Transcript Directors And Officers Liability Insurance ExecuSummit

Directors & Officers Liability Insurance
ExecuSummit
WHISTLEBLOWERS
Presented by
Frederick D. Lipman
May 9, 2012
John Wiley & Sons, Inc. (2012)
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Public Whistleblower Incentives
• Dodd-Frank – 10% to 30% of amount collected for
violation of federal securities laws (including Foreign
Corrupt Practices Act) or Commodity Exchange Act if
monetary sanctions exceed $1 million.
• False Claims Act – 15% to 25% of collected recovery, but
can be as high as 30% or as low as 10%.
• IRS – Mandatory Awards of 15% to 30% of amount
collected if amounts in dispute exceed $2 million and if
target taxpayer is an individual, annual gross income must
exceed $200,000. If target taxpayer is an entity, there is no
gross income requirement. Discretionary awards
authorized below the $2 million threshold.
• Miscellaneous statutes: Act to Prevent Pollution From
Ships (up to one-half of fine), etc.
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Dodd-Frank and SEC
Whistleblower Rules
• Effective August 12, 2011, SEC rules adopted under the
Dodd-Frank Act do not require employee whistleblowers
to comply with the internal corporate governance policies
in order to obtain an award.
• All public companies must, therefore, reevaluate the
effectiveness of their corporate compliance systems,
particularly their hotlines and whistleblower policies.
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Why is This Relevant to D & O
Underwriters?
• Public reporting of misconduct because of bounties is
typically followed by law suits, including class actions,
against directors and officers.
• The failure of the insured to maintain an effective and
robust system for internal whistleblowing is a major risk
factor for D & O underwriters.
• A robust internal whistleblower system encourages
employees to reveal illegal acts or excessive risk-taking
internally so that the corporation has time to correct the
problem. Therefore it is an important entity level internal
control which will reduce D & O underwriting losses.
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Cheryl Eckard - The $96 Million
Plus Whistleblower
• Cheryl Eckard worked for SmithKlineBeecham
Corporation d/b/a GlaxoSmithKline from 1992 through
May 2003, when her employment was terminated after she
had repeatedly expressed serious quality assurance and
compliance problems at the Cidra plant in Puerto Rico.
• After internal investigation by Glaxo employees, Eckard’s
complaints were found to be without merit.
• In October 2010, Glaxo paid $750 million in connection
with a Department of Justice suit under the False Claims
Act and civil class actions and Eckard was given a bounty
of $96 million plus.
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John Kopchinski – The $51 Million
Plus Whistleblower
• Kopchinski was employed by Pfizer, Inc. and its
subsidiary from 1992 until March 2003 when he was
discharged, allegedly in retaliation for his complaints
about the off-label marketing of Bextra.
• In September 2009, Pfizer, Inc. agreed to pay $2.3 billion,
the largest healthcare fraud settlement in the history of the
U.S. Department of Justice., to settle its criminal and civil
liability.
• There were a total of ten whistleblowers, including six
who worked in sales positions at Pfizer, who received
bounties, with Kopchinski receiving the largest bounty of
over $51 million.
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Whistleblowers Without Bounties
• In 1972, Firestone Tire Director of Development Thomas
A. Robertson sent top management a memo warning that
the 500 tire was inferior and subject to belt-edge separation
at high speeds. His warning was ignored despite reports
about poor performance from major customers such as
General Motors, and the 500 tire was kept on the market.
• By the time Time magazine reported that accidents caused
by blowouts had resulted in more than 41 deaths and
hundreds of serious injuries, the company had already
replaced 3 million tires and spent millions of dollars in
personal injury lawsuits.
• Firestone ultimately lost its relationship with Ford as a
result of bad publicity.
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Disincentives to External
Whistleblowing by Employees
• Plaintiffs may have to wait six years or more to receive
bounties and be unemployed during all or a portion of that
period.
• Cheryl Eckard was laid-off in 2003 and did not receive any
bounty until 2010.
• Inability to obtain new employment because of poor
recommendations by prior employer. No one wants to
employ a “snitch”.
• Even if external whistleblowing is anonymous, employees
fear that they may be discovered by their employer and
retaliated against.
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Many Whistleblowers Initially
Report Internally
• Between 2000 and 2009 about 59 percent of employees on
average said that they observed and reported misconduct,
usually to an internal company authority. (Source: Ethics
Resource Center: Blowing the Whistle on Workplace Misconduct –
December 2010)
• However, many of those reports of misconduct typically
never reach the independent directors on the audit
committee of the board of directors.
• Example: Matthew Lee, a senior vice president of Lehman
Bros, reported accounting improprieties to his superior, but
not to the audit committee, concerning Repo 105
transactions. (Source: Bankruptcy Examiner Report – Pages 21, 1460
and 1464)
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Sarbanes-Oxley Act of 2002
• In reaction to Enron, WorldCom, and the other shareholder
disasters that took place from 2000 to 2002, Congress
enacted the Sarbanes-Oxley Act of 2002 (SOX), which
mandated that companies whose stock is traded on national
securities exchanges require their audit committees to
establish procedures for “the confidential, anonymous
submission by employees of the issuer of concerns
regarding questionable accounting or auditing matters.”
• This resulted in employee hotlines (including ethics lines)
being established by most public companies.
• However, these hotlines have not been effective in most
cases to induce management personnel to go over the heads
of the CEO or CFO and make disclosures to the audit
committee.
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Ineffective Hotlines
• Only 3% of employees would use hotlines to report
misconduct. (Source: Ethics Resource Center: Blowing the Whistle on
Workplace Misconduct, December 2010)
• AIG: Why did Eugene Park not use the AIG anonymous
employee hotline to report to the AIG audit committee the
excess risks being taken by AIG in insuring credit default
swaps? (Source: Lewis “The Great Hangover”).
• Lehman Bros.: Why did Matthew Lee not use the
Lehman Bros. anonymous employee hotline to report to the
Lehman Bros. audit committee the accounting
improprieties resulting from the Repo 105 transactions of
Lehman Bros? (Source: Bankruptcy Examiner Report – Pages 21,
1460 and 1464.)
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Ineffective Hotlines (Cont.)
• Merrill Lynch: Why did Jeff Kronthal or other Merrill
Lynch executives not use the anonymous employee hotline
to report to the Merrill Lynch audit committee the
excessive sub-prime mortgage credit risk being assumed by
Merrill Lynch? (Source: Bethany McLean and Joe Nocera, All the
Devils Are Here: The Hidden History of the Financial Crisis – Pages 308
and 320)
• Bear Stearns: Why did Matthew Tannin not use the
anonymous employee hotline to report to the Bear Stearns
audit committee the excessive sub-prime mortgage credit
risk being assumed by Bear Stearns? (Source: The Financial
Crisis Inquiry Report, Page 238)
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Internal Whistleblowing
Disincentives
• Using the hotline to the audit committee is viewed as an act
of disloyalty, particularly for members of the management
team and may end an executive’s career at the company
and in the industry as well.
• There is little upside and much downside in squealing to
the audit committee on the CEO or CFO. Example: Enron
director, Herbert Winokur, Jr., pre-bankruptcy
conversation with an Enron risk manager.
• Few executives will become whistleblowers unless their
anonymity is fully guaranteed and there is some upside.
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Internal Whistleblowing
Disincentives (Cont.)
Examples of Retaliation
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Poor performance reports by the whistleblower supervisors
Disqualification from incentive bonuses
Destruction of potential for career advancement
Being fired
Inability to obtain new employment because of poor
recommendations or no recommendations from prior
employer
• Social ostracism – you lose all of your friends
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Major Problems with Current
Whistleblower Policies
• There is no meaningful reward for the internal
whistleblower even though the use of the hotline may be a
career ending decision.
• There is no guarantee of anonymity. Voice recognition
technology can be used to identify the whistleblower.
Anonymous e-mails may be tracked back to the
whistleblower’s computer. Private detectives can be used
by the company to identify the whistleblower.
• Audit committees tend to give less credence to anonymous
whistleblowers. (See 2010 study by Hunton and Rose.)
• Inability to communicate with anonymous whistleblowers.
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Major Problems with Current
Whistleblower Policies (Cont.)
• No independent administration of hotline complaints.
Complaints are typically referred to the internal auditor,
director of compliance, inside counsel, or other employees
who may not be viewed as independent by the
whistleblower.
• Many whistleblower complaints are not investigated by
independent counsel but by other employees who may not
have forensic skills and are not viewed as independent.
Example: Sharon Watkins at Enron.
• Failure to adequately communicate the whistleblower
policy.
• The motivations and personality of the whistleblower are
considered more important than the truth of the
allegations. Why was Harry Markopolos not believed by
the SEC?
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Importance of Anonymity
• James F. Bingham, an assistant treasurer at Xerox, was
terminated by Xerox in 2000 and alleged in his subsequent
lawsuit that he was fired for reporting accounting
irregularities in the company’s Mexican business. Xerox
claimed that Bingham’s allegations were presented to
directors and auditors and found to be “without merit.” The
SEC began an investigation, after which Xerox restated its
earnings for four years and paid a fine of $10 million. The
lawyer for James Bingham summed up Bingham’s
situation in this way: “Jim had a great career, but he’ll
never get a job in Corporate America again.”
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Importance of Anonymity (Cont.)
• On April 8, 2011, the first whistleblower award was made
under the IRS mandatory bounty provisions in the amount
of $4.5 million (less withholding) to an in house accountant
who tipped off the IRS that his employer was skimping on
taxes. The accountant’s tip netted the IRS $20 million in
taxes and interest from the employer, a financial services
firm and a Fortune 500 company. The accountant’s identity
was not disclosed, and his lawyer made the announcement
in a television interview. According to the accountant’s
lawyer, the accountant continues to work as an in-house
certified public accountant and never wants to be known as
a whistleblower.
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We Were Duped!
• The independent directors of the following companies
claimed they were duped by the CEO, CFO or the
management team:
• Lehman Brothers Holding, Inc. – Bankruptcy Examiner
Report – Pages 21, 1460 and 1464
• Merrill Lynch – Bethany McLean and Joe Nocera, All the
Devils Are Here: The Hidden History of the Financial
Crisis – Pages 308 and 320
• Tyco – Gary Strauss, “Tyco Events Put Spotlight on
Directors’ Role.” USA Today, 9/15/2002
• Enron – U.S. Senate Report, July 8, 2002, page 6
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Sources of Information for
Independent Directors to Discharge
Their Oversight Function
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CEO and CFO.
Independent auditors and internal auditors.
Lower level management.
Securities analysts, short sellers, etc.
Whistleblowers. The hotline and whistleblower system is
an important entity level internal control, the effectiveness
of which must be periodically monitored.
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Conclusions of PCAOB Investor
Advisory Group
• “The recent financial crisis presented auditors, and by
extension the Sarbanes-Oxley Act audit reforms, with
their first big test since these reforms were put into place.
By any objective measure, they failed that test. Dozens of
the world’s leading financial institutions failed, were sold
in fire sales, or were prevented from failing only through a
massive government intervention – all without a hint of
advance warning on their financial statements that
anything might be amiss.”
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Conclusions of PCAOB Investor
Advisory Group (Cont.)
A sampling of failed financial institutions, all of which received
unqualified audit opinions within months of the failure
Company
Event
Event Date
Investor
Losses ($m)*
Audit Firm
Lehman Bros.
Bankruptcy
09/15/2008
31,437.10
E&Y
AIG
TARP
09/16/2008
155,499.60
PwC
Citigroup
TARP
10/26/2008
212,065.20
KPMG
Fannie Mae
Gov’t takeover
09/6/2008
64.10
Deloitte
Freddie Mac
Gov.t takeover
09/02/2008
41.50
PwC
Wash Mutual
Bankruptcy
09/26/2008
30,558.50
Deloitte
New Century
Bankruptcy
04/02/2007
2,576.40
KPMG
Bear Stearns
Purchased
03/17/2008
20,896.80
Deloitte
Countrywide
Purchased
01/11/2008
22,776.00
KPMG
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Robust Whistleblower Policies
• Tone at the top which supports an ethical, law-biding
culture. Independent directors, particularly audit
committee chair, as well as CEO, must set this tone.
• Employees at all levels should be required to report major
risk exposures of the organization in addition to any
potential law violations.
• Absolute protection for whistleblower’s identity. Permit
whistleblowers to communicate through their own personal
attorneys, with the company paying reasonable costs if the
information is legitimate.
• A meaningful internal reward.
• Recognition for whistleblowers who wish to be identified.
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Robust Whistleblower Policies
(Cont.)
• Independent administration and investigations (except for
minor employment related complaints). Challenge of
identifying frivolous complaints
• Report results to whistleblower and keep whistleblower
informed.
• There should be no presumption that anonymous
complaints are less deserving of investigation.
• The motivations and personality of the whistleblower are
not relevant to the truth of their allegations.
• Provide annual reports to all employees as to actions taken.
• Effective communication of the whistleblower policy to all
employees.
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Action Items for D & O Underwriters
• Review D & O applications for public companies to add
questions relating to current whistleblower policies of the
company.
• Add questions such as the following:
– Does the company provide rewards for legitimate
employee whistleblowers?
– Do independent directors (such as audit committee
members) directly receive whistleblower complaints
concerning significant accounting , auditing or
enterprise risk issues, including direct reports from any
hotline or ethics line provider.
– Do independent directors (such as audit committee
members) employ independent counsel or other
ombudsmen who has no significant relationship with
management to administer and investigate such
whistleblower complaints.
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Action Items for D & O Underwriters
(Cont.)
– Are employee whistleblowers permitted to use their
own personal counsel to protect their identity, with the
company reimbursing legal fees if the information is
legitimate?
– Are employee whistleblowers kept apprised as to the
status of the investigation of their complaints?
– Is there annual communication with employees
concerning the company’s whistleblower system?
– Do independent directors have to approve any
termination of employment of employee
whistleblowers?
– Has the company joined the Association of Audit
Committee Members, Inc., which advocates the
adoption of robust whistleblower policies?
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Contact Information
Frederick D. Lipman, Esq.
Blank Rome LLP
One Logan Square
130 North 18th Street
Philadelphia, PA 19103-6998
Tel: 215-569-5518
Fax: 215-832-5518
E-Mail: [email protected]
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