The U.S. District Court for the Central District of California ruled that a SOX whistleblower complaint survived a Rule 12(b)(6) challenge on “reasonable belief” grounds and found that complaints of potential future violations of the law may amount to protected activity. Zulfer v. Playboy Enterprises, Inc., No. 12-cv-08263 (C.D. Cal. Feb. 11, 2013). This ruling (styled as “tentative”) is in line with a few other district court rulings, but is at odds with a seminal Fourth Circuit decision and other district court cases.
Defendant Playboy Enterprises, Inc. (Company) employed Plaintiff Catherine Zulfer for approximately 30 years in various accounting positions. During the last 18 months of her employment, she served as senior vice president and corporate controller. According to Plaintiff, in late 2010, the CFO instructed her to accrue $1M in discretionary bonuses for certain corporate executives without approval by the Board of Directors (Board). And the CFO allegedly demanded that she accrue $1M in bonuses again in January 2011. Plaintiff claims she refused to comply with these alleged directives based on her purported belief that the Board was required to vote on and approve of discretionary bonuses before they were accrued or paid. Plaintiff reported the request to both the General Counsel and outside counsel. Her employment was subsequently terminated.
Plaintiff then filed suit under Section 806 of SOX, alleging she was discharged in retaliation for refusing to circumvent internal controls in violation of federal securities laws. The Company moved to dismiss pursuant to Rule 12(b)(6), asserting she lacked a reasonable belief because she did not and could not allege that any bonuses were actually accrued or paid without Board approval — i.e., her complaint was based on potential future violations of the law, not ongoing or past violations — and her belief that accruing bonuses without Board approval violated federal securities laws is objectively unreasonable in any event. The Company further argued that Plaintiff failed to allege a violation of one of the fraud or securities laws set forth in Section 806; the Company asserted that violations of statutory laws, such as the Securities and Exchange Act — and the internal controls requirements therein — do not constitute violations of “any rule or regulation of the SEC,” as that phrase is used in Section 806. Also, the Company argued that Plaintiff failed to plead “fraud on shareholders” because she did not allege the accrual requests would have resulted in a misrepresentation to shareholders.
The Court’s Ruling
The Court refused to dismiss Plaintiff’s SOX claim at this stage. As an initial matter, it gave deference to Plaintiff’s experience in accounting in general, and in the Company’s accounting department in particular; it found her experience sufficient to support her alleged belief that there were attempts to circumvent internal controls. It then concluded that Plaintiff may have engaged in protected activity by complaining of a purported future violation of the law, recognizing the dearth of applicable Ninth Circuit decisions, and relying on district court decisions out of the Northern District of Georgia and the Northern District of Illinois. In doing so, the Court diverged from a recent decision from the Eastern District of Pennsylvania and, significantly, from the Fourth Circuit’s seminal decision in Livingston v. Wyeth, Inc., 520 F.3d 344 (4th Cir. 2008). In Livingston, the Fourth Circuit stated that Section 806
requires [a plaintiff] to have held a reasonable belief about an existing violation, inasmuch as the violation requirement is stated in the present tense: a plaintiff’s complaint must be ‘regarding any conduct which he reasonably believes constitutes a violation’ of the relevant laws.
Id. at 352 (emphasis added).
Also, the Court concluded that Plaintiff adequately stated a claim by pleading that she had a reasonable belief that the Company violated internal controls required by the Securities and Exchange Act. It was comfortable concluding that Board approval of large bonuses to executives was an “internal control,” Plaintiff reasonably believed (for pleading purposes) that the Company circumvented those controls, and such circumvention implicates SEC rules and regulations. In addition, the Court concluded Plaintiff failed to allege shareholder fraud, highlighting the absence of any allegation that Plaintiff believed the accrual requests would have resulted in the communication of a specific misrepresentation to shareholders, or that particular individuals intended to communicate a misrepresentation to shareholders. In this regard, it stated:
While it may not be necessary to plead scienter to show that an employee has a reasonable belief that her disclosure was related to a violation of an SEC rule or regulation, the Ninth Circuit has clearly stated that allegations of scienter are required to demonstrate that an employee has a reasonable belief that shareholder fraud has taken place.
This is the first decision within the Ninth Circuit to address whether reporting a potential future violation of the law can constitute protected activity under Section 806 of SOX. Employers may be rightly concerned that this ruling could open the floodgates to highly speculative claims where purported violations of the law have not occurred and may never actually occur. Will the Ninth Circuit follow suit or join the Fourth Circuit? Stay tuned …