In Case Of First Impression, Federal Court Rules That Whistleblower Protections Extend To Company’s Outside Investors – Corporate/Commercial Law

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:

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:

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.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.