Playboy Financial Whistleblower Allowed to Proceed with SOX Claim

Catherine Zulfer, a former employee of Playboy Enterprises, will be allowed to proceed with her case against Playboy alleging that the company violated the whistleblower-protection provisions of the Sarbanes-Oxley Act of 2002 (“SOX”) when it retaliated against her for refusing to participate in, and ultimately reporting, what she believed was fraud against Playboy shareholders. On April 24, 2013, the U.S. District Court for the Central District of California ruled that Zulfer had adequately alleged that she had engaged in “protected activity” under SOX, confirming its February 11, 2013 tentative ruling we wrote about earlier this year.

Zulfer alleged that Christoph Pachler, Playboy’s Chief Financial Officer (“CFO”), instructed her to accrue one million dollars in discretionary bonuses for various corporate executives for the third quarter of 2010, without first receiving approval from Playboy’s Board of Directors. According to Zulfer, during her time at Playboy the Board had always approved discretionary bonuses before they were accrued or paid. In Zulfer’s complaint, she asserted that she believed that accruing or paying the bonuses without Board approval would be “dishonest to shareholders and violate Playboy governance and GAAP,” and she was concerned that Pachler and the Chief Executive Officer (“CEO”), Scott Flanders, were attempting to embezzle the money. Accordingly, Zulfer repeatedly refused Pachler’s requests to accrue the bonuses, and informed him that she would not do so until she received Board approval. Zulfer then repeated Pachler’s requests to accrue bonuses without Board approval to Playboy’s General Counsel and outside counsel for the Securities and Exchange Commission (“SEC”).

According to Zulfer’s complaint, almost immediately after she reported the matter, Pachler began to retaliate against her by ostracizing her, excluding her from meetings and discussions, withholding crucial information she needed to carry out her corporate accounting responsibilities, and eliminating corporate accounting staff. This retaliation continued until Zulfer was terminated on December 31, 2011, in what Playboy described as a layoff.

The court first found that the fact that the illegal activity Zulfer refused to participate in and ultimately reported was never actually carried out was not fatal to Zulfer’s claim. The court found that reporting an attempt to commit a SOX violation still constituted protected activity under SOX’s Section 806, which prohibits employer retaliation against financial whistleblowers.

The court next rejected Playboy’s argument that Zulfer did not successfully allege a SOX violation because she failed to allege scienter on the part of Pachler or Flanders. Noting that SOX protects employees from retaliation for reporting violations of “any rule of regulation of the SEC,” the court found that Zulfer successfully alleged SOX protected activity by reporting Playboy’s attempts to circumvent internal accounting controls in violation of 15 U.S.C. § 78m(b)(5).

Unfortunately, constrained by the Ninth Circuit’s 2009 decision in Van Asdale v. Int’l Game Tech., the court did dismiss the portion of Zulfer’s complaint that alleged that Playboy had engaged in shareholder fraud. In Van Asdale, the Ninth Circuit held that “[t]o have an objectively reasonable belief there has been shareholder fraud, the complaining employee’s theory of such fraud must at least approximate the basic elements of a claim of securities fraud.” The court defined those elements as “(1) a material misrepresentation or omission of fact, (2) scienter, (3) connected to the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss.” In this case, the court determined that because Zulfer failed to allege that the bonus accrual “would have led to the inclusion of the bonuses in published financial statements disseminated to shareholders prior to Board approval of the bonuses,” Zulfer had failed to allege a misrepresentation to shareholders. The court further determined that Zulfer had failed to allege scienter. Accordingly, while Zulfer’s SOX retaliation claim will survive, it will be constrained confined to her allegations of violations of SEC rules and regulations.

While the district court in this case had little choice but to apply precedent from the Ninth Circuit, we hope that the Ninth Circuit will soon join the Third Circuit in doing away with the requirement that a plaintiff’s protected reporting activity must “approximate the basic elements of a claim of securities fraud.” In its March 2013 decision in Wiest v. Lynch, the Third Circuit adopted the 2011 decision by the Administrative Review Board (“ARB”) of the Department of Labor in Sylvester v. Paraxel, in which the ARB held that although “[s]ome courts have misinterpreted [Platone’s] analysis as a requirement that SOX complainants must allege elements of a securities fraud claim for protection . . . a complainant can engage in protected activity under Section 806 even if he or she fails to allege or prove materiality, scienter, reliance, economic loss, or loss causation.” The Third Circuit found the ARB’s interpretation to be reasonable because “there is nothing in the statutory text that suggests that a complainant’s communications must assert the elements of fraud in order to express a reasonable belief that his or her employer is violating a provision listed in Section 806.”