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  1. Directors & Officers Liability Insurance ExecuSummitWHISTLEBLOWERS Presented byFrederick D. Lipman May 9, 2012

  2. John Wiley & Sons, Inc. (2012)

  3. 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.

  4. 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.

  5. 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.

  6. 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.

  7. 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.

  8. 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.

  9. 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.

  10. 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)

  11. 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.

  12. 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.)

  13. 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)

  14. 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.

  15. Internal Whistleblowing Disincentives (Cont.) Examples of Retaliation • 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

  16. 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.

  17. 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?

  18. 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.”

  19. 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.

  20. 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

  21. Sources of Information for Independent Directors to Discharge Their Oversight Function • 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.

  22. 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.”

  23. Conclusions of PCAOB Investor Advisory Group (Cont.)

  24. 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.

  25. 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.

  26. 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.

  27. 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?

  28. 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: