and Exchange Commission over a ten-year period, found that news of an alleged fraud resulted in an average 16.7 percent abnormal stock price decline in the two days surrounding the announcement. Companies engaged in fraud often experienced bankruptcy, delisting from a stock exchange, or asset sale, and in nine out of ten cases the SEC named the CEO and/or CFO for alleged involvement.”
Securities fraud harms corporations and shareholders. It is overwhelmingly led by the controlling officers. Credible whistleblowers to the SEC, therefore, will overwhelmingly be giving evidence of likely frauds led by the CEO and CFO. It would be insane to assume out of existence “control fraud” in the securities fraud context where such frauds are nearly always control frauds. The opponents of whistleblowing take their orders from the CEOs and CFOs so their opposition to the SEC’s proposed rules invariably – and implicitly – assume control fraud does not exist and that securities fraud originates in the cubes instead of the C-suites. They never cite the COSO study findings that demonstrate that it originates almost exclusively in the C-suites even though the COSO study was the definitive work that had just been released. Economists emphasize “revealed preferences.” Corporate CEOs have revealed their preferences about integrity – forget their prating endlessly about their principles – their actions on whistleblowing demonstrate that their true preference is to prevent the disclosure of securities fraud by senior corporate officers.
The SEC rule does not forbid the whistleblower from alerting the corporation about the misconduct he has spotted. An honest CEO who sends a clear message through her acts and deeds that she demands integrity and takes forceful action against corporate misconduct should be successful in encouraging whistleblowers to inform her of such misconduct.
Corporations and Courts Encourage Retaliating v Whistleblowers
But it gets much, much worse. Corporations are going to court and claiming that the Dodd-Frank provisions that protect whistleblowers from retaliation do not apply if the whistleblower only blows the whistle to the corporation, but not the SEC. The real reason why corporations objected to the SEC’s proposed whistleblower rule, which provided greater encouragement to whistleblowers to notify the SEC becomes clear. The corporate CEOs hoped to maintain the ability to take reprisals against greater numbers of whistleblowers. The obscene news is that the Fifth Circuit Court of Appeals has ruled that Dodd-Frank’s anti-reprisal remedy does not protect whistleblowers who only notify the corporation of the likely crime.
Conclusion and a Plea to Act
The degree of hostility against regulators and whistleblowers, and intense sympathy for the CEOs leading the control frauds, is palpable among large numbers of Reagan and Bush judicial appointees. When the Republicans obtain control of presidency they will resume appointing similar judges and are likely to use their control over the SEC to force whistleblowers to tip off the crooks so that elite corporate criminals can further enhance their already near total ability to defraud and to take reprisals against whistleblowers with impunity. It is disturbing that when corporate CEOs and these SEC board members revealed their desire to help fraudulent CEOs escape prosecution and retaliate against whistleblowers they paid no political or reputational price. The business media typically supported their disgraceful efforts. It needs to be emphasized that COSO has confirmed what white-collar criminologists and effective regulators have stressed for decades – many of the frauds led by the CEOs harm the corporation, so the ideologues cannot even claim that they are “pro-business.” They are pro fraudulent CEOs, which makes them anti-business, anti-labor, anti-capitalist, and anti-American. We need to use logic, common sense, and the long-standing banking rule requirements, now endorsed for international application by FATF, to build a backfire today rather than waiting until they formally propose to destroy the SEC rule or conservative judges gut it by claiming that its costs exceed the benefits and that many whistleblowers are not entitled to protection from reprisals because they trusted the CEO and blew the whistle only inside the firm. The most famous whistleblowers at Enron and Worldcom would have been excluded from Dodd-Frank’s protection from reprisals under the Fifth Circuit decision because they blew the whistle only internally.