Can hedge funds double dip under Dodd-Frank whistleblower rules? (Westlaw Business)

By Guest Contributor
January 6, 2011

By Jesse R. Morton

NEW YORK, Jan 6 (Westlaw Business) – Whistleblower provisions in Dodd-Frank may have handed hedge funds a golden opportunity and the SEC a unique challenge.

Funds have long conducted unique analyses that power their trading strategies and at times prompt quite public “revelations” of possible funny business. Think Greenlight Capital’s company-shaking revelations about Lehman Brothers in 2008 and Allied Capital in 2002.

Though the law remains unclear on this issue, its quite-intentional similarity to pre-existing approaches under the False Claims Act and the whistleblower program of the IRS may provide funds with a profitable two-fer. Though not necessarily the intent of Dodd-Frank’s enacters, one is left to wonder as to the role of shorts, touted (by shorts), as de-facto enforcement division of the SEC.

Hollywood might not turn the saga of Greenlight Capital and Allied Capital Corp into a blockbuster film. Nonetheless, lawyers may have to rehearse a new script and prepare for a new breed of whistleblower in light of paragraph 922 of the Dodd-Frank Act. Indeed, it just may be that the whistleblower of the future is just that — a boring hedge fund money-making machine looking to collect a government reward.

That is, if the law allows it… which it just may.

On May 15, 2002, David Einhorn, the Founder and President of the hedge fund Greenlight, gave a speech at a charity event in which he disclosed potential accounting irregularities and fraud at Allied. The resulting market selloff was nothing short of remarkable, and Greenlight, which held a substantial short position in Allied, stood to profit immensely. Fast-forward to a post-Dodd Frank era where paragraph 922 encourages and pays huge rewards for disclosing to the SEC exactly these types of allegations — does the Dodd Frank Act not only allow, but encourage, whistleblower rewards to be paid to hedge funds and other short-sellers?

The answer is certainly not black-and-white, but it appears that the Act left open the possibility of just such a scenario — and, on some readings, it may not even preclude collecting a massive government payout on top of private profiteering.

You can read details of the allegations made by Einhorn by clicking on the following link: http://r.reuters.com/fun94r.

Einhorn’s stated doubts about Allied led him to conclude that Allied was overvalued; akin to a ponzi scheme which “picked its flowers and watered its weeds”, and destined for financial ruin. Therefore, Einhorn believed that Allied was a perfect short opportunity and Greenlight took a substantial short position in its portfolio.

Not surprisingly, between 2002 and 2007, Einhorn took many of his allegations to the SEC. And, on June 20, 2007, after numerous rounds of back-and-forth, including an investigation into Greenlight for potential market manipulation, the SEC finally issued a cease-and-desist order against Allied related to many of its accounting practices that Einhorn uncovered.

Although the SEC did not issue a fine, the question remains — if the SEC did levy a fine, and the same set of facts applied post-Dodd-Frank, would Einhorn, or Greenlight, have been eligible to collect a reward under paragraph 922?

Now, in this particular case, the potential payout probably would have paled in comparison to the profits made on the short-sale. However, SEC-driven fines are not necessarily small potatoes. Just ask Siemens or Goldman Sachs, which were recently fined $800 million and $550 million, respectively, though to be fair not under whistleblower provisions. Under Dodd-Frank, the whistleblower rewards for those could have been up to $240 million and $165 million (30 percent of the fine) — certainly no small change, even for a mammoth hedge fund like Greenlight.

INCENTIVES

Ironically, the Dodd-Frank Act that explicitly provides (and incentivizes) whistleblower allegations was also intended to ferret out potential market manipulation — the very same allegation that the SEC investigated Greenlight for after Einhorn publicly disclosed Allied’s shady accounting techniques. And more specifically, one major reform, reflected in various sections of the Act, relates to the perceived manipulation on the part of short-sellers — especially after the sharp decline of Lehman which many attributed to negative pressure on the part of short-sellers, and more specifically, hedge funds.

To be sure, the 2,319-page long piece of legislation includes various sections explicitly intended to further regulate hedge funds and eliminate the dissemination of false information leading to short-sale profits. A strange co-existence plays out. There is no doubt that the intention of Congress, by passing Dodd-Frank, was to incentivize individuals to uncover and report wrongdoing in corporate America. Even with that major impetus, it sure seems unlikely that Congress at the same time intended a big payday for hedge funds.

In particular, one wonders whether Congress intended not only to incentivize hedge funds to report potential wrongdoings, but also to provide a lucrative monetary reward (at the expense of taxpayers) should the allegations prove to be accurate. Keep in mind: that same hedge fund may have a double payday, possibly having made millions, or even billions privately acting on the same information.

Even so, the Act defines whistleblower as “any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission…” Indeed, the Act even provides an exhaustive list of those precluded from collecting an award, and hedge funds and/or short-sellers are not included on the list, provided, of course, that the whistleblower provides “original information.” Therefore, while a literal interpretation of paragraph 922 does not preclude a hedge fund or short-seller from collecting a whistleblower award, it does appear that they have a few hurdles to get over.

First, there is the issue of original information. In the case of Greenlight/Allied, the allegations on which Einhorn based his recommendation were based on an independent analysis of publicly available information. The Act defines original information as “information that… is derived from the independent knowledge or analysis of a whistleblower; is not known to the Commission from any other source, unless the whistleblower is the original source of the information; and is not exclusively derived from an allegation made in a judicial or administrative hearing, in a governmental report, hearing, audit, or investigation, or from the news media…”

This may present a problem to a reward-seeking hedge fund or short-seller, particularly in an era where the outbound flow of insider information, directly or via expert network, is increasingly under scrutiny: Virtually any fund-generated whistleblower allegation will probably be based on information contained in a company’s SEC filings or other public source of information. Indeed, in the case of Greenlight and Allied, Einhorn’s allegations of improper accounting at Allied were based on the following: a white paper published on Allied’s website where the company, perhaps recklessly, publicly contested the notion of fair value accounting; an analysis of the company’s quarterly and annual reports; public records; news reports; court documents; and Freedom of Information Act (FOIA) requests.

In fact, the issue of original information may have been partially resolved in the recent ruling United States of America, ex re. Brickman & Greenlight, at least as it relates to the False Claims Act (FCA) since many of the provisions of paragraph 922 are modeled after and use much of the same language as the FCA. The lawsuit, filed in the U.S District Court for the Northern District of Georgia in 2005, alleged that BLX, one of the SBA’s largest originator of Section 7(a) loans (loans that the SBA guarantees in order to encourage private lenders “to loan money to small businesses that otherwise would not be able to obtain loans.”), did not comply with the SBA’s underwriting standards for numerous “shrimp boat loans”.

ORIGINAL SOURCE

Using public records searches, FOIA requests, news stories, and other information, Brickman & Greenlight uncovered several cases of outright fraudulent origination, mostly stemming from one particular BLX location (Richmond, VA). In almost all of the cases, the borrowers were later prosecuted. Not surprisingly, therefore, these loans, and countless others, defaulted, which Brickman & Greenlight claimed had defrauded the government out of “tens of millions of dollars.” Among other things, there was also the further issue of the head of the Richmond, VA office, who had a criminal record for “character” violations and, accordingly, was subject to government-imposed sanctions, yet still served on some of BLX’s committees.

In the decision (later affirmed by the U.S. Circuit Court for the Eleventh Circuit), the court dismissed the case citing the language in the FCA that “no court shall have jurisdiction over [an FCA qui tam action] based upon the public disclosure of allegations or transactions in a criminal, civil, or administrative hearing… or from the news media, unless… the person bringing the action is an original source of the information.” According to the court, the purpose of limiting jurisdiction to those who are the original source of information was to ensure that “parasitic lawsuits based on information that is already in the public domain” are prohibited.

The court then continued its analysis by performing a three-part inquiry as to the information provided by Brickman & Greenlight in support of their lawsuit. First, the court determined “whether the allegations or transactions asserted by the relator have been publicly disclosed.” Publicly disclosed, for purposes of the analysis, means “already in the possession of the government.” Brickman & Greenlight, however, argued that while the information was publicly disclosed, the “allegations or transactions” were not, and therefore, the suit should not be barred. Nevertheless, the court took a strict interpretation of the statute in spite of this apparent exception. Second, the court determined whether the publicly disclosed information formed the basis of the action, which was irrefutable. Finally, the court concluded that since Brickman & Greenlight were not the original source of the publicly disclosed information, the suit was barred and, therefore, they were ineligible to collect a whistleblower reward under the FCA.

Since the language contained in Dodd-Frank is the same as the language contained in the FCA, the result certainly does not bode well for a short-seller or hedge fund hoping to collect a reward under paragraph 922. But, importantly, Dodd-Frank contains a caveat to the “original information” language contained in the FCA. Under Dodd-Frank, unlike the FCA, “original information” includes not only independent knowledge, but also adds the word “analysis”. Accordingly, it seems plausible that an analysis, such as that performed by Brickman & Greenlight, might pass muster even though the information on which the analysis was based is obtained entirely from information that is publicly disclosed. Although using different terminology, that was essentially the crux of Brickman & Greenlight’s argument over “allegation or transaction” — that they were the first parties to compile the publicly available information and relate it to fraudulent transactions.

Furthermore, the IRS whistleblower program contained in Internal Revenue Code paragraph 7623(b) also does not bar an award that is based on information that is publicly disclosed. However, when a disclosure is based on publicly available information the reward percentage is greatly reduced from up to 30 percent of the disputed amount to up to 10 percent. Even so, it may be unlikely that Congress, which created paragraph 922 because it wanted to create a robust public reporting and enforcement mechanism would take such a rigid interpretation of what is considered “original information.” Indeed, if such an inflexible interpretation were adopted it may deter potential whistleblowers who do have valuable information.

The second major hurdle that a short-seller or hedge fund might encounter in collecting a whistleblower award is under SEC proposed Rule 21F-2, Definition of a Whistleblower. According to the Proposed Rules for Implementing the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, “(a) whistleblower must be a natural person; a company or other entity is not eligible to receive a whistleblower reward.” This ordinarily may seem cut-and-dry, clearly indicating that a hedge fund is not eligible to collect.

However, there are three reasons why a hedge fund could theoretically succeed in spite of this proposed rule. First, obviously, this is merely a proposed rule and the rules interpreting paragraph 922 have not yet been finalized. Second, as mentioned above, the whistleblower statute was modeled after the FCA, which does not narrow a whistleblower to only a natural person. Lastly, paragraph 922 of Dodd-Frank contains an appeals process whereby a whistleblower can appeal an SEC determination regarding payment of an award. The section, which amends Section 21F(f) of the ’34 Act states that “any determination… including whether, to whom, or in what amount to make awards, shall be in the discretion of the Commission… (and) such determination, except the determination of the amount of an award… may be appealed to the appropriate court of appeals…”

Thus, while it may seem like a hedge fund and/or short-seller collecting a reward under paragraph 922 may be a monumental feat, it does not, however, seem impossible. Plus, since some market players believe that short sellers “are the de facto enforcement division of the SEC,” perhaps allowing and even encouraging hedge funds and/or short-sellers to report potential wrongdoings isn’t such a bad idea. Of course, there would have to be a careful balance between promoting honest allegations based on solid analysis and pure speculation and/or outright intentional deception with the intention of market manipulation in order to profit privately. (Editing by Joel Dimmock) ((joel.dimmock@thomsonreuters.com))

(This is an edited version of an article published by Thomson Reuters’ legal information and services business Westlaw. For the full article, click on http://r.reuters.com/fun94r)

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