In Case of First Impression, Federal Court Rules that Whistleblower Protections Extend to Company’s Outside Investors

For the first time, a federal court has held that the whistleblower protection rules of the US Securities and Exchange Commission (SEC or Commission) extend to a company’s outside investors. In Securities and Exchange Commission v. Collector’s Coffee, Inc. (d/b/a Collectors Café), 19-cv-04355, the US District Court for the Southern District of New York recently found that a company and its founder violated Rule 21F-17 of the Securities Exchange Act of 1934 (Exchange Act) by requiring investors to adhere to provisions in certain agreements that limited the investors’ ability to share information with regulators or other third-parties. While this is the first time a federal court has issued a ruling on this topic, the SEC has previously brought similar charges for attempting to impede an investor from communicating possible securities violations to regulators in Securities and Exchange Commission v. Vaccarelli et al., 17-cv-1471 (D. Conn., filed Aug. 31, 2017), though that action was stayed pending the outcome of a parallel criminal proceeding and the parties are now in settlement discussions.

While it remains to be seen whether the court’s decision in Collector’s Coffee will be reviewed by the United States Court of Appeals for the Second Circuit, Collector’s Coffee should serve as a cautionary note concerning the terms of agreements with outside investors, including the relevant confidentiality obligations therein and the scope of any included “carve outs” to those obligations. Although the Collector’s Coffee decision is specific to the facts and circumstances present in that case, the principles underlying the SEC’s allegations could potentially impact similar provisions in limited partnership and limited liability company agreements, shareholder agreements, subscription agreements, and other investor agreements and governing documents.

This Advisory summarizes the applicable SEC whistleblower regulations, discusses the Collector’s Coffee case, and identifies some practical takeaways for companies and managers of investment funds to consider going forward.

Rule 21F-17 and Prior SEC Enforcement Actions

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) amendments to the Exchange Act included the adoption of Section 21F, entitled Securities Whistleblower Incentives and Protection. 15 U.S.C. § 78u-6. This section directs the Commission to make monetary awards to eligible individuals who voluntarily provide original information that leads to successful SEC enforcement actions resulting in monetary sanctions over $1 million and related actions. The Commission’s implementing rules for Section 21F include Rule 21F-17, which, among other things, bars companies and individuals from taking “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. . . .” 17 C.F.R. § 240.21F-17(a). As we detailed in a recent article, the SEC has encouraged whistleblower reporting and sought to punish companies that have failed to respond appropriately.

Rule 21F-17 went into effect in August 2011, and enforcement actions initially focused on companies’ agreements with their current and former employees. The first case involving violations of Rule 21F-17 was brought as a settled administrative proceeding in April 2015, when the SEC issued an order concerning language in a company’s form confidentiality agreements used for internal investigation interviews (e.g., Upjohn warnings) that prohibited disclosure of what was discussed during the interviews without prior authorization from the company’s in-house law department. Several additional settled enforcement actions followed, which were generally related to language in severance agreements. In October 2016, the Office of Compliance Inspections and Examinations (now, the Division of Examinations) issued a Risk Alert identifying certain documents of specific focus during registered investment adviser and broker-dealer examinations, such as compliance manuals, codes of ethics, and employment and severance agreements.

In August 2017, the SEC filed the Vaccarelli action alleging that Leon Vaccarelli and his related companies misappropriated and misused investment funds defendants obtained from clients and customers. The SEC further alleged that defendants violated Rule 21F-17 by entering into an agreement with a brokerage customer that included language preventing the customer from discussing defendants’ conduct with “FINRA, The [sic] SEC or anyone else” in exchange for the return of her investment. There is no indication in the SEC’s complaint that defendants attempted to enforce the confidentiality agreement. This case was stayed pending the outcome of a separate criminal trial against Vaccarelli, United States v. Vaccarelli, 18-cr-92 (D. Conn., filed May 2, 2018), in which he was found guilty and sentenced in October 2020, and the parties are now in settlement discussions related to the SEC’s charges.

In the most recent Rule 21F-17 action, in June 2021, the SEC announced settled charges against broker-dealer Guggenheim Securities, LLC (Guggenheim) for violations of Rule 21F-17. As discussed in a prior Advisory, the Guggenheim matter expanded the cases brought to include language in compliance manuals and annual training materials, thus serving as an important notice to the industry that the Commission does not consider Rule 21F-17 to apply only to severance agreements. According to the order, Guggenheim’s compliance manual included language expressly prohibiting employees from initiating contact with any regulator without prior approval from the firm’s legal or compliance department, and similar language appeared in annual training materials.

Notably, in several instances, these enforcement actions were brought even where the Commission was unaware of any individuals who were prevented from communicating with the Commission or where the company took action to enforce the companies’ agreements. For instance, in a June 2016 settled enforcement proceeding against Merrill Lynch, the company was found to have violated Rule 21F-17 because of the “language found in certain of the [company’s] policies, procedures, and agreements” that prohibited employees from disclosing confidential information or trade secrets to any person or entity except pursuant to formal legal process or unless the employee first obtained the written approval from the company. The language did not permit an individual to voluntarily disclose confidential information to regulatory authorities. Similar to the Merrill Lynch case, in the Guggenheim matter, the Commission acknowledged that it was unaware of any instances in which (i) an employee was prevented from communicating any potential securities laws violations or (ii) Guggenheim took action to enforce the compliance manual’s restrictions or otherwise prevent such communications. Nevertheless, the SEC found that this language could impede whistleblower reporting and thus undermined the purpose of the whistleblower regulations, which are intended to encourage individuals to report possible securities laws violations to the SEC.

Collector’s Coffee Background

According to the SEC’s complaint, Collector’s Coffee, Inc. is a private company that sought to develop a website for the auction of collectibles such as sports memorabilia as well as an affiliated social network and television show. The SEC alleges that, from 2007 through 2018, Collector’s Coffee raised approximately $30.75 million from multiple investors through various sales of stock and convertible promissory notes and, in so doing, made several misrepresentations regarding Collector’s Coffee’s business. In addition, the SEC alleges that the company’s founder misappropriated more than $6.1 million of the investor funds for his personal benefit.

Central to the alleged scheme was the company’s claim to own the rights to the original baseball player contracts signed by Jackie Robinson, purportedly worth more than $36 million. The SEC alleges that Collector’s Coffee only had a fractional interest in these player contracts, and the value of the contracts, as appraised, was at most $10 million. Additionally, the SEC alleges that Collector’s Coffee made numerous written and oral false and misleading statements regarding the number, dealers, and amount of inventory on the company’s website.

According to the SEC’s complaint, in 2015, investors accused the company and its founder of fraud. In response, the company arranged for the repurchase of the investors’ shares through a stock repurchase agreement that included the following language:

[Investors] . . . warrant and affirm that they have not, directly or indirectly, individually, collectively or otherwise, as of the date of execution of this Agreement, contacted any third-party, including but not limited to governmental or administrative agencies or enforcement bodies, for the purpose of commencing or otherwise prompting investigation or other action relative to [Collector’s Coffee] or the subject herein. [Investors] . . . further warrant and affirm that . . . they will not, directly or indirectly, individually, collectively or otherwise, contact any third-party, including, but not limited to governmental or administrative agencies or enforcement bodies, for the purpose of commencing or otherwise prompting investigation or other action relative to [Collector’s Coffee] or the subject matter herein. The parties agree that the terms of this provision are not designed or intended to accomplish any improper purpose, but rather, are included as material consideration in light of the time and expense which could be incurred by all parties, if investigation or other third-party action were to arise regarding the subject matter herein . . . .

The SEC also alleges that, in 2017, two investors filed suit against Collector’s Coffee for securities fraud. The company settled those claims, and the settlement agreement contained the following provision:

The Shareholders, for themselves and their counsel and advisors, confirm that they are not aware of, and have not had to date, and will not initiate on a going forward basis, any communications with any regulatory agencies such as the United States Securities and Exchange Commission or any other Federal, State, or Local governmental agency concerning the matters related to this Agreement. Nothing herein would prevent the parties from responding to, and/or fully complying with, a subpoena or other governmental and or regulatory compulsory process.

In 2017, the SEC launched an investigation into Collector’s Coffee and sought information from the investors who had previously commenced suit against the company concerning their allegations in that action. The investors informed the SEC that they could not voluntarily cooperate because of a provision in their settlement agreement. The SEC then served subpoenas on the investors, who subsequently produced information to the SEC. In April 2019, Collector’s Coffee filed suit against those same investors for communicating with the SEC in violation of the parties’ settlement agreement. Collector’s Coffee alleged that such communications jeopardized its business. The company then allegedly told other investors about their efforts to enforce the confidentiality provisions of such agreements.

Collector’s Coffee Litigation

In May 2019, the SEC filed a securities fraud action against Collector’s Coffee, alleging violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Exchange Act. In November 2019, the SEC amended its complaint to add a claim that Collector’s Coffee violated Rule 21F-17 of the Exchange Act by impeding the reporting of securities laws violations to the Commission based on the company’s stock repurchase and settlement agreements with investors. Thereafter, Collector’s Coffee moved to dismiss the newly-added Rule 21F-17 claim, arguing that the SEC had violated its rulemaking authority in promulgating the rule because the scope of the relevant statute (Section 21F of the Exchange Act) is limited to employers and employees, not investors. The company further argued this rule violated its First Amendment right to freely contract with investors. The SEC opposed these arguments.

On May 17, 2021, the magistrate judge denied the company’s motion to dismiss. The company filed objections, which the SEC opposed. On July 21, 2021, the district court adopted the magistrate judge’s report and recommendation in its entirety. In its order, the district court stated: “Rule 21F-17 falls squarely within the SEC’s statutory authority to issue necessary and appropriate regulations to implement Section 21F of the Exchange Act.” The court noted that the definition of “Whistleblower” in Section 21F refers to “any individual” and “is not limited to those persons in an employee-employer relationship.” With respect to the company’s First Amendment argument, the court concluded that there was no constitutional right to enter into unenforceable and illegal contractual provisions like the ones at issue.

Separately, Collector’s Coffee and the SEC sought permission to cross-move for partial summary judgment. On November 17, 2021, the district court granted the SEC’s motion for partial summary judgment as to the Rule 21F-17 claim, reaffirming its prior holding that Rule 21F-17 constitutes an appropriate exercise of the SEC’s rulemaking authority and does not violate the First Amendment. The court further observed that the company entered into confidentiality agreements that prevented investors “from communicating with the SEC regarding securities laws violations,” and that the company “actually sued to prevent such communications and advertised those suits in order to chill further communication.”

Litigation concerning the SEC’s remaining securities fraud claims remains ongoing in the Collector’s Coffee case. Given the limitations on seeking appeals of interlocutory orders under 28 U.S.C. § 1292, while it is possible that the company will seek appeal of the partial summary judgment decision, it is unlikely that the Second Circuit will review the decision until the case is finally disposed of by the district court.

Practical Takeaways

Rule 21F-17 prohibits actions that would impede any “individual” from reporting to the SEC, and at least one district court has now agreed with the SEC’s interpretation that this rule includes investors. Although appellate review remains an eventual possibility in Collector’s Coffee, the district court’s decision may embolden the SEC to begin investigations and seek to enforce Rule 21F-17 more broadly based on language in agreements with investors as well as in various governing documents of companies and investment funds.

The Collector’s Coffee and Vaccarelli cases suggest the SEC expects market participants to ensure that confidentiality provisions applicable to investors are not so broad as to chill the ability of the investors to raise whistleblower complaints with the SEC. Thus, confidentiality provisions that prohibit an investor from sharing confidential information with all third-parties, unless compelled, could potentially be viewed by the SEC as problematic. Unlike many of the provisions customarily included in agreements with investors and governing documents, the provisions at issue in the Collector’s Coffee and the Vaccarelli cases contained express, specific prohibitions on communications with governmental and regulatory agencies. In the Collector’s Coffee case in particular, the defendants sued the investors for breach of the provisions when they did communicate with the SEC, which clearly defied the policies underlying Section 21F and Rule 21F-17. The scope and extent to which the SEC may assert violations of Rule 21F-17 in the context of agreements with investors that do not expressly prohibit communications with the SEC, or with governmental or regulatory agencies more generally, remains to be seen. That said, past cases like Merrill Lynch, coupled with the pro-whistleblower stance signaled by the current administration, may portend a broader reading of the law in connection with investor documents.

We will continue to monitor the Collector’s Coffee case and any appeals. In the meantime, companies and investment fund managers should carefully consider with counsel the confidentiality language used in any new investor documents that are prepared while the case awaits final resolution. Companies and fund managers also should consider conducting a risk assessment to review the confidentiality provisions in existing agreements with investors and other third-parties to determine whether any merit revision.

If companies or investment fund managers would like guidance or advice on how to reduce risk related to these issues, please contact any author of this Advisory or your regular Arnold & Porter contact.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.