SEC Whistleblower Protection Rule Not Restricted to Employee Whistleblowers

On July 21, in S.E.C. v. Collector’s Coffee, Inc. et al.,^[1] a New York federal court held that a Securities and Exchange Commission (SEC or Commission) whistleblower protection rule prohibiting actions to impede the reporting of potential violations of the securities laws to the SEC — Securities Exchange Act Rule 21F-17 — is not restricted to employees of a company, and extends to a company’s shareholders.

By way of background, the SEC whistleblower program, codified at Section 21F of the Securities Exchange Act of 1934, 15 U.S.C. § 78u-6, authorizes the SEC 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. The program also provides whistleblowers confidentiality and anti-retaliation protections, including the right of whistleblowers to bring a private right of action against employers who retaliate against those who report.^[2] Rule 21F-17, promulgated by the Commission, facilitates reporting by directing 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.”^[3]

In Collector’s Coffee, the SEC alleged that Mykalai Kontilai (Kontilai) and Collector’s Coffee, Inc. (Collector’s Coffee) (collectively “defendants”), defrauded investors. The SEC contends that Kontilai and Collector’s Coffee, an entity Kontilai controlled, misappropriated over $6 million in investor funds purportedly raised in connection with the development of an online sports memorabilia auction site, but that Kontilai took for his personal use. In addition to multiple claims of securities fraud in connection with the solicitation of these investments, the SEC accused the defendants of violating Exchange Act Rule 21F-17 by employing agreements with investors that prohibited the investors from communicating with the SEC.

The SEC alleges that after certain investors raised concerns to the defendants about their investments and the status of the company, the defendants, in attempting to cover up the investor fraud, prepared two documents — a 2015 “Stock Purchase Agreement” and a 2017 “Settlement Agreement” — that conditioned the return of the investors’ funds on their agreement not to communicate with the SEC.

The Stock Purchase Agreement, executed in 2015 by the defendants in connection with the repurchase of certain investors’ shares, contained a provision stating the investors would 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 [Collectors Coffee] or the subject matter herein.”^[4]

In 2017, two more investors sought the return of their investment funds, and alleged the defendants made fraudulent material misrepresentations. When the defendants would not return the funds, the investors sued. To resolve the suit, the defendants and investors entered into the Settlement Agreement that contained a provision stating that the investors “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.”^[5] The SEC’s complaint states that when the agency contacted the investor-plaintiffs, their counsel advised the agency that “a confidentiality agreement prevented his clients from speaking to SEC staff voluntarily.” When the defendants later learned that the investors had responded to an SEC subpoena, the defendants sued the investors for breach of the Settlement Agreement.^[6]

The Collector’s Coffee decision stems from defendants’ motion to dismiss the Rule 21F-17 claim. A Magistrate Judge hearing the case initially denied defendants’ motion.^[7]

In their objections to the Magistrate Judge’s Report and Recommendation made to the district court, defendants argued that “Rule 21F-17 exceeded the SEC’s rulemaking authority because Rule 21F-17 applies to any ‘person,’ while Section 21F of [the] Exchange Act applies only to whistleblower-employees.” Therefore, defendants argued, the Rule 21F-17 claim must be dismissed “because Defendants were not in an employer-employee relationship with those individuals whom the SEC claims were impeded” — the investor-victims.^[8] The SEC countered that the statutory whistleblower protections are “not limited to individuals in the employee-employer relationship, and as such, Rule 21F-17’s application to any ‘person’ is a proper exercise of its rulemaking authority.”^[9]

The district court agreed with the SEC, holding the agency’s promulgation of Rule 21F-17 was within its rulemaking authority. Examining the statutory language and the congressional purpose, the district court concluded that “[t]he statutory definition of ‘Whistleblower’ refers to ‘any individual’ and is not limited to those persons in an employee-employer relationship.” Further, while “certain portions of Section 21F provide anti-retaliation protections specific to those whistleblowers who are employees,” the court found that “nothing in the statute’s text nor the supporting documents indicates that Congress intended to protect only those whistleblowers who are employees.” Rather, “the statute allows eligibility for whistleblower status, and the various incentives and protections that come with that status, to extend beyond the employer-employee relationship.”^[10]

While defendants may appeal to the Second Circuit, the court’s holding that Rule 21F-17 applies to any “person” who impedes a whistleblower’s communications with the SEC — not just an employer who impedes an employee — should put companies on notice that agreements with any counterparty, including vendors, shareholders, third parties and others, that contains language restricting a party’s ability to communicate to the SEC, could expose the company to potential liability, including SEC enforcement under Rule 21F-17. Companies should therefore be aware that such agreements containing gag provisions may draw the attention of the SEC.

^[1] _{Case No 19-cv-04355 (S.D.N.Y.).}

^[2] _{Since the program’s inception in 2012, the SEC has awarded approximately $562 million to 106 individuals, including awards totaling approximately $175 million to 39 individuals in FY 2020 alone. See U.S. Securities and Exchange Commission 2020 Annual Report to Congress, Whistleblower Program at 2, available at https://www.sec.gov/files/2020%20Annual%20Report_0.pdf.}  

^[3] _{17 C.F.R. § 240.21F-17(a).}

^[4] _{Amended Complaint ¶¶ 112-116, S.E.C. v. Collector’s Coffee et al., Case No. 19-cv-04355, Docket No. 134 (S.D.N.Y. Nov. 4, 2018).}

^[5] _{Id. ¶¶ 118-121.}

^[6] _{Id. ¶¶ 125-133.}

^[7] _{S.E.C. v. Collector's Coffee Inc. et al., No. 19-cv-4355 (VM) (GWG), 2021 WL 1956369, at *5 (S.D.N.Y. May 17, 2021).}

^[8] _{S.E.C. v. Collector’s Coffee Inc., et al., No. 19-cv-4355 (VM), 2021 WL 3082209, at *2 (S.D.N.Y. July 21, 2021).}

^[9] _Id.

^[10] _{Id. Defendants separately argued that Rule 21F-17 violates the First Amendment. But the district court quickly rejected the argument, finding that the SEC was within its authority to challenge an agreement that was unenforceable, writing “no First Amendment right is abridged when a party allegedly violates Rule 21F-17 by seeking to enforce an illegal, and therefore unenforceable, contractual provision in court.” Id. at *3.}