First Circuit Court Sets Standard for Sarbanes-Oxley Whistleblower Claims

In a decision of first impression in the Circuit, but resembling those of other courts, the United States Court of Appeals for the First Circuit has found a plaintiff’s allegations of shareholder fraud were not “objectively reasonable” under the whistleblower protection provision of the Sarbanes-Oxley Act (“SOX” or “Act”), and so has affirmed summary judgment for the employer. Day v. Staples, Inc., No. 08-1689 (1st Cir., Feb. 9, 2009). The standard by which a plaintiff’s reasonable belief of fraudulent activity is measured under SOX had not previously been addressed by the First Circuit. The Court also found the employer’s explanation to the employee of the business reasons behind the complained of issues further decreased the reasonableness of the plaintiff’s belief of fraudulent activity. The First Circuit has jurisdiction over Maine, Massachusetts, New Hampshire, Puerto Rico, and Rhode Island.

The plaintiff, Kevin Day, was offered an entry level position with Staples as a Reverse Logistics Analyst shortly before his graduation from the University of Massachusetts-Amherst. Day’s duties included analyzing open customer returns for assigned warehouse locations and addressing courier issues with returns. Day held this position for less than three months. During this time, Day made numerous complaints to the company about what he believed to be unlawful and unethical practices he observed in the Reverse Logistics Department. Specifically, Day complained that Reverse Logistics issued credits to customers without first receiving proper documentation as required by company policy. Day also alleged that the company knowingly withheld money from contract customers by under-issuing credits over $25. Day alleged these practices raised various risks, including overpayment of credits and overstating revenues. Finally, Day claimed that the Reverse Logistics’ practice of cancelling and reissuing pick-up orders could permit couriers to overbill the company and thereby reduce the company’s profits.

Day had several meetings with his supervisor and other members of the company’s upper management regarding his concerns. The company conducted an investigation and ultimately concluded that the issues Day raised had been discussed previously internally and alternative methods had been rejected. In a meeting that included the company’s Director of Planning, who had helped create the Reverse Logistics Department, Day was advised that the company had determined that the methods currently used by the Department provided the greatest benefits to the company, such as increased efficiency and the promotion of customer goodwill. At the conclusion of this meeting, however, Day insisted that his methods were preferable to those the company had adopted. The Director of Planning believed that as this was at least the fourth meeting Day had with upper management, he should have had a greater appreciation for the Reverse Logistics processes. Due to Day’s stubbornness, as well as complaints regarding his job performance – including his recommending a competitor’s product to a customer – the company decided to terminate Day’s employment.

Day then filed a Sarbanes-Oxley complaint with the Occupational Safety and Health Administration (“OSHA”). Following its investigation, OSHA concluded that Day’s concerns did not rise to the level of a SOX violation because they were nothing more than a disagreement with management about internal procedures and did not involve intentional deceit of shareholders.

In accordance with the SOX regulations, 180 days from the filing of his initial SOX complaint, Day requested a dismissal of his appeal of OSHA’s decision and filed a complaint in District Court. The District Court granted the company’s motion for summary judgment, finding as a matter of law that while Day communicated his concerns to the company with adequate particularity, he did not have a reasonable belief of fraud against shareholders, because he lacked the knowledge, training and experience to form such a belief.

Day appealed the District Court’s decision to the First Circuit. The appellate court found Day’s claim turned on what constitutes a reasonable belief of securities fraud under the SOX whistleblower provision. Based upon the SOX regulations and existing case law from other jurisdictions, the First Circuit held that the term “reasonable belief” under SOX has both a subjective and an objective component. It found Day had a subjectively reasonable belief because he actually believed the conduct he complained of constituted shareholder fraud. It then examined whether Day could have had an objectively reasonable belief.

The Court began its analysis by noting that an essential element of a fraud claim is the existence of a misrepresentation or deceit. Moreover, to establish shareholder fraud, a plaintiff must show at least the basic elements of a claim of securities fraud: a material misrepresentation or omission, scienter (knowledge), loss and a causal connection between the misrepresentation or omission and the loss. The Court found the issues Day complained of did not establish either fraud, in general, or securities fraud, in particular. At most, Day had complained about internal tracking systems which were not reported to shareholders or that the company’s practices did not maximize shareholder profits. It found such complaints of corporate inefficiency and “needless loss of revenue” were not intended to be covered by the SOX whistleblower provision.

The Court also rejected Day’s attempts to connect his allegations to violations of generally accepted accounting principles (“GAAP”). It held that generalized allegations of accounting inaccuracy are insufficient to establish a reasonable belief in a violation of GAAP, much less a reasonable belief of fraud against shareholders. Moreover, merely stating conclusory allegations that a company’s accounting records are not in compliance with GAAP would not, in and of itself, demonstrate liability under Securities and Exchange Commission rules or regulations.

Significantly, the Court found that the company’s explanations to Day were relevant in determining the objective reasonableness of Day’s belief of shareholder fraud. It agreed with the District Court’s conclusion that even assuming Day’s complaints were initially reasonable, they ceased to be reasonable after the company explained the rationale for its returns processes and assured Day that no fraud was being committed. The Court concluded that Day’s beliefs “were not initially reasonable as beliefs in shareholder fraud and they became less reasonable as he was given explanations.”

This decision shows how open communication at the time employee concerns are raised can help in defeating an employee’s SOX claim of a reasonable belief of improper or fraudulent conduct. Jackson Lewis attorneys are available to answer your inquiries regarding this decision and assist employers in this and other areas of workplace law.