Financial regulators may find themselves fighting in court if they require whistleblowers seeking to expose corporate financial crimes to first report alleged violations to their employers' internal compliance programs.

A key component of the Dodd-Frank financial reform law's whistleblower provision is meant to encourage tips on wrongdoing by allowing individuals who expose crimes to share in any fines or penalties that are recovered. Business groups are urging the Securities and Exchange Commission and the Commodities Futures Trading Commission, both of which are writing rules to implement the Dodd-Frank's whistleblower provisions, to require that whistleblowers report misdeeds to their employers at the same time, if not before, they are reported to the government. The industry groups warn that allowing whistleblowers to go straight to the feds without telling their employers could stymie corporate compliance programs.

Watchdog groups, alarmed that the industry's arguments may be gaining traction, warn about the legality and wisdom of such a move. They are telling both the CFTC and the SEC that delaying government investigations would not only run counter to the spirit of Dodd-Frank and emasculate protections that the law provides whistleblowers, but violate federal law and potentially make it much more difficult to prosecute offenders.

"It does not fulfill the congressional intent to encourage whistleblowers and fully incentivize employees to risk their careers by doing the right thing," says Stephen M. Kohn, who heads Kohn, Kohn & Colapinto LLP, a law firm specializing in whistleblower cases, and executive director of the National Whistleblowers Center.

He says business groups are asking federal agencies to condone obstruction of justice. "What these companies are asking for constitutes an obstruction of justice, and we would immediately sue," he says. "If you see a crime, you report it to police. You don't go to the burglar and give them 90 days to investigate. There are no separate rules for white-collar crimes."

Tom Devine, legal director of the Government Accountability Project, says that his group warned the SEC that giving companies time to investigate allegations first sets a dangerous precedent.

"If an internal compliance program is credible, it is going to be a natural first choice [for a whistleblower]," he says. "But if it's not credible, requiring [a whistleblower to report to a company] could sabotage investigations by sharing information with wrongdoers, giving them the opportunity to destroy documents, intimidate or destroy witnesses and perfect defenses."

He says he's been involved in several cases where prosecutors have asked whistleblowers to wear a wire to gather information. "It's like giving [only] one side in the trial discovery. It's the equivalent of legalized obstruction of justice," he says. "It would be a handicap so severe, it would be a waste of time to proceed with enforcement."

The Dodd-Frank Act lets the SEC and the CFTC pay up to 30% of money the government gets as a result of prosecutions, whenever the government obtains more than $1 million.

In comments filed with the CFTC, business groups reiterated their concern that the size of the rewards could induce whistleblowers to skip corporate reporting systems. The business groups have asked that whistleblowers be required to report internally and that bonuses be limited to employees who have no role in corporate compliance procedures.

"We have no objection when the company itself is unwilling or unable to engage in self-policing," said the U.S. Chamber of Commerce in its comments to the agency. "Our most significant concern is that the rule does not do enough to preserve the important role served by corporate compliance programs."

The Investment Company Institute warned that the rule "will incentivize employees, particularly disgruntled employees, to report violations or suspected violations to the CFTC" rather than a mutual fund's internal compliance officials. The program "will be seen as a 'get rich quick scheme.' "

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Ira Teinowitz covers financial industry regulation for The Deal magazine.