They say success is the best revenge. Few know that better than Karen Kaiser, who walked away from her contentious divorce and custody battle with David Zilkha $1 million richer. In July, the Securities and Exchange Commission (SEC) awarded Kaiser a $1 million bounty for blowing the whistle on an insider-trading scheme at Connecticut hedge fund Pequot Capital Management, where her estranged spouse was a trader. During the divorce, Kaiser discovered some e-mails between Zilkha and his boss that revealed a scheme to profit from insider information about Microsoft. Kaiser turned the emails over to the SEC, which extracted a $28 million settlement from Pequot, forcing the firm to close its doors.

Kaiser received her payout under Section 21A(e) of the SEC Act, which provides that individuals who give the commission information about insider trading are entitled to receive up to
10 percent of any penalties the commission obtains. Kasier’s $1 million payday broke records. In the 20 years before the Pequot settlement, the commission had paid out a total of only $160,000
to whistleblowers.

“The Pequot settlement was the SEC’s way of advertising that they’re open for business,” says Peter Unger, a partner at Arent Fox.

And blowing the whistle on securities violations is about to become bigger business than ever before. The Dodd-Frank Act, which President Obama signed into law July 21, expands the types of activities that whistleblowers can profit from reporting and ups the ante for the would-be whistleblower, who will be entitled to receive 10 to 30 percent of any penalty greater than $1 million.

“I’m not a ‘sky is falling’ type, but I’m holding on to the edge of my seat,” says Covington & Burling Partner David Martin. “The act provides great potential for plaintiffs lawyers to drum up business.”

Race Against Time

Companies are concerned that Dodd-Frank’s whistleblower bounty provision will have the unintended consequence of making internal compliance programs less effective. The act provides that whistleblowers who give the SEC “original information” about any violation of the SEC Act or Sarbanes-Oxley (SOX) that leads to a successful enforcement action are entitled to a portion of the recovery. The promise of a large financial reward could incentivize employees to go directly to regulators with information about possible violations rather than first bringing them to light internally.

This puts employers in an especially tight spot. “Under the federal sentencing guidelines, a corporate defendant gets a credit if it was the first to self-report a violation,” says Beth Moskow-Schnoll, a partner at Ballard Spahr. “If you’re under pressure, thinking an employee may report something, you might go to the government before conducting a thorough investigation.”

Unfortunately, that means an employer might be inviting the federal government to come and take a look around when a violation hasn’t even occurred. This makes it essential for employers to take a fresh look at their compliance procedures and remind employees that it’s in everyone’s interest to first report problems internally.

“Employees don’t usually become whistleblowers unless they feel they’ve been ignored internally,” says Betsy Lewis, a partner at Cooley. “Your internal compliance plan needs to be robust, easy to use and, above all, communicated to employees in a way that shows the company believes in the process and takes it seriously.”

Others counsel a more aggressive approach to keeping employees from becoming snitches. “Senior executives are excluded from the ability to recover as whistleblowers,” Unger points out. “Consider having senior people acknowledge that in their employment contracts.”

Irresistible Incentive

But even companies with airtight compliance practices face an increased risk that their employees will be tempted to go to regulators. The money at stake is huge, and plaintiffs lawyers know it.

Many experts compare the scope of potential liability to that under the Foreign Corrupt Practices Act (FCPA). The average successful FCPA whistleblower obtains a whopping $46 million. A successful Dodd-Frank whistleblower will be entitled to collect a portion of what the commission obtains internationally, not just from domestic penalties. Moreover, the Dodd-Frank Act expands whistleblower protection to the employees of nonpublic companies, subsidiaries of public companies and all financial services employees, none of whom were covered under SOX or the SEC Act.

“More opportunities to complain mean a higher likelihood of complaints,” Lewis says. Plaintiffs firms are already advertising on the Internet for potential whistleblowers. And venture capitalists are pooling funds to cherry pick plaintiffs to go to the SEC.

“It is not surprising that plaintiffs lawyers are advertising,” Unger says. “This could become a cottage industry, similar to whistleblower litigation in regulated industries such as pharmaceuticals and oil and gas.”

Another area ripe for litigation is the Dodd-Frank Act’s broad anti-retaliation provision, which has a lengthy six-year statute of limitations and provides for remedies such as double back pay with interest.

“That creates a burden as far as recordkeeping and document retention,” Martin says. “That can get lost in the weeds.”

Speaking Out

The SEC has 270 days from the date the act was signed to issue the regulations that will govern how the law is enforced. That means the commission is accepting comments from interested parties now and must finalize the rules by April 2011, although it may do so sooner. Companies and trade associations that participate in that rulemaking process have an opportunity to steer the commission in the right direction.

Experts point to several areas where the SEC regulations will have a significant impact, including narrowing the type of information that is covered and narrowing the type of employees who can go to the SEC. For example, it’s unclear at this point whether internal auditors are excluded from being able to benefit from blowing the whistle. The rulemaking process will clear that up.

“There should also be an exclusion for reporting privileged information,” Unger says. “Whistleblowers should have to certify that the information they are reporting is not privileged.”

Unger also urges companies to comment on the provisions that allow whistleblowers to report anonymously. “The identity of the whistleblower should be disclosed at some point,” he says.