Sarbanes Oxley Protected Conduct Does Not Require a Showing of Materiality
The great weight of authority holds that there is no independent materiality element to establish protected whistleblowing under Section 806 of SOX.
Most recently, Judge Brantley Starr soundly rejected an employer’s argument that SOX protects only disclosures about material violations: “Materiality isn’t in the Sarbanes-Oxley whistleblower law. It isn’t in the four of the six specifically defined trigger laws.” Seybold v. Charter Communications Inc., 2022 WL 675804 (N.D.Tx. Mar. 7, 2022) (citing 18 U.S.C. §§ 1341, 1343, 1344, 1348).
In Donaldson v. Severn Sav. Bank, F.S.B.,[i] Vanessa L. Donaldson brought a SOX whistleblower action against her former employer, Severn Savings Bank (“Severn”), claiming she was unlawfully terminated after she reported to her supervisor her suspicions about an inaccurate bank report. Specifically, Ms. Donaldson alleged that she informed her supervisor about a scheme in which the commercial/retail manager for Ms. Donaldson’s branch falsified the retail production report for the third quarter of 2013, in order to collect unearned bonus pay.
Severn argued that Ms. Donaldson failed to allege she engaged in protected activity because she failed “to allege any facts whatsoever that would indicate any material misrepresentations (or omissions) were reported to Severn’s shareholders,” and so she lacked an objectively reasonable belief that she was disclosing shareholder fraud. The court rejected Severn’s narrow construction of SOX:
[T]he federal criminal fraud statutes . . . prohibit the scheme to defraud, not a completed fraud. . . .Materiality of falsehood . . . was a common-law element of actionable fraud at the time these fraud statutes were enacted and is an incorporated element of the mail fraud, wire fraud, and bank fraud statutes. . . . But § 1514A carries no independent materiality element. Consequently, Donaldson’s objective belief need not be about a material matter, as Severn has argued. Rather, her objective belief must be based on facts permitting an inference that [the manager’s] allegedly false representation was material to Severn’s course of conduct.[ii]
The court found that Ms. Donaldson met this standard because the manager’s alleged inflation of the retail production figures was intended to, and likely would, affect the size of a bonus awarded him by Severn. Therefore, the court concluded, “it may be inferred from Donaldson’s complaint that she had an objectively reasonable belief that [the manager was] engaged in a scheme to defraud Severn.”[iii]
Similarly, the Third Circuit held in Wiest v. Lynch, 710 F.3d 121 (3d. Cir. 2013) that a SOX whistleblower need not prove materiality: “[R]equiring a complainant to prove or approximate the specific elements of a securities law violation contradicts the statute’s requirement that an employee have a reasonable belief of a violation of the enumerated statutes.” Sylvester, 2011 WL 2165854, at *18. The ARB further explained, “a complainant can engage in protected activity under Section 806 even if he or she fails to allege or prove materiality, scienter, reliance, economic loss, or loss causation.” Id. We find this interpretation to be reasonable because there is nothing in the statutory text that suggests that a complainant’s communications must assert the elements of fraud in order to express a reasonable belief that his or her employer is violating a provision listed in Section 806. Therefore, the District Court erred by requiring that an employee’s communication reveal the elements of securities fraud, including intentional misrepresentation and materiality.”
Per SEC Staff Accounting Bulletin No. 99 (SAB 99) and well-established precedent, exclusive reliance on quantitative benchmarks to assess materiality in preparing financial statements and performing audits of those financial statements is inappropriate; misstatements are not immaterial simply because they fall beneath a numerical threshold. In Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824 (8th Cir. 2003), the Eighth Circuit relied on the following principles to assess materiality:
- A fact is deemed material if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as substantially altering the mix of information available to the investor.
- Information can be material because a reasonable investor would be interested in knowing that the senior managers of a company were oblivious to their underlings’ malfeasance. Management’s integrity is important to investors.
- In order to take the decision about materiality away from the jury, the circumstances must make it obvious why a reasonable investor would not be concerned about the facts misrepresented
- The importance of the misrepresented facts should not be judged with the advantage of hindsight. The test is whether there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” Rodney v. KPMG Peat Marwick, 143 F.3d 1140, 1144 (8th Cir. 1998) (quotations omitted) (emphasis added). This requires the factfinder to look at the information from the perspective of a reasonable investor at the time of the misrepresentation, not from the perspective of a reasonable investor looking back on how events unfolded.
Pursuant to SAB 99, “among the considerations that may well render material a quantitatively small misstatement of a financial statement item are –
- whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate14
- whether the misstatement masks a change in earnings or other trends
- whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise
- whether the misstatement changes a loss into income or vice versa
- whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability
- whether the misstatement affects the registrant’s compliance with regulatory requirements
- whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements
- whether the misstatement has the effect of increasing management’s compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation
- whether the misstatement involves concealment of an unlawful transaction.”
[i] No. JKB-15-901, 2015 WL 7294362, at *3 (D. Md. Nov. 18, 2015).
[ii] Id. at *3 (citations omitted).
SOX Whistleblower Retaliation Law
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We are also one of the leading law firms representing whistleblowers worldwide before the SEC, and indeed our attorneys represented whistleblowers at the SEC before the enactment of the Dodd-Frank Act. We helped shape the SEC rules implementing the SEC Whistleblower Program, and have represented whistleblowers in disclosing a wide range of violations of federal securities laws, including:
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See our recent article in Forbes: One Billion Reasons Why The SEC Whistleblower-Reward Program Is Effective. If you have information you would like to report to the SEC, contact an experienced SEC whistleblower attorney at Zuckerman Law for a free, confidential consultation by calling 202-262-8959.
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In a speech titled Living in a Material World: Myths and Misconceptions about “Materiality”, Commissioner Lee noted:
So, what are the possible sources of a duty to disclose? A duty may arise by virtue of an explicit SEC disclosure requirement, such as those set forth in Regulation S-K. A duty may also arise, as it did in Basic, in order to make other statements made by a company materially accurate or not misleading . . . another means by which a duty may arise is through statements a company makes on a topic which may then require the disclosure of additional information “necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading.”In other words, if a company makes statements on a topic, a duty may arise to disclose additional information needed to ensure that those statements are materially accurate and complete.
In a speech titled Assessing Materiality: Focusing on the Reasonable Investor When Evaluating Errors, Acting Chief Accountant Paul Munter noted some key points about materiality:
Management is responsible for providing investors with GAAP-compliant financial statements, so whenever a material error is identified in previously-issued financial statements, investors must be notified promptly and the error must be corrected. The determination of whether an error is material is an objective assessment focused on whether there is a substantial likelihood it is important to the reasonable investor.
A materiality analysis is not a mechanical exercise, nor should it be based solely on a quantitative analysis. Rather, registrants, auditors, and audit committees need to thoroughly and objectively evaluate the total mix of information. Such an evaluation should take into consideration all relevant facts and circumstances surrounding the error, including both quantitative and qualitative factors, to determine whether an error is material to investors.
Therefore, while the existence of a material accounting error is an indicator of the existence of a material weakness, a material weakness may also exist without the existence of a material error. Management’s assessment of the effectiveness of ICFR should therefore be focused on a holistic, objective analysis of what could happen in the context of current and evolving financial reporting risks.
In our disclosure-based regime, investors have a right to financial statements prepared in accordance with GAAP. When an error is identified, it is important for registrants, auditors, and audit committees to carefully assess whether the error is material by applying a well-reasoned, holistic, objective approach from a reasonable investor’s perspective based on the total mix of information. To be objective, those involved in the process must eliminate from the analysis their own biases, including those related to potential negative impacts of a restatement, that would be inconsistent with a reasonable investor’s view. Additionally, the objective analysis should consider all relevant facts and circumstances including both quantitative and qualitative factors.
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- Matt Stock is a Certified Public Accountant, Certified Fraud Examiner and former KPMG external auditor. As an auditor, Mr. Stock developed an expertise in financial statement analysis, internal controls testing and fraud recognition, and he uses his auditing experience to help whistleblowers investigate and disclose complex financial frauds to the government and obtain damages for retaliation. He is lead author of SEC Whistleblower Program: Tips from SEC Whistleblower Attorneys to Maximize an SEC Whistleblower Award.
- Both Bachman and Zuckerman served in senior positions at the Office of Special Counsel, where they oversaw investigations of whistleblower retaliation claims and whistleblower disclosures, and enforced the Whistleblower Protection Act.
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