As often happens in the rulemaking process, the devil is in the details. This is certainly true when considering the Securities and Exchange Commission's proposed "whistleblower" program, mandated by Congress in the Dodd-Frank Wall Street Reform and Consumer Protection Act.

There are a number of critical questions raised by the SEC's proposed program: How will financing the fund for paying whistleblowers actually play out? Will only the institution producing the whistleblower complaint pay into this fund? Will those enforcement actions stemming from all whistleblower complaints pay into the fund? Or will every institution that is sanctioned by the SEC pay, even if no whistleblower was involved? The likely, if surprising, answer is that every institution will pay. That's because one particular section of the proposed whistleblower program could have the effect of creating a potential hidden tax on monetary sanctions imposed by the SEC in every action that it brings.

When Congress enacted the Dodd-Frank Act, it added Section 21F to the Securities Exchange Act of 1934, requiring the SEC to establish the whistleblower program. In response, the SEC proposed Regulation 21F, a collection of 16 rules designed to provide individuals (whistleblowers) with an opportunity to receive large cash awards for providing information to the SEC about possible securities law violations. Awards will be paid if the whistleblower's information leads to the successful enforcement of a judicial or administrative action (or related action) that results in monetary sanctions exceeding $1 million.

Most of Regulation 21F and the 181-page SEC release proposing it focus on defining who qualifies as a whistleblower, how awards are paid, the kinds of information that will lead to an award and how to report information to the SEC. But perhaps the most significant part of the proposed regime is Proposed Rule 21F-13, which sets out the procedures for payment of whistleblower awards.

Proposed Rule 21F-13(a) simply provides that awards must be paid from the "Securities and Exchange Commission Investor Protection Fund," or the whistleblower fund. Rule 21F-13(d) goes on to set the rules governing the timing of payments if "there are insufficient amounts available in the Whistleblower Fund to pay the entire amount of an award payment within a reasonable period of time."

This latter point is easy to overlook on a quick reading of the lengthy proposing release, but it poses what may be one of the most significant issues created by the proposed rules -- that potential hidden tax on monetary sanctions imposed by the SEC in every action that it brings.

How could the whistleblower fund ever have less than enough to pay a whistleblower? Because of the way that it is funded.

Newly added Exchange Act Section 21F(g) establishes and governs the fund. Section 21F(g)(3)(A) provides that there will be deposited into or credited to the whistleblower fund an amount equal to "any monetary sanction collected by the Commission in any judicial or administrative action brought under the securities laws that is not added to a disgorgement fund or other fund under Section 308 of the Sarbanes-Oxley Act ... or otherwise distributed to victims of a violation of the securities laws, or the rules and regulations thereunder, underlying such action." Thus, while the whistleblower fund will be funded with monies from all relevant SEC securities law enforcement actions, not just those involving whistleblowers, only the amount of a monetary sanction that is not added to a disgorgement fund or otherwise given to victims is actually added to the whistleblower fund. Moreover, the SEC cannot take into consideration the amount of money in the whistleblower fund when determining how much to give the whistleblower. Section 21F(c)(1)(B)(ii) explicitly forbids that.

So, if a whistleblower provides original information to the SEC that leads to a $100 million sanction against a company, and $90 million of that amount is distributed to the victims of the violations, there will only be $10 million available to be deposited in the whistleblower fund. But if the SEC determines that, based on the importance of the information provided by the whistleblower, a 30% award is appropriate, there will be a $20 million shortfall, and the balance owed to the whistleblower must come from the total monetary sanctions collected in the action precipitated by the whistleblower, meaning that the whistleblower takes precedence over the victims. In essence, the whistleblower receives an award paid for out of the victims' pockets. The SEC recognizes that this creates tension between the interests of whistleblowers and victims, and in the proposing release, it requested comments addressing the significance of the tension, the likelihood that the situation would arise and whether there is anything that the SEC can or should do to mitigate this tension.

Dodd-Frank makes one thing clear: Whistleblowers must be paid.

The concern, of course, is that the SEC will have to get the money somewhere and, because it possesses wide discretion in the assessment of monetary sanctions, could seek to resolve the tension between whistleblowers and victims by generally assessing larger sanctions against all institutions in order to keep the whistleblower fund solvent.

Although this would allow the SEC to continue making distributions to victims of securities law violations, while maintaining enough excess sanction money to satisfy large whistleblower awards, it would be unfair because it would force companies to pay larger sanctions not because of the conduct or offense, but solely to keep the whistleblower fund adequately financed. This would be particularly unfair to a company that is facing sanctions stemming from an action that doesn't involve a whistleblower. Because the whistleblower fund receives the excess sanctions collected by the SEC in any judicial or administrative action that it brings under the securities laws, the SEC will have an incentive to increase sanctions in every action, regardless of whether it is based on information provided by a whistleblower. Companies may end up paying higher sanction amounts to help pay other companies' whistleblowers.

In essence, Exchange Act Section 21F(g)(3) and Proposed Rule 21F-13 may provide the SEC with an opportunity to institute a "whistleblower tax." And while, as explained above, this would be unfair to the sanctioned parties, it could be counterproductive in a much larger sense as well. Given that many SEC enforcement matters are resolved through settlement, increasing the demanded amount is likely to reduce the appetite of many companies to accept such settlements, forcing the parties to engage in protracted proceedings to resolve the matters. This would be unfortunate. The SEC must make every effort to avoid allowing the level of the whistleblower fund to become a factor in determining the amount of sanctions to seek in any action, and to avoid any perception that it is doing so. Otherwise, companies will begin to view enhanced sanctions as a hidden whistleblower tax and more strenuously resist settling such matters.

So the question really is: Will every company that is sanctioned by the SEC potentially be paying to finance the whistleblower fund, even if there was no whistleblower in its case? The answer appears to be yes -- if the proposed rules are adopted as currently written, everyone will pay.

Christine Edwards is a partner in the Chicago office of Winston & Strawn LLP's corporate practice group. Edward Johnsen is a partner in the firm's financial services practice group, resident in New York. Jerry Loeser is of counsel in the firm's Chicago office, his practice focuses on banking regulation. Associate Michael Skokna contributed to the preparation of this article.