Ropes & Gray's Investment Management Update: February-March 2012

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry:

First Circuit Declines to Extend Sarbanes-Oxley Whistleblower Provision to Employees of Non-Public Companies

In a decision the ultimate significance of which is uncertain, a split panel of the U.S. Court of Appeals for the First Circuit held on February 3, 2012 that the "whistleblower" provision of the Sarbanes-Oxley Act of 2002 ("SOX") does not cover employees of non-public companies. See Lawson v. FMR LLC, No. 10-2240, 2012 U.S. App. LEXIS 2085. The court's decision addressed the scope of the term "employee" under Section 806 of SOX, 18 U.S.C. § 1514A, which generally prohibits retaliation against covered employees for protected whistleblowing activity. However, because the conduct at issue in the case occurred several years before the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank"), the decision does not address whether a similar and potentially far broader provision of Dodd-Frank might extend coverage to employees of non-public companies for post-enactment whistleblowing activity.

The dispute in Lawson arose from two separate cases involving former employees of private companies affiliated with Fidelity Management & Research Company, the investment adviser to the Fidelity family of mutual funds. The plaintiffs alleged that they were terminated for raising concerns about the Fidelity funds' registration statements and accounting methodologies. The district court denied the defendants' motion to dismiss, holding that Section 806 extends whistleblower protection to employees of contractors and subcontractors of public companies.

The First Circuit disagreed, relying primarily on the statutory text and legislative history of Section 806. That section, as enacted, provides: "No company with a class of securities registered under section 12 of the Securities Exchange Act of 1934 . . . , or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934 . . . , or any officer, employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee in the terms and conditions of employment because of" the employee's protected whistleblowing activity.

Chief Judge Sandra Lynch's majority opinion concluded that the term "employee" under Section 806 refers to an employee of a "public" company – one "with a class of securities registered under section 12" or that "file[s] reports under section 15(d)" – and not to employees of contractors or subcontractors of such a company.1 The court read the clause "officer, employee, contractor, subcontractor, or agent of such company" as identifying entities that are prohibited from taking retaliatory action against employees of public companies, not as identifying entities whose own employees are protected from retaliatory action. Accordingly, only employees of the defined public companies are covered by the whistleblower provision.

The court found support for this interpretation in the title and caption of Section 806, which both refer to "protection for employees of publicly traded companies." The court also pointed to provisions elsewhere in the statute that explicitly provide broader whistleblower protection in other circumstances, reasoning that Congress's choice to enact more limited coverage under Section 806 was not inadvertent. (Section 1107, for example, prohibits retaliation against government informants regardless of their employer's status as public or private.) The court went so far as to state that Congress's primary concern in enacting SOX was not to address the activities of the advisers to mutual funds, since Congress knew that mutual funds often do not have their own employees and are often advised and managed by private entities – and if they have no employees, they are not subject to Section 806. The court also noted that although there is a close relationship between investment advisers and their client mutual funds, had Congress intended to ignore that separation and provide whistleblower protection for the employees of private investment advisers, it could easily have done so explicitly.

In interpreting the scope of Section 806 to exclude the employees of private investment advisers to mutual funds, the First Circuit rejected the views of both the Securities and Exchange Commission (the "SEC") and the Department of Labor (the "DOL"), which filed amicus briefs arguing that the plaintiffs were covered employees under SOX. The court held that the agencies' position was not entitled to deference because Congress had given neither agency authority to interpret the term "employee" under Section 806 and because that term "is not ambiguous." Nor were regulations promulgated by the Occupational Health & Safety Administration of the DOL interpreting the coverage provision entitled to deference, because they "contained no reasoning" and lacked "persuasive power."

Judge Rogeriee Thompson issued a forceful dissent challenging both the majority's reading of the statute and its logical implications. The dissent argued that the majority's reading of the word "employee" to mean only employees of "public" companies was neither compelled by the statutory text nor suggested by the legislative history of Section 806. The dissent implies that the majority's reasoning as applied in the special context of "public" (i.e., registered) investment companies – which ordinarily do not have employees and are instead managed and operated entirely by investment advisers and other service providers – would render the statute meaningless. Under the majority's reasoning, if "contractors" and "subcontractors" of mutual funds are prohibited from retaliating against only mutual fund employees rather than their own, they are not precluded from retaliating against anyone. A petition for rehearing or rehearing en banc by the full First Circuit Court of Appeals has been filed by one of the plaintiffs. The case will be argued en banc if a majority of the active circuit judges vote to rehear the case.

The First Circuit is the first federal appellate court to address the scope of covered employees under Section 806, and the case is significant because many private companies – including virtually all investment advisers to mutual funds – are contractors or subcontractors of one or more public companies. However, neither opinion noted the enactment – subsequent to the facts giving rise to the dispute in Lawson – of a separate, parallel whistleblower protection regime under Section 922 of Dodd-Frank, which by its terms extends coverage to "any individual who provides . . . information relating to a violation of the securities laws."2 The coverage of Section 922 appears to be quite broad and may be construable as applying to all employees, not just employees of public companies. Thus, even if the Lawson case is not reheard or the decision is upheld, its significance (as well as the concerns voiced by the dissent) may be largely muted for whistleblowing activity falling within the scope of the Dodd-Frank provision.

Money Market Fund Reforms Expected from the SEC

The SEC is widely reported to be considering new regulations governing money market funds, although recently three of the five SEC commissioners have expressed reluctance to support new reforms, making the outcome of any proposal highly uncertain at this time. The SEC is expected to release a two-part proposal offering alternatives for money market fund reform. The first proposal will likely require money market funds to use a floating net asset value ("NAV"); the second is anticipated to require a capital buffer as well as redemption restrictions in the case of full redemptions. Following a comment period that is likely to generate widespread and critical attention, the SEC will likely select only one of the proposed reforms in the final rule, according to industry reports. Before the rule proposals can be submitted to the public for comment, at least three of...