Publications: Labor Department SOX It to Privately-Held “Turnaround Specialist”

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Sarbanes-Oxley casts a broad shadow over corporate America that just keeps growing and growing. A Labor Department administrative law judge recently found a privately-held “turnaround specialist,” liable with its bankrupt, publicly-held client under the Act’s whistleblower provisions. The administrative law judge (“ALJ”) did so despite the fact that the turnaround specialist, AP Services (“AP”), never employed the alleged whistle-blower, who was formerly an in-house attorney for its client, DVI Financial Services (“DVI”). The attorney, Sheila Kalkunte, was discharged while AP provided crisis management and restructuring services to DVI. She claimed, and the ALJ found, that she was fired in retaliation for reporting financial improprieties at DVI and questioning the progress of the investigation of her allegations. See Kalkunte v. DVI Financial Services, Inc., DOL ALJ, No. 2004-SOX-0056, 7/18/05.

The Kalkunte decision’s finding of retaliation against the employer, DVI, was not nearly as noteworthy as its conclusion that AP, a private company, was also liable under Sarbanes-Oxley despite the Act’s principal objective of eradicating accounting fraud in publicly-traded companies such as Enron. (Sarbanes-Oxley’s opening subtitle characterizes it as an act to “protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws...”)

In the Kalkunte case, DVI’s independent auditors abruptly resigned and the company’s stock began a dramatic decline. The SEC, which had already questioned previous DVI financial disclosures, began an inquiry into the auditor’s resignation. Kalkunte reported her allegations of improprieties to the company’s president and audit committee, which immediately appointed outside counsel to investigate. Mere days after the investigation began, DVI declared bankruptcy and AP was appointed receiver.

DVI began a reduction in force soon after its bankruptcy, but did not immediately discharge Kalkunte. A few weeks later, however, after a tense meeting with AP officials during which Kalkunte questioned the status of the investigation into her allegations, she was discharged, allegedly as part of a DVI reduction in force.

The ALJ found that the short interval between Kalkunte’s complaints and her termination was “strong evidence of [a] nexus” between her whistle-blowing and her firing, holding both DVI and its turnaround specialist, AP, liable for violating Sarbanes-Oxley. While there was no dispute that DVI was a proper target of Kalkunte’s allegations, the ALJ made short work of AP’s defense that it could not be liable under Sarbanes-Oxley because it was indisputably a privately-held company that had never employed Kalkunte. The ALJ rejected AP’s argument that Sarbanes-Oxley’s plain language extended jurisdiction only to companies that either (1) had securities registered under section 12 of the Securities and Exchange Act of 1934 or (2) were required to file reports under section 15(d) of the same act. See 18 U.S.C. 1514A(a). He emphasized, instead, that Sarbanes-Oxley’s whistleblower provisions state that:

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 [that Act], or any officer, employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in any other manor discriminate against an employee” because the employee provides information regarding a violation of any SEC rule or regulation or any federal law relating to fraud against shareholders. See 18 U.S.C. § 1514(a)(1) (emphasis added).

This statutory language prompted the ALJ to find that the privately-held AP was, by virtue of its agreement with DVI, its “subcontractor and agent” and/or its “trustee in bankruptcy,” and thus subject to Sarbanes-Oxley whistleblower liability. DVI entered into a contract with AP during its financial crisis, thereby agreeing to furnish employees to navigate DVI through bankruptcy. In addition, AP’s principal became DVI’s temporary president and CEO. Significantly, Kalkunte alleged that the interim president and CEO was her main antagonist and instrumental in her discharge.

In addition to finding AP an “agent” and “subcontractor” of DVI for Sarbanes-Oxley purposes, the ALJ relied on previous decisions holding that Congress must have intended for Sarbanes-Oxley’s whistleblower provisions to protect the employees of privately-held companies that were also subsidiaries of a publicly-traded company. See, Morefield v. Exelon Services, Inc. et al, 2004-SOX-00002 (ALJ Order Jan. 28, 2004). He also found that AP assumed respondeat superior liability for DVI’s actions.

The Kalkunte case is a cautionary tale for privately-held companies working in concert with publicly-traded companies as contractors, subcontractors or agents, and for the private subsidiary companies of publicly-traded parents. Such private companies clearly face potential liability exposure under Sarbanes-Oxley’s whistleblower protections, and the adverse employment actions they take or participate in taking against the whistle-blowing employees of public companies carry significant risks under Sarbanes-Oxley. Those risks should be carefully assessed and proactively contained through judicious management aimed at avoiding Sarbanes-Oxley violations and liability.