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.

Background

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.

Implications

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 …

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Photo of Steven J. Pearlman Steven J. Pearlman

Steven J. Pearlman is a partner in the Labor & Employment Law Department and Co-Head of the Whistleblowing & Retaliation Group and the Restrictive Covenants, Trade Secrets & Unfair Competition Group.

Steven’s practice covers the full spectrum of employment law, with a particular…

Steven J. Pearlman is a partner in the Labor & Employment Law Department and Co-Head of the Whistleblowing & Retaliation Group and the Restrictive Covenants, Trade Secrets & Unfair Competition Group.

Steven’s practice covers the full spectrum of employment law, with a particular focus on defending companies against claims of employment discrimination, retaliation and harassment; whistleblower retaliation; restrictive covenant violations; theft of trade secrets; and wage-and-hour violations. He has successfully tried cases in multiple jurisdictions, and defended one of the largest Illinois-only class actions in the history of the U.S. District Court for the Northern District of Illinois. He also secured one of only a few ex parte seizures orders that have been issued under the Defend Trade Secrets Act, and obtained a world-wide injunction in federal litigation against a high-level executive who jumped ship to a competitor.

Reporting to boards of directors, their audit committees, CEOs and in-house counsel, Steven conducts sensitive investigations and has testified in federal court. His investigations have involved complaints of sexual harassment involving C-suite officers; systemic violations of employment laws and company policies; and fraud, compliance failures and unethical conduct.

Steven was recognized as Lawyer of the Year for Chicago Labor & Employment Litigation in the 2023 edition of The Best Lawyers in America. He is a Fellow of the College of Labor and Employment Lawyers.  Chambers describes Steven as an “outstanding lawyer” who is “very sharp and very responsive,” a “strong advocate,” and an “expert in his field.” Steven was 1 of 12 individuals selected by Compliance Week as a “Top Mind.” Earlier in his career, he was 1 of 5 U.S. lawyers selected by Law360 as a “Rising Star Under 40” in the area of employment law and 1 of “40 Illinois Attorneys Under Forty to Watch” selected by Law Bulletin Publishing Company. Steven is a Burton Award Winner (U.S. Library of Congress) for “Distinguished Legal Writing.”

Steven has served on Law360’s Employment Editorial Advisory Board and is a Contributor to Forbes.com. He has appeared on Bloomberg News (television and radio) and Yahoo! Finance, and is regularly quoted in leading publications such as The Wall Street Journal.

The U.S. Chamber of Commerce has engaged Steven to serve as lead counsel on amicus briefs to the U.S. Supreme Court and federal circuit courts of appeal. He was appointed to serve as a Special Assistant Attorney General for the State of Illinois in employment litigation matters. He has presented with the Solicitor of the DOL, the Acting Chair of the EEOC, an EEOC Commissioner, Legal Counsel to the EEOC and heads of the SEC, CFTC and OSHA whistleblower programs. He is also a member of the Sedona Conference, focusing on trade secret matters.

Photo of Noa Baddish Noa Baddish

Noa M. Baddish is a senior counsel in the Labor & Employment Law Department. She is a member of the Sports, Employment Litigation & Arbitration, Class and Collective Action, Wage & Hour and Whistleblower & Retaliation Practice Groups.

Noa’s practice concentrates on all…

Noa M. Baddish is a senior counsel in the Labor & Employment Law Department. She is a member of the Sports, Employment Litigation & Arbitration, Class and Collective Action, Wage & Hour and Whistleblower & Retaliation Practice Groups.

Noa’s practice concentrates on all aspects of labor and employment law. Her employment litigation practice in state and federal courts includes class and collective actions and defending claims of discrimination, harassment, breach of contract and violations of wage and hour laws. Noa represents Major League Baseball and its clubs in an ongoing litigation brought by current and former minor league players who allege minimum wage and overtime violations. In addition, Noa has represented clients in the media and entertainment and fashion industries in lawsuits brought by unpaid interns in wage and hour disputes.

Noa also provides significant assistance on counseling matters on a wide array of issues for clients in various industries, including, but not limited to, sports, law firms, financial institutions, media and fashion.

Noa has been recognized as a Rising Star by New York Super Lawyers since 2015. She has authored and contributed to several articles and newsletters on employment and labor topics, including “State Whistleblowing Laws Provide Whopping Verdicts,” New York Law Journal (January 2014). Noa is also a frequent contributor to the Firm’s Whistleblower Defense blog.

Previously served as Assistant General Counsel to the New York City Mayor’s Office of Labor Relations, Noa defended the Mayor and City agencies against both employee grievances at arbitration and improper practice petitions before the Board of Collective Bargaining. Prior to that, she was a Law Clerk to Judge Ellen L. Koblitz of the Appellate Division of the New Jersey Superior Court.

While in law school, Noa served on the Executive Board as notes and articles editor of the Fordham Urban Law Journal.