Image of SEC Prevails in Case Challenging its Anti-Gag Rule, a Pillar of the SEC Whistleblower Reward Program

SEC Prevails in Case Challenging its Anti-Gag Rule, a Pillar of the SEC Whistleblower Reward Program

A critical reason for the success of the SEC whistleblower program is the SEC’s adoption and enforcement of a strong anti-gag rule prohibiting any “person” 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 . . . .”  Exchange Act Rule 21F-7, 17 C.F.R. § 240.21F-17.  The SEC has taken 14 enforcement actions for violations of this rule, most of which focus on employer agreements and policies that have the effect of impeding whistleblowing to the SEC.  These enforcement actions have strengthened the SEC’s whistleblower program by encouraging whistleblowers to report fraud and encouraging employers to revise their NDAs and policies to clarify that such agreements and policies do not bar lawful whistleblowing.

 Until recently, none of the companies that were penalized for violating the SEC’s anti-gag rule challenged the SEC’s authority to enforce Rule 21F-17 and instead paid the penalties and changed the policies or agreements that ran afoul of the anti-gag rule.  An opinion issued on July 21, 2021 reveals that the first legal challenge to the SEC’s anti-gag rule failed to gain any traction, and instead, Judge Marrero’s well-reasoned opinion suggests that future challenges are unlikely to succeed.

The SEC should continue to vigorously enforce Rule 21F-17.  Any company accessing U.S. public markets should not need to silence whistleblowers through unduly restrictive NDAs or intimidate whistleblowers by suing them for exercising their non-waivable right to report fraud to the SEC.  Registrants can certainly use confidentiality agreements to serve legitimate interests, such as protecting intellectual property, but such agreements cannot bar lawful whistleblowing to the SEC or law enforcement.

Rule 21F-17 Enforcement Action Against Collector’s Coffee

In November 2019, the SEC brought a misappropriation case against Collector’s Coffee, Inc. (CCI) in which the SEC included a count alleging a violation of Rule 21F-17.  According to the SEC’s complaint, CCI made numerous false and misleading statements to raise funds to pursue its stated business plans and then diverted the money for other purposes.  In particular, CCI solicited investors to invest in coffee houses where collectors would meet and an auction website for collectors but misappropriated more than 25% of investor funds to pay for owner Mykalai Kontilai’s lavish lifestyle.  Some investors discovered the fraud and demanded relief from CCI.  The company agreed to return funds to investors on the condition that they sign provisions impeding them from communicating with the SEC. 

When the SEC commenced an investigation of the fraud, CCI suspected that some of the investors that agreed not to report to the SEC breached the settlement agreement, and sued those investors for breach of contract, unjust enrichment, intentional interference with contractual relations, civil conspiracy, and breach of the implied covenant of good faith and fair dealing.  The SEC deemed the lawsuit a violation of Rule 21F-17 (by enforcing a confidentiality agreement impeding whistleblowing to the SEC).

CCI moved to dismiss the SEC’s enforcement action and challenged the SEC’s authority to enforce the anti-gag rule.   In particular, CCI asserted that the Dodd-Frank Act does not authorize the SEC to adopt a rule that would invalidate investors’ voluntary waiver of the right to report alleged securities violations to the SEC. On May 17, 2021, Magistrate Judge Gorenstein issued a recommended decision and report (“Report”) denying the motion and holding that the gag restrictions in CCI’s settlement agreements violated the plain text of Rule 21F-17 and that such restrictions are unenforceable as a matter of public policy (it is contrary to public policy for parties to agree to not to reveal facts relating to alleged or potential violations of law).

CCI objected to the Report and in an opinion issued July 21, 2021, Judge Marrero adopted Judge Gorenstein’s Report and rejected additional arguments advanced by CCI their objections to the Report.

Anti-Gag Rule Does Not Violate the First Amendment

CCI asserted that Rule 21F-17 violates the First Amendment in that it prevents them from filing a lawsuit to enforce a contractual confidentiality provision.  Judge Marrero rejected this argument on the basis that a gag provision is void as a matter of public policy and therefore unenforceable.  The First Amendment is not abridged when a party violates Rule 21F-17 by seeking to enforce an illegal gag clause.  In other words, a lawsuit enforcing an illegal confidentiality agreement is “sham activity” not protected by the First Amendment.

SEC Anti-Gag Rule Falls Within the SEC’s Statutory Authority

CCI also argued that the SEC exceeded its statutory authority when it promulgated Rule 21F-17 in that the rule applied to any person, whereas Section 21F of the Dodd-Frank Act applies only to whistleblower-employees.  In other words, the SEC expanded the statutory mandate in the Dodd-Frank Act from whistleblowers who report information to the SEC as specified by Congress to anyone who might report information to the SEC, including investors seeking an extra shot at financial gain.

Judge Marrero rejected CCI’s flawed interpretation of the statute and concluded that Rule 21F-17 is a “necessary and appropriate” regulation to implement Section 21F in that the definition of “whistleblower” in Section 21F includes “any individual who provides . . information relating of the securities laws” to the SEC.  15 U.S.C. § 78u-6(a)(6).  The definition is not restricted solely to whistleblower-employees.  The statute’s broad grant of rulemaking authority to the SEC to implement Section 21F encompasses an anti-gag rule that encourages any individual (including an investor) to report wrongdoing to the SEC.

Implications for Whistleblowers

By some estimates, fraud and other white-collar crime costs the US economy $300 billion to $800 billion per year.  To combat fraud, regulators and law enforcement need the assistance and cooperation of whistleblowers to detect and effectively prosecute fraud.  But there are many substantial risks that deter whistleblowers from coming forward, including the risk of being sued for breaching a confidentiality agreement.   The continued success of whistleblower reward programs will hinge in part on regulators taking a firm stand against agreements and policies that impede whistleblowing and combatting SLAPP suits.  The SEC’s decisive win in the first challenge to Rule 21F-17 sends a strong message that registrants cannot immunize illegal conduct by contracting to engage in illegal conduct.

For more information on unlawful restrictions on whistleblowing, see the article De Facto Gag Clauses: The Legality of Employment Agreements That Undermine Dodd-Frank’s Whistleblower Provisions.

De Facto Gag Clauses- The Legality of Employment Agreements That Undermine Dodd-Frank’s Whistleblower Provisions

Jason Zuckerman, Principal of Zuckerman Law, litigates whistleblower retaliation, qui tam, wrongful discharge, and other employment-related claims. He is rated 10 out of 10 by Avvo, was recognized by Washingtonian magazine as a “Top Whistleblower Lawyer” in 2015 and selected by his peers to be included in The Best Lawyers in America® and in SuperLawyers.

Matthew Stock is the Director of the Whistleblower Rewards Practice at Zuckerman Law. He represents whistleblowers around the world in SEC, CFTC and IRS whistleblower claims. He is also a Certified Public Accountant, Certified Fraud Examiner and former KPMG external auditor.