Online Exclusive: Legislation promotes information sharing between criminal and civil investigations.

The Securities and Exchange Commission (SEC) was likely as glad as anybody in the recession-weary U.S. to see the calendar flip to 2010. Last year, the Government Accountability Office–and pretty much everyone else–eviscerated the SEC for its failure to detect and prevent the breakdowns that contributed to the recession. But just a little more than two weeks before the ball dropped in Times Square, the House passed a bill containing elements charged with rekindling public trust in the beleaguered agency.

The Investor Protection Act, just one facet of the nearly 1,300-page financial reform bill, recognizes “deep deficiencies” in the existing system and arms the SEC with enhanced enforcement ammunition.

“[B]y doubling the budget of the U.S. Securities and Exchange Commission and by requiring a comprehensive study to fundamentally reform the way the agency operates, this bill lays the foundation for us to put in place a superior securities regulatory system going forward,” Rep. Paul Kanjorski, D-Pa., declared to the House on Dec. 9, 2009. Kanjorski introduced the Investor Protection Act in October 2009.

Key provisions, if adopted, would radically impact the business world. Whistleblowers whose disclosures result in successful enforcement actions would receive a hefty cut of the recovered sanctions. Perhaps most chillingly for in-house counsel, companies could be pulled into someone else’s fraud investigation for recklessly–if unknowingly–assisting in a securities fraud.

All of this depends, of course, on what endures in the Senate version of the bill and whatever law eventually emerges. But the message from the House is clear: One way or another, change is coming to Wall Street.

“This is sweeping legislation that’s trying to attack problems that came to light as result of the financial meltdown,” says Marc Powers, head of Baker Hostetler’s Securities Litigation and Regulatory Enforcement Practice. “Certain clear areas of concern that may have contributed to [the meltdown] are the pieces that will most likely be adopted.”

On the Hunt

Some of the biggest frauds in history have been derailed by those with ties closest to the source–employees of the wayward companies. Though a few little-used niche whistleblower incentive programs already exist, reformers suspect more tipsters would come forward if promised a handsome reward.

That’s the idea behind the whistleblower bounty provision of the Investor Protection Act. In addition to the protections Sarbanes-Oxley affords whistleblowers, the bounty program would reward people whose tips result in a successful enforcement action with a payout of up to 30 percent of any monetary sanctions exceeding $1 million.

The possibility of a whistleblower bounty raises several alarms for companies, not the least of which is the potential for false reporting from employees greedy for extra cash, says Edward Johnsen, a partner at Winston & Strawn. Deliberately or innocently, people might be more likely to speak up even if there’s no whistle to blow.

Companies also face the challenge of employees who directly approach government regulators instead of going through internal fraud reporting channels, says Laurence Weiss, a partner at Hogan & Hartson.

“You don’t want your first knowledge that someone is engaging in misconduct to be when you get a call from the government,” he says. “You want to be able to find out about a problem, remedy it and self-report it rather than be surprised.”

Congress could remedy this concern by adding a stipulation that considers whether an employee first reported through internal procedures when the SEC determines how large a bounty the whistleblower receives, he says. Nothing in the current provision encourages whistleblowers to go through company channels first.

Conversely, companies could provide their own incentives to employees who report fraud internally rather than contacting regulators first, Powers says.

Risky Assistance

Just two years ago, the Supreme Court ruled in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. that a third party would not be held liable for assisting in another company’s fraud. Under the Investor Protection Act, this would all change.

In Stoneridge, Scientific-Atlanta and Motorola supplied Charter Communications, a cable TV company, with set top converter boxes. Charter overpaid for the boxes with the understanding that the respondents would buy advertising later in the year to make up the difference. The cable company then reported the inflated earnings to investors.

In this case, even if the respondents knew about the fraud, the Supreme Court ruled they wouldn’t be liable since they didn’t defraud their own investors.

But under the proposed act, companies would be liable not only for knowingly aiding in another company’s securities fraud violation but also for recklessly–if blindly–assisting in the fraud. This creates a risk that an otherwise innocent company could be pulled into fraud litigation over what seemed to be an ordinary commercial transaction, Weiss says.

“If I were an in-house counsel or a CFO of a large company, I’d be concerned about that because it poses the risk of getting wrapped up in potentially expensive fraud litigation and potentially enormous damages without actually having intentionally deceived anybody,” he adds.

The best way to tackle the proposed provision is to continue practicing good business hygiene, Weiss says. In-house counsel need to pore over business transactions, as most already do, making sure they understand each facet and the context in which the deals were undertaken.

Enhanced Enforcement

Though the legislation would provide a bump in agency funding and more avenues for enforcement, questions remain about how effectively the SEC would use its enhanced power. As it stands, it would definitely increase the number of cases the agency brings. But even with more money, the SEC would still have finite resources, says Nicolas Morgan, a partner at DLA Piper.

“They can’t follow up on everything,” Morgan says about more whistleblowers coming forward. “The bounty program creates a path for more information to come to the SEC. They’ll have to reduce the allocation of resources in some other area.” But in the wake of the Madoff scandal, it’s been worth the SEC’s time to devote more resources to investigating tips.

Johnsen is optimistic about the agency’s reorganization efforts. During the past year, he says the SEC has already taken big steps toward more effective enforcement.

“The challenge is to write rules that are effective and work with the various divisions on how to enforce those requirements,” he says. “I’m very confident they’re going to do a good job at this going forward.”