The SEC Clears the Path for Investors as Potential Whistleblowers: Greater Scrutiny May Be on the Horizon During Regulatory Examinations

November 21, 2019

Ira Kustin, John P. Nowak, Michael Spafford, Amanda Pober & Daren Stanaway

For the first time, the SEC recently applied Rule 21F-17 of the Securities Exchange Act of 1934 (“Exchange Act”) outside the context of the traditional employer/employee relationship. Rule 21F-17 is a whistleblower protection that prohibits interference with an individual’s ability to communicate with the SEC about potential securities violations. Since Rule 21F-17’s adoption in August 2011, the SEC has enforced the rule only in the context of an employer/employee relationship—that is, where an employer allegedly interfered with an employee’s ability to speak with the SEC. That enforcement approach ended earlier this month when the SEC charged Collectors Café with violating the rule by allegedly interfering with an investor’s ability to communicate with the SEC about possible misconduct at the company.

This action is likely to lead to greater scrutiny of financial institutions during SEC regulatory examinations. Rule 21F-17 has been on the radar of the Office of Compliance Inspections and Examinations (“OCIE”) for quite some time. In fact, in 2016, OCIE issued a risk alert indicating that it had begun to review employee agreements and compliance documents during regulatory examinations in an effort to determine whether those documents comply with Rule 21F-17. Since that time, a number of OCIE examinations have included employee severance agreements and employment policies within the scope of the examiners’ review. In light of the recent Collectors Café action, we now expect OCIE to expand the scope of its review regarding Rule 21F-17 to include not only employer/employee issues, but also investor communications and investor agreements. As a result, investment advisers, broker dealers, and their compliance personnel are encouraged to consider certain practical takeaways identified below and incorporate investor agreements into their annual review for Rule 21F-17 compliance.

Background to Rule 21F-17

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 amended the Exchange Act to, among other things, provide certain incentives and protections to securities whistleblowers. To implement Section 21F of the Exchange Act, one of the new whistleblower protections, the SEC adopted Rule 21F-17, which provides that “no person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.”[1]

Although the rule purportedly covers all classifications of potential whistleblowers (e.g., current and former employees, counterparties, and third-party market participants), the SEC historically has pursued enforcement actions only against employers for allegedly interfering with an employee’s ability to communicate with the SEC. For example, the SEC filed separate actions against BlueLinx Holdings Inc. and Health Net, Inc. on the theory that language in the entities’ severance agreements impeded the ability of former employees to communicate with the SEC.[2]

The SEC alleged, among other things, that the agreements improperly (1) prohibited employees from disclosing confidential information unless compelled by law; (2) required the employees to provide notice to their employer of any compulsory request to disclose confidential information; and (3) obligated employees to waive their right to any whistleblower reward.

Notably, the SEC has taken the view that it is not required to demonstrate that an entity actually impeded one’s ability to communicate, or even threatened to enforce any restrictive provision in an employment agreement. According to the SEC, a violation may occur simply because language in an agreement has the potential to impede communications between an employee and the SEC.

In response to those enforcement actions, OCIE issued a National Exam Program Risk Alert in 2016 confirming the SEC’s commitment to identifying potentially restrictive language in employment agreements that might violate Rule 21F-17. OCIE announced that it was reviewing, among other things, compliance manuals, codes of ethics, and severance and employment agreements of registered advisers and broker dealers to determine whether they raise concerns under the rule. By way of guidance, OCIE identified certain provisions in employee agreements that might contribute to violations of the rule, including terms that (1) prohibit any disclosure of confidential information without any exception for voluntary communications with the SEC; (2) require an employee to provide notice or obtain consent from the employer prior to disclosing confidential information; or (3) permit disclosures of confidential information only as required by law.[3]

The Collectors Café SEC Enforcement Action

In the Collectors Café action, the SEC amended its complaint against Collectors Café to include a claim that the company violated Rule 21F-17. Although the gravamen of the amended complaint related to allegations of misappropriation of investor funds and misrepresentations, the amended complaint also included a Rule 21F-17 claim alleging that Collectors Café offered to repurchase the shares of certain investors who had raised concerns to the company about their investments. In connection with the repurchase, the company and the investors allegedly entered into a stock purchase agreement that included a representation that the investors have not, and will not, contact any third-party for the purpose of commencing or otherwise promoting investigation or other action, including any governmental or administrative agencies. The representation also specifically noted that the terms were not designed to “accomplish any improper purpose, but rather, [were] included as [a] material consideration in light of the time and expense which could be incurred by all parties, if [an] investigation or other third-party action were to arise. . . .”[4]

Despite the fact that the provision was a negotiated term, material to the parties, the SEC found this language to violate Rule 21F-17. As with prior SEC actions, the SEC did not allege that these investors were in fact impeded from speaking with the SEC, or that the company had even threatened to enforce the terms of the agreement against them.[5] The mere inclusion of this term in the parties’ stock purchase agreement was sufficient for the SEC to allege a Rule 21F-17 violation.

Practical Takeaways

The SEC is firmly committed to protecting potential whistleblowers and removing any impediment that might stand between a potential whistleblower and the SEC. Given that the Collectors Café enforcement action represents the first time the SEC has enforced Rule 21F-17 outside the employer/employee context, the OCIE likely will soon incorporate investor communications and contractual arrangements into examination reviews in an effort to identify language that might touch upon the rule.

Accordingly, legal and compliance personnel at investment advisers and broker dealers should include investor communications and contractual arrangements in their annual review for Rule 21F-17 compliance. Specifically, compliance personnel should consider whether any current or historical investor agreements (including limited partnership agreements, subscription documentation, and any settlement-related agreements) or investor communications allow for the following:

Limiting an investor’s ability to collect a whistleblower bounty;
Requiring notification, or consent, prior to disclosing confidential information, without allowing for an exception for communications with the SEC relating to securities laws violations; and
Prohibiting disclosures of confidential information unless required by law.

Identifying potential problematic language is a key first step in light of the SEC’s position that it does not need to demonstrate actual interference or threatening behavior—language that has the potential to impede is enough.

[1] 17 C.F.R. § 240.21F-17(a).

[2] See In re BlueLinx Holdings Inc., SEC Release No. 78528, Admin. Proc. File No. 3-17371, 2016 WL 4363864 (Aug. 10, 2016); In re Health Net, Inc., SEC Release No. 78590, Admin. Proc. File No. 3-17396, 2016 WL 4474755 (Aug. 16, 2016).

[3] National Exam Program Risk Alert, Office of Compliance Inspections and Examinations of the Securities and Exchange Commission, Examining Whistleblower Rule Compliance (Oct. 24, 2016), https://www.sec.gov/ocie/announcement/ocie-2016-risk-alert-examiningwhistleblower-rule-compliance.pdf.

[4] SEC v. Collector’s Coffee, Inc., No. 19-cv-04355, ECF No. 134, at 28 (S.D.N.Y., filed Nov. 4, 2019), https://www.sec.gov/litigation/complaints/2019/comp-pr2019-227.pdf.

[5] In a separate set of allegations, the SEC claimed that Collectors Café entered into a settlement agreement with a different set of investors, and that the terms of the agreement prohibited the investors from initiating communications with regulatory agencies, including the SEC. According to the SEC, the company later believed that those investors communicated with the SEC and filed a lawsuit on the theory that the investors had breached their agreement with the company.

Click here for a PDF of the full text