The issue of how poorly Sarbanes-Oxley protects finance executives who blow the whistle on alleged corporate abuse seems headed for a wild showdown in federal court.
And when the five-year-old case finally is heard in the Fourth District Court of Appeals in Richmond, Va., it promises to put generally accepted accounting principles in the spotlight as well. In the latest ruling, handed down in May by the Department of Labor’s Administrative Review Board, the ARB reversed a law judge’s earlier finding that a CFO deserved reinstatement and back pay because he had reported a serious violation of GAAP, and later was fired. The ARB, however, said that exposing GAAP violations doesn’t necessarily qualify an employee for Sarbox protection.
The case in question — involving Cardinal Bankshares Corp. finance chief David Welch’s 2002 firing — is the first Sarbox whistle-blower claim to wend its way completely through DoL’s Occupational Safety and Health Administration’s (OSHA) process, toward a federal-court resolution. Some experts in the employee-rights field originally saw Welch as a model claimant because he had so clearly identified wrongdoing, including the misclassification of $195,000 in loan recoveries. The company entered the amount as income, without Welch’s knowledge, improperly boosting quarterly income by 13.7 percent. Also clear was that he was thwarted in his attempts to go through corporate channels to remedy that and other problems.
Now, however, the same experts see the case as evidence that the current enforcement system is stacked against whistle-blowers — a conclusion the numbers certainly seem to validate. Indeed, in a study earlier this year by Orrick, Herrington & Sutcliffe LLP of 947 Sarbox cases, 70 percent had been dismissed and 28 percent settled or withdrawn. Only 2 percent had made it to an administrative law judge. Of the six cases to reach the ARB appeal stage, three were reversed and two settled, with a sixth remaining open.
“Welch Did Everything Right”
Richard Moberly, an assistant professor of law and employee-rights specialist at the University of Nebraska, originally figured the Welch-Cardinal case might qualify as the first to win the reinstatement and back pay that Sarbox offered to successful whistle-blowers — especially after the favorable law-judge ruling. “Welch did everything right. He reported the problems internally, and then went to the board members. In terms of transparency and law enforcement, you’d expect a case like this to be supported after the favorable ruling from the law judge,” says the professor, who testified before a Congressional committee studying the problems of Sarbox whistleblower protection.
The hearings took place May 15, three days before the ARB reversed the ruling by the administrative law judge (ALJ). Since then, legislation to “expand and simplify” employee protections has been introduced by U.S. Rep. Lynn Woolsey, chair of the House Subcommittee on Workforce Protections, and fellow California Democrat George Miller.
The ARB’s May reversal surprised the professor in part because it seemed to overturn the “objective reasonableness” standard that is supposed to support a whistle-blower like Welch who had good reason to suspect wrongdoing, even if there wasn’t positive proof. “We want people to report what they believe to be violations, but we don’t expect them to be experts on what they’re reporting. What it seems like the ARB is requiring is that Welch needed to be right; that it’s more of an absolute standard.”
Prof. Moberly also was shocked by the board’s ruling that Welch’s identification of GAAP errors and poor internal controls — most specifically Cardinal’s misclassification of $195,000 in loan recoveries — didn’t qualify him to be reinstated under Sarbox. “I think accountants would be surprised to learn that a whistle-blower who finds GAAP and internal-control violations isn’t protected,” he says.
“My personal view is that businesses and courts have the wrong perspective on whistle-blowers,” says Prof. Moberly. “If you want the company to run right, you ought to support the strongest cases.” Instead, out of fear that encouraging whistle-blowers might expose companies to more frivolous actions, “the process has not been kind to Sarbanes-Oxley whistle-blowers. So few of them have won a case in front of ALJ, and to get through all three (ALJ, ARB, and a federal court) has been impossible.”
Or, as Welch’s attorney Bruce Shine puts it in describing the prospects for whistle-blower adversaries: “For a company, you have a better chance of being struck by lightning than you do of losing a SOX case.”
The New Testament Sans Jesus
Since Welch’s firing, Shine, a partner in the Kingsport, Tenn., law firm of Shine & Mason, has worked to draw lightning to Cardinal Bankshares.
The attorney felt vindicated by the favorable law-judge ruling. The brief he filed last week, in preparation for the Fourth Circuit case, tried to capture what he describes as his disbelief that the ARB’s opinion dismissed the revelation of GAAP violations and poor internal controls that his client had found at the company.
Because the Securities and Exchange Commission requires the use of GAAP, “it stands to reason that Cardinal’s failure to apply the baseline standards embodied by GAAP…leaves Cardinal in violation of longstanding federal securities laws, and SEC rules and regulations which predate the enactment of SOX,” Shine wrote.
The review board, however, sided with Cardinal Bankshares’ position that misclassifying the $195,000 as income, even if a violation of GAAP, still gave a fair picture of the company’s financial condition because “whether reported as income or as a credit to expenses, the fact remained that (Cardinal) had $195,000 that it previously did not have.” Indeed, it said that to accept Welch’s contention that a claimant reporting a GAAP violation qualifies for Sarbanes-Oxley protection “amounted to a wholesale rewriting” of a section of the legislation.
“I’ll be blunt. The ALJs and the decisions they’ve rendered have evidenced significant legal scholarship, an attribute which does not appear to exist in the ARB’s decison,” says Shine. “To reverse a 72-page (law-judge) opinion in 12 pages without citing a single significant case, statute or regulation to support their position is mind-boggling.”
The ARB’s ruling that exposing a GAAP violation doesn’t entitle a claimant to Sarbanes-Oxley protection “is the core of my quandary,” Shine tells CFO.com. “It’s so obvious to anyone who knows anything about the securities industry and reporting. It’s like saying that you read the New Testament and that you can’t find any record of Jesus.”
Shine’s conclusion from the decision, and from the statistics showing that the ARB hasn’t yet sustained an ALJ victory by a claimant, he says, is that the board “just doesn’t like SOX or whistle-blowers.”
The Labor Department’s position overall, he suggests, is a bit harder to understand. Shine notes that the Fourth Circuit appeals court actually may be hearing oral arguments on two related cases: Welch’s challenge of the review board’s reversal of the DoL law judge, and Welch’s appeal of a federal district court’s failure to enforce the law judge’s interim order for Welch to be reinstated at Cardinal. While the DoL is defending the review board’s reversal of the law judge, the department has joined Welch in his appeal of the second case, according to Shine. The date of the hearing hasn’t been set yet.
Did His Expertise Work Against Him?
Douglas W. Densmore, an attorney from the Roanoke, Va., firm of LeClairRyan, who represented Cardinal, tells CFO.com that Cardinal’s policy is not to comment on cases still in litigation. He adds that his brief to the Fourth Circuit hasn’t yet been filed.
Last year, however, CFO.com reported on comments at the Cardinal annual meeting by CEO Leon Moore, who said the bank at the time had spent at least $400,000 on the case. Further, the tiny community bank, which recorded $450 million in assets and a net income of $2.2 million for 2005, was set to shell out about $125,000 separately in Sarbanes-Oxley compliance costs for that year, he estimated. In an interview with CFO.com, he said, Cardinal’s board and shareholders supported the bank’s defense strategy.
“Nobody — shareholders or directors — [is] suggesting that we settle,” Moore asserted at the time. He said that the case had ramifications for other public companies, since a win by Welch would “set a precedent” allowing employees to make accusations and refuse to meet with the audit committee unless accompanied by a lawyer, as Cardinal said Welch had done.
Moore further pointed out that in 2003, the SEC had asked for documents related to Welch’s claims, and that it had never come back to the bank with any comments. Bank regulators, including the Virginia State Corporation Commission and the Federal Deposit Insurance Corp., have also given Cardinal a clean bill of health three times since Welch made his allegations, the CEO noted.
Another attorney with experience representing employers in whistle-blower cases, Lloyd B. Chinn, a partner with ProskauerRose LLP, is supportive of the ARB’s decision. “Not every violation of GAAP equals fraud. You can make a mistake and not have fraud on your balance sheet,” Chinn says. And he notes that Sarbanes-Oxley’s first goal is to protect investors, not employees, who get protection only secondarily. Thus, only serious whistle-blowers making serious charges should be protected by the act.
Once the review board concluded that there wasn’t evidence of fraud in the GAAP violation or the other complaints Welch issued, adds Chinn, Welch became “a victim to some extent, in that he’s a highly qualified individual. If it’s not fraud, someone in Welch’s position knows that.”
Also supporting Cardinal’s position with an amicus curiae brief before the ARB were three banking organizations, including the American Bankers Association. ABA associate general counsel Gregory F. Taylor notes that industry’s desire is for standards that discourage frivolous actions by employees, while encouraging legitimate complainants to speak up, go through company channels, and point out where the channels may be broken. “A determination of whether a covered Sarbanes-Oxley violation has occurred can be tricky, as demonstrated by the back and forth in this particular case,” says Taylor. The banking industry “wants the Sarbox standards to strike a balance between protecting legitimate whistle-blowers and discouraging frivolous actions by employees.”
He adds: “The more guidance you can provide the people having to apply the statute in identifying covered activity, the better. The ARB’s ruling was closer to a bright line for our members, although we don’t have that bright line yet, and probably never will have.”
Prof. Moberly, however, sees the review board’s exclusion of GAAP violations and disclosures of internal-controls violations from the list of Sarbox-covered whistle-blower activities as something that needs a serious review by the appeals court. “This is what people predicted when enforcement of this law was given to the Department of Labor,” he says. “That the department could get into the nuances of securities regulation seemed far-fetched.”