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Second Circuit Limits Scope of SEC Whistleblower Incentives
Thursday, August 4, 2022

A recent decision by the U.S. Court of Appeals for the Second Circuit has implications for whistleblowers under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act” or “The Act”). In Hong v. SEC, No. 21-529 (2d Cir. July 21, 2022), the Court held that a person who provides the Securities and Exchange Commission (“SEC”) with information about potential securities laws violations is entitled to receive a whistleblower award under Section 21F of the Securities Exchange Act (15 U.S.C. § 78u-6)if the SEC itself brings a qualifying action, but not when the SEC shares the whistleblower’s information to other agencies who then bring an action in partial reliance upon it. The decision sets definitive limits on the reach of the Dodd-Frank Act’s whistleblower incentives and may affect the calculus for individuals considering whether to risk their personal and professional careers to come forward with information of wrongdoing.

Victor Hong worked at a bank for six weeks in the fall of 2007 before resigning, prompted by what he believed to be unlawful practices engaged in by the bank in connection with its portfolio of residential mortgage-backed securities (“RMBS”). After his resignation, he formally submitted information to the SEC about the bank’s perceived misconduct. The SEC itself took no action against the bank but shared the information with the Department of Justice (“DOJ”) and the Federal Housing Finance Agency (“FHFA”) (together, the “Agencies”), each of which had already begun RMBS-related investigations into the bank. The Agencies then obtained additional information and documents from Hong by subpoena and later entered into settlements with the bank requiring it to pay over $10 billion.

Hong applied to the SEC for an award under Section 21F of the Securities Exchange Act, the SEC’s whistleblower program (the “Program”) established by the Dodd-Frank Act to motivate those with inside knowledge of securities law violations to share information with the government despite the risks that speaking out could pose to the whistleblower’s reputation and career. Hong asserted that the statute entitled him to between 10% and 30% of the total amounts collected. Hong’s application was denied on the grounds that he had identified no action brought by the Commission under the securities laws based on his information. The Commission also rejected Hong’s alternative theory of recovery that the DOJ and FHFA settlements qualified as “related actions,” reasoning that an “action” that was “brought by the SEC” was still a necessary predicate for an action brought by another agency to qualify as a “related action.” Hong petitioned the Second Circuit for judicial review.

The Court reviewed the SEC’s decision to deny Hong an award under the standard set forth in Section 706 of the Administrative Procedure Act (“APA”), which allows the Court to “set aside agency action, findings, and conclusions found to be . . . arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” Section 21F(f) of the Exchange Act also provides that “any determination . . . including whether, to whom, or in what amount to make awards, shall be in the discretion of the commission.”

When evaluating an APA challenge to an agency’s interpretation of a statute it administers, courts apply a two-step analysis known as the Chevron framework, which considers: (1) whether the statutory language at issue is ambiguous, and, if it is, (2) whether the agency’s interpretation is reasonable and, thus, to be accorded deference.

The Court first applied this framework to the two interrelated elements of the statutory definition of a covered action: first, the phrase “judicial or administrative action,” and second, the phrase “brought by the Commission.” As to the former, the Court concluded that while the concept was not entirely free from ambiguity, a conclusive determination was unnecessary because the SEC’s interpretation that an “judicial or administrative action” generally means a single captioned judicial or administrative proceeding as well as limited types of settlement and non-prosecution agreements was reasonable and, thus, to be accorded deference. After considering the Black’s Law definition of “action,” its common usage by courts, and the statutory text, the Court found that it was reasonable for the SEC to conclude that the concept did not extend to the full range of investigative or information-sharing activities the SEC may undertake with respect to a tip. The Court briefly addressed the phrase “brought by the Commission,” concluding that the SEC’s interpretation that this contemplated a leading enforcement role by the SEC was “not arbitrary, capricious, or otherwise not in accordance with law.”

The Court then considered whether the DOJ and FHFA settlements qualified as “related actions” under the Program, making Hong eligible for the award. It held that to the extent the statutory definition of “related action” is ambiguous, the SEC reasonably interpreted the provision to require a predicate action brought by the SEC. The Court found this conclusion logically flowed from the contextual statutory language, which requires the non-SEC action to be “based upon the original information” that the “successful” SEC action relied upon, presupposing an SEC action that could be “enforce[d].” Accordingly, the Court held that an award-eligible “related action” must be predicated upon a covered judicial or administrative SEC action, which the DOJ and FHFA settlements were not.

The decision in Hong demonstrates that despite the broad goals underlying the Dodd-Frank Act’s whistleblower program aimed at preventing the kind of misconduct that led to the financial crisis of 2008, it has its limits. The Second Circuit concluded that its provisions do not leave the SEC on the hook for whistleblower awards where other agencies reached settlements based in part upon tips the SEC received and shared with those agencies. The ruling has important implications for prospective whistleblowers considering whether to risk their personal and professional reputations in bringing information of wrongdoing to light.

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