A recent ruling from a federal judge marks the first time any court in the country has found that whistleblower protections apply to those working in the mutual fund industry, according to several lawyers familiar with the case.

In Lawson v. FMR LLC, et al., U.S. District Court Judge Douglas P. Woodlock in Boston ruled that two investment advisers were protected under the Sarbanes-Oxley Act even though they were not employed by a public company.

“The case stands for the proposition that employees of companies, whether they are contractors or subcontractors, who are reporting potential fraud against investors and the public companies of the mutual funds, are covered,” said Indira Talwani, who represented one of the plaintiffs in the case. “That is what [SOX] was designed to do, and the judge made clear that people can take that risk and report fraud when they see it.”

The defendant, Fidelity Investments, argued that when Congress enacted SOX in 2002, it never intended for the statute to apply to investment advisers and other affiliates working for privately held companies.

But Woodlock disagreed in a 58-page ruling, reversing a decision rendered by an administrative law judge in 2008.

“For the goals of SOX to be met, contractors and subcontractors, when performing tasks essential to insuring that no fraud is committed against shareholders, must not be permitted to retaliate against whistleblowers,” he wrote. “If [the statute] only protected employees of public companies, then any reporting of fraud involving a mutual fund’s shareholders would go unprotected, for the very simple reason that no ‘employee’ exists for this particular type of public company.”

A call to the SEC

Talwani, who practices in Boston, called the ruling “a huge decision” that likely will be cited by lawyers in court and administrative hearings.

“The industry has been contending that if you have your money with an entity like Fidelity, you have to rely on their word for what happens, even though there’s no guarantee the employees handling these issues could dare to speak up,” she said. “The judge clearly rejected Fidelity’s position that the case involved private companies and, therefore, that any reporting of fraud that could affect shareholders was not protected.”

Chip Muller of Providence, R.I., said whistleblower laws like SOX were passed because many jurisdictions, including Rhode Island, did not provide adequate coverage for employees fired in retaliation for speaking out against their employers.

“Prior to the passage of the law, there were some startling examples out there where courts had found that good people who were trying to prevent bad stuff from happening simply weren’t protected,” he said. “When the Legislature took a look at some of those cases, they said that something has to be fixed.”

While mutual funds are, without question, public companies, Mercer E. Bullard, a securities law professor who was retained as an expert by one of the plaintiffs in Lawson, said that problems have arisen because most mutual funds are run by only a board of directors.

“These [boards] operate by essentially contracting out all of the fund’s services,” he said. “So if the administrative law judge’s decision had remained, it would have effectively removed mutual funds from the coverage of the whistleblower provision.”
Though the decision is a major defeat for Fidelity, which has requested that the case be certified for an interlocutory appeal, legal questions raised in the matter remain unanswered, Bullard said.

“Everyone is better off with a uniform interpretation of the provision, and what needs to happen is the SEC needs to get off its fanny and tell us what it thinks the law is here,” he said. “The SEC is the expert; it is the one who is supposed to know. But instead it has sat by and done nothing.”

Bullard, who runs a fund shareholders’ advocacy organization and has previously met with the agency, said unless the SEC provides a clear answer, it is likely that courts will continue to issue conflicting rulings.

Fidelity’s counsel, Eugene Scalia, who practices in Washington, D.C., and is the son of U.S. Supreme Court Justice Antonin Scalia, declined to comment.

Alan D. Rose Sr. of Rose, Chinitz & Rose in Boston, who represented plaintiff Jonathan Zang in a related case, Zang v. Fidelity Management & Research Company, et al., also declined to comment.

Speaking out

Plaintiff Jackie Lawson worked as a Fidelity mutual-fund finance director from 1993 to 2007. At the end of her tenure, Lawson said, she was punished for reporting numerous problems at the company.

She accused Fidelity in part of improperly setting fund fees and failing to make necessary disclosures to the board of trustees. As a result of coming forward, she claimed, Fidelity denied her a promotion, gave her unfair performance ratings, verbally abused her and eventually forced her to resign.

In a separate matter, plaintiff Zang said Fidelity fired him after he complained that certain filings the company planned to submit to the SEC failed to accurately state portfolio-manager compensation plans.

Zang, who acted as a portfolio manager for several mutual funds, reportedly told his Fidelity superiors that its plan violated securities laws by improperly documenting how pay was calculated. In response, he said, Fidelity questioned his work performance and criticized him for voicing his concerns via e-mail. He alleged that he was fired in 2005 in retaliation for conduct covered by SOX.

Both plaintiffs lodged their complaints with the Occupational Safety & Health
Administration.

An administrative law judge found in Fidelity’s favor on Zang’s case after concluding, in part, that SOX did not apply.

The plaintiffs then filed complaints in U.S. District Court in Boston.

Passing the test

In reversing the ALJ, Woodlock said the statute was far from “pellucid.” He wrote that many courts have criticized SOX for being hastily passed and poorly drafted.

Although the statute protects employees, it does not directly state at which entity an individual must work, he said. While the statute’s legislative history is not helpful, the law was designed to prevent and punish corporate fraud involving public companies, Woodlock wrote.

He said the plaintiffs had sufficiently pleaded facts showing that Fidelity was either a contractor, subcontractor or agent of a publicly held investment company.
“If the Funds did not have investment advisers as their agents, the only activity that could take place on the Funds’ behalf would be actions taken by the Board of Trustees,” he said.

Because of the unique relationship that exists between mutual funds and their investment advisers, Woodlock said, Congress imposed a fiduciary duty on them with regard to compensation paid by the company.

“These concerns are especially strong for mutual funds, which have no employees and implement the funds’ management through contractual arrangements with investment advisers.”

The judge also rejected Fidelity’s claim that the ALJ ruling barred the plaintiffs from pursuing their complaints in federal court.