Section 304(1), The Whistleblower Provision: The Real Power Behind Sarbanes-Oxley

Abstract

Shooting The Messenger

For centuries, it's been an unwritten tenet of war that one side does not shoot the other side's messenger. The respectful treatment afforded messengers plying their trade back and forth between enemy lines, has been codified in great works of literature. In Henry V, Shakespeare has young Henry receiving the French messenger several times before the gruesome battle at Agincourt in 1415. Each time, the messenger faithfully and dispassionately relays the French King's rebukes, insults, and demands for surrender. And, each time, Henry contains his rage, knowing the herald is merely repeating what the king told him to say. Just before the battle begins, Henry listens to the messenger deliver the last of the king's insults, then sends him away with these words: "Herald, save thou thy labour; Come thou no more for ransom, gentle herald ..." If only Shakespeare were writing for 21st Century corporate CEOs.

Until recently, 'shooting the messenger' was an accepted practice in corporate America, albeit figuratively. With few exceptions, whistleblowers could expect to be ostracized, demoted, transferred, and, more often than not, fired. The impact on the families of whistleblowers was tragic. Of course, that was by design. The implication was that if you wanted to keep your job, if you wanted to stay in the game, you had to play ball. Or, at the very least, obfuscate, ignore, and deny the fouls committed by your own team. This shameful treatment of people who only wanted to do the right thing, caught the attention of mainstream America in 1999, when Hollywood released "The Insider, " starring Russell Crowe.

The Sarbanes-Oxley Act of 2002

In the summer of 2002, President Bush signed his name on a piece of paper and the Sarbanes-Oxley Act became the law of the land. The official purpose of Sarbanes-Oxley, or SARBOX, as some refer to it, is "An Act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes."

The most well known provisions of SARBOX are 1) both CEO and CFO must certify quarterly, in writing, that their financials are correct, and 2) if the financials are not correct, "I wasn't aware" no longer works as a defense for a disengaged CEO and CFO. Criminal penalties will apply. Of course the idea here is that when a CEO and CFO are required to actually sign on the dotted line that everything is on the up-and-up, checked, and re-checked so help me God, the scandals ascribed to Enron, WorldCom, Adelphia, et al., can be avoided.

SARBOX Section 304(1): Whistleblower

Clearly, it is a major step forward to have CEOs and CFOs now 'guarantee' that their financials are in order, and, by implication, that they aren't squandering corporate dollars on $20 million Van Gogh's for their beach homes. However, I believe a powerful argument can be made that the most far-reaching impact of SARBOX lies not with the autographs of CEOs and CFOs on a dotted line, but with the 44-words contained in Section 304(1). "Each audit committee shall establish procedures for the receipt, retention, and treatment of complaints received by the issuer regarding accounting, internal accounting controls, or auditing matters; and the confidential anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters."

Welcome to 'whistleblower'! This section of SARBOX will prove to be the real change agent and the most lasting legacy of the act. For while nefarious CEOs and CFOs can always try to make an end-run on SARBOX, they can no longer shoot the messenger who brings their nefariousness to light. The cost-benefit of the whistleblower provision is so favorable that private companies, not subject to the legislation, will also be swept up in this freedom-from-retribution tsunami.

Whistleblower Effects on Employees

Very simply, the reign of terror perpetrated against corporate employees because of information they share regarding corporate malfeasance, has ended. This is good news. The only people who don't view this as good news are executives with something to hide. Corporate fraud - malfeasance of any kind - can, and has, destroyed dreams and disrupted hundreds of thousands, if not millions, of innocent lives.

The wording, "confidential anonymous submissions," in Section 304(1) of SARBOX, prevents management involvement in the whistleblower process in any way. Clearly, the process must be kept out of the hands of management to circumvent a potentially unresponsive or resistant bureaucracy. And, of course, there is always the concern of management involvement in a process where management is implicated. Not unlike putting a fox in charge of security for the henhouse. By vesting responsibility in the audit committee, and ensuring confidential anonymous submissions, the process will encourage complainants to come forward. It will also erase the fear that complaints will be suppressed or the complainant will be the object of retaliation.

Any effort that guarantees an avenue of redress without recrimination is a giant step forward. The whistleblower provision of SARBOX gives us this step forward.

Whistleblower Effects on Boards of Directors

The Whistleblower provision, with its direct tie-in to a board's audit committee, is as strong an opportunity to strengthen the board as an independent counterweight to management, as I have seen in my 38 years as CEO of 10 venture-backed companies and director of 5 public and 15 private companies. The SARBOX Whistleblower provision provides value to corporate boards in three ways:

1. An early warning system to catch potential problems in time to prevent or mitigate the effect of misconduct and the resulting liability.

When I was Administrator of the $18 billion credit union industry in North Carolina, insider tips to my office uncovered over half the defalcations. Our audit staff uncovered the others. However, in most of the cases uncovered by the audit staff, too much time had elapsed between the start of the crime and its discovery. In most cases, meaningful restitution was simply not possible.

2. A catalyst to heighten ethics.

Whistleblower will elevate both transparency and ethics. Like Neighborhood Watch, in a community concerned about safety, quality of life, and property values, it will soon be apparent that no bad deed goes unnoticed and unpunished. Whistleblower will link the act, and its consequences, so strongly, that potential perpetrators will be dissuaded from acts that, previously, had a better than average chance of success.

3. The opportunity to enhance a company's reputation boosts public trust and enhances net worth.

When evidence of corporate malfeasance was filtered up through company management, as it typically was prior to SARBOX, the results were less than gratifying. In most cases, the effort was a waste of time and, as shown earlier, led to a complete implosion of the Whistleblower's life. The Whistleblower provision of SARBOX now provides an opportunity to gain unbiased information for better management decisions and board policy. Information reported confidentially and anonymously through an independent third party, such as an audit committee, is unvarnished and rapid. Untainted information will also elevate strategic decision making at the management and board level where multimillion-dollar decisions on the margin are made. Interestingly enough, the comic strip "Dilbert" frequently captures how information passed up the ranks to management is tainted by selfinterest.

Whistleblower Effects on Shareholders

The SARBOX Whistleblower provision will also have a significant impact on maintaining shareholder value:

1. It encourages the discovery of malfeasance at an early stage. Since the first investor bought the first share of stock, there has been a direct relationship between corporate news and the price of its stock: good news usually prompts an increase in stock value and bad news has the opposite effect. Catching malfeasance at an early stage, while not the greatest news, is certainly better than catching it so late that a company finds it impossible to repair its reputation.

Typically, it rarely does any good for a forensic audit to catch fraud more than a year after its initiation. The perpetrators have either spent their ill-gotten gains or safely hidden it in offshore accounts. Often, as we have recently seen, public outcry is such that the company cannot survive. The effect of protecting confidential and anonymous whistleblower call-ins will help catch malfeasance at an early stage and, thereby, protect shareholder value.

2. The opportunity to discover fraud perpetrated by extended constituencies.

Vendors, customers, shareholders, banks, analysts, and stock exchange officials will be encouraged to use confidential, secure 800 numbers and encrypted, anonymous Emails. Whistleblower makes it much easier for an employee of a shipping vendor to do the right thing when he overhears a loading dock supervisor encourage workers to short pounds on a textile company's shipments. When this fraud is brought to light early in the illegality, both the textile company's profitability and shareholder value can be preserved.

3. Uncontaminated and timely information facilitates both management and board-level decision making.

Corporate profitability and shareholder value both depend on uncontaminated and timely information getting to the board. The whistleblower provision of SARBOX encourages the efficient and effective dissemination of information crucial to corporate viability.

Whistleblower Will Be Embraced Beyond SARBOX

As the benefits of early and uncontaminated whistleblower information to board audit committees become obvious, public companies will encourage new constituencies to share relevant information regarding fraud. As mentioned above, vendors, customers, shareholders, banks, analysts, and stock exchange officials will be encouraged to use confidential, secure 800 numbers and anonymous E-mails. In the case of vendors, an anonymous tip that a supplier is cutting corners on shipping could save the user company millions of dollars.

Private companies will immediately embrace the Whistleblower concept with open arms. School systems will pony up. Government agencies and not-for-profits will see advantages. Even though these organizations are not subject to SARBOX, the cost-benefit will be compelling. Even if defalcations and sexual harassment were the only issues, savings would be substantial.

The Downside of Whistleblower

There will always be disgruntled employees, with no legitimate complaint, who use Whistleblower as a means for their own, personal retribution. This is going to happen. However, expert, independent services with attorneys trained in information collection, retention, and distillation, will give professional guidance to audit committees. Legal guidance is of crucial importance. After all, the audit committee is comprised of independent board members whose work for the board is part-time. They have jobs outside the company on whose board they sit. By legal definition, and the spirit of the original legislation, the audit committee cannot turn to management for help. Recently, both Coca-Cola and Denny's embarrassed themselves by posting information on their corporate websites that requested employees report auditing and accounting wrongdoing to "senior management."

Some pundits may say that the whistleblower process is too good. It may unearth facts regarding situations best left hidden; exposing the company, its officers, and directors to liability. This is absolutely groundless. Among experienced board members, it is fully understood that the sooner one learns of a problem, the easier and less costly it is to resolve.

The third seeming downside of the whistleblower provision of SARBOX is Big Brother. Even though George Orwell was describing the government in his classic book, 1984, some will see the whistleblower provision as encouraging too little privacy and sharing too much transparency. Hogwash! The elevation of corporate ethics beyond a written ethics policy, as well as the very favorable cost-benefit relationship, clearly trumps this concern.

Implementation of Whistleblower is Proving a Challenge

Even though common and statute laws provide anonymity and confidentiality to a complainant reporting to a company's Ombudsman (up to the point of potential loss of life), employees' knowledge of, and experience with, companies that monitor phone calls and E-mails contaminates this process. case law, in time, will corroborate this. Company counsel, alter egos of management, cannot oversee the whistleblower process. Outside auditors, even though they technically work for the audit committee, have the appearance of toting water for management. This subverts confidentiality and anonymity. In point of fact, outside auditors are weaved into the fabric of management on a daily basis.

The Value of Independent Service Firms

Public companies can fully comply with SARBOX section 304(1) by engaging outside, independent firms with secure 800 numbers, the ability to receive anonymous whistleblower Emails, and a proven way to guarantee "retention and treatment of complaints." Service firms with expertise in advising corporate boards will provide substantial added value in overseeing this process and, after analyzing the data collected, interacting with the audit committee. When directed by the audit committee the vetting and analysis by the professional service firm will be invaluable information for independent auditors to identify and assess risks. Lawyers with expertise in corporate law and the collection and distillation of information, will dominate these specialty service firms. Again, audit committee members have substantial duties outside the companies on whose boards they sit. The biggest corporate sin, in my opinion, is half-baked information at the board level.

Summary

When properly implemented, Sarbanes-Oxley section 304(1), the whistleblower provision, not only safeguards, but substantially benefits, shareholders. When this process is thought out, adopted as policy, and executed at the board level, there will be a clear benefit to the corporation's bottom line. Public companies will voluntarily extend the whistleblower system to various constituencies in addition to mandated employees. Even those private companies not covered by SARBOX, including schools, government agencies, and not-for-profits, will embrace the whistleblower provision once its bottom-line benefits are fully appreciated.

In the 15th Century, Henry V clearly understood that a good king, a smart king, a king with his subjects' best interests at heart, does not shoot a messenger who brings him bad news. To the contrary, such a messenger is treated well. He's done the king a service. Today, in the 21st Century, corporate CEOs will come to the same conclusion in time, and with a little help from the whistleblower provision of Sarbanes-Oxley.

By: J. Phillips L. Johnston, J. D.

Phil Johnston has served on 15 private and 5 public boards, including 10 years of service on the audit committee of a NYSE - listed company. He has been a CFO, & a CEO often venture backed, primarily technology companies, 2 of them public, and has served as chief government regulator of the $18 billion N.C. credit union industry. Phil is a frequently nationally published author and lecturer on corporate governance, he is also the author of two books, including one that Esquire magazine called the "the best book ever written about small business". He is currently writing a new book entitled "Disruptive Strategy at the Board Level". He graduated from UNC Law School, attended the Stern MBA School at NYU, Stanford's Director College, the John F. Kennedy School at Harvard, and the Director's College of the National Association of Corporate Directors, and has an Economics degree from Duke University. Phil was the CED 1997 Entrepreneur of the year. He is currently an Entrepreneurial Fellow at Wake Forest University. Phil may be reached at Johnston Tobin, LLC., 336-889-2900 or at Pjohnston(a)iohnstoniobin.com

Copyright Credit Research Foundation Second Quarter 2004
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