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From Securities Regulation Daily, May 20, 2013

U.S. Supreme Court to Hear SOX Whistleblower Claim; Denies Cert on 16(b) Derivative Action

By Lene Powell, J.D.

The Supreme Court granted certiorari on the issue of the meaning of “employee” under the Sarbanes-Oxley Act for purposes of whistleblower retaliation by contractors of public companies (Lawson v. FMR LLC, May 20, 2013). The Court also denied certiorari on the question of whether an uninjured private plaintiff had standing to sue under Section 16(b) of the Exchange Act (Bulldog Investors General Partnership v. Donoghue, May 20, 2013).

Whistleblower retaliation by contractors: cert granted. In Lawson, the question presented was whether an employee of a privately held contractor or subcontractor of a public company is protected from retaliation under Section 806 of the Sarbanes-Oxley Act (18 U.S.C. §1514A).

Defendant-appellees are the privately held parent company and several subsidiary companies that operate the Fidelity family of mutual funds. As the petition explained, each of the hundreds of Fidelity mutual funds is a separate registered investment company required to file reports with the SEC. A mutual fund has no employees of its own, instead contracting to an investment adviser that conducts all the activities of the fund. Employees in the mutual fund industry, including plaintiff-appellants, thus work for fund advisers or subadvisers, not the mutual fund itself. The defendants are investment advisers, or subadvisers, to particular Fidelity mutual funds.

Plaintiff-appellants are Jackie Lawson, a former Senior Director of Finance, and Jonathan Zang, a former equity analyst. Lawson and Zang were employees at one of the private Fidelity entities; neither worked for any of the Fidelity mutual funds.

According to the petition, Lawson was subjected to a series of adverse actions following her objections to alleged misallocation of fund expenses and ultimately resigned. Zang was dismissed after he objected to a statement that one respondent was going to file with the SEC because it allegedly contained misleading information. Zang also objected that defendants were operating “veiled index funds,” or index funds for which management improperly collected active management fees.

Under Section 1514A, a publicly traded company, mutual fund, contractor, or subcontractor of a company may not discriminate against “an employee” in the terms and conditions of employment because of protected whistleblower activity. In the proceedings below, the First Circuit held that, under Section 1514A, privately held contractors and subcontractors may retaliate against their own employees. They are prohibited only from retaliating against employees of the public companies for whom they work.

The First Circuit’s ruling was strenuously objected to by the Department of Labor, according to the petition. The DoL Administrative Review Board (ARB) rejected the court’s reasoning and held that Section 1514A does protect such whistleblowers. The Board’s decision is controlling in the administrative adjudication of Section 1514A claims in every circuit other than the First Circuit.

The SEC also objected, pointing out that, because virtually all employees in the mutual fund are employed by investment advisers rather than the mutual funds themselves, the First Circuit’s decision would mean that the anti-retaliation provision would not protect most of the workers in the industry. In the case of Fidelity, which manages over $1.4 trillion in assets and employs approximately 39,000 individuals, not a single worker would be protected by Section 1514A. In addition, limiting the section to employees of public companies would exclude employees of public accounting firms, like the now-defunct Arthur Anderson, said the SEC.

In the view of the petitioners, “the First Circuit and ARB decisions systematically canvassed the same grounds and arrived at diametrically opposed conclusions.” The petition observed that claimants in circuits other than the First Circuit can invoke the more favorable ARB decision by pursuing their claims in the administrative process rather than district court. This will inevitably result in forum shopping until the Court definitively resolved the meaning of Section 1514A, said the petitioners.

The petitioners noted that under the First Circuit’s reasoning, as applied to the participants in the original Enron scandal that prompted the enactment of Sarbanes-Oxley, Section 1514A would only have forbidden the consulting firm Arthur Anderson from somehow retaliating against a whistleblower who worked for Enron itself. It would have allowed Arthur Anderson to use retaliation to prevent its own employees from reporting Enron-related fraud to the SEC, Congress, or the managers or directors of either firm.

Uninjured plaintiff in Section 16(b) action: cert denied. The questions presented in Donoghue were: (1) whether plaintiff-appellees had standing to sue under Exchange Act Section 16(b), in the absence of any allegation that the petitioner’s statutory violation caused injury; and (2) whether Section 16(b) creates a fiduciary duty owed by every 10-percent stockholder of a public company and whose breach is always an injury-in-fact to the company.

The petitioner, a private investment fund, noted that the Court had previously granted a petition for cert to decide whether a federal statute’s grant of a private cause of action for its violation is, by itself, sufficient to give an uninjured private plaintiff constitutional standing to sue in federal court. However, the writ was dismissed before decision in that case.

According to the petitioner, despite its purchase of more than 10 percent of the registered common stock of Morgan Stanley High Yield Fund, now known as Invesco High Yield Investments Fund, the petitioner was a consummate outsider, with an arm’s length adversarial relationship with Invesco’s management. Invesco declined to pursue short-swing profits from the petitioner. Plaintiff Deborah Donoghue, who according to the petitioner was a serial nominal Section 16(b) plaintiff, sued the petitioner derivatively on Invesco’s behalf.

At trial, the petitioner admitted violating Section 16(b), but moved to dismiss the case for lack of subject matter jurisdiction, arguing that Invesco lacked standing under Article III, Section 2 of the U.S. Constitution because the complaint did not assert any actual injury to Invesco. According to the petition, the district court denied the petitioner’s motion, holding that Invesco’s as-yet unsatisfied statutory entitlement to Bulldog’s short-swing profits was its injury-in-fact.

The Second Circuit affirmed and went further, holding that Section 16(b) creates a fiduciary duty owed by all 10-percent holders to issuers not to engage in short-swing trading. The Second Circuit ruled that the breach of this fiduciary duty was the injury-in-fact, according to the petition.

The petitioner argued that the Second Circuit’s grant of Article III standing without actual injury was erroneous and diluted the requirement of “injury-in-fact” to the point of insignificance. The petitioner also contended that the Second Circuit erred in its holding that Section 16(b) creates an implied fiduciary duty owed by 10-percent holders to public companies. The Supreme Court denied the petition without comment.

Companies: Bulldog Investors General Partnership; Fidelity Brokerage Services, LLC; Fidelity Management & Research Company; FMR Co. Inc.; FMR Corp.; FMR LLC; Invesco High Yield Investments Fund; Morgan Stanley High Yield Fund, Inc.

Attorneys: Eric Schnapper, University of Washington School of Law, Indira Talwani (Segal Roitman, LLP), and Kevin G. Powers (Rodgers, Powers & Schwartz, LLP) for Jackie Lawson and Jonathan Zang. Richard W. Cohen (Lowey, Dannenberg, Cohen & Hart, P.C.) for Bulldog Investors General Partnership.

MainStory: TopStory Arbitration CorporateGovernance InvestmentAdvisers InvestmentCompanies SarbanesOxleyAct

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