In response to Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:
(a) 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.
I have mostly heard stories about violation of the rule as applied to employee severance agreements or employment agreements. You can’t prevent departing employees from being whistleblowers.
In a different approach to whistleblower protection, the Securities and Exchange Commission brought a case against a company for trying to limit the ability of its former investors from reported alleged wrongdoing to the SEC.
Mykalai Kontilai, wanted to build a website for the auction of collectibles, especially sports memorabilia. He grew that idea into plans for an affiliated social network, a physical coffee shop, and a television show. He managed to raise $23 million from 140 investors to implement his vision. Collectors Café was born.
According to the SEC complaint, Kontilai misappropriated more than $6.1 million of the money raised for personal use. He is also accused of misrepresenting the material facts about Collectors Café to those investors.
According to the SEC some of the investors alleged wrongdoing and wanted their money back. In at least two instances, Collectors Café and Kontilai attempted to resolve investor allegations of wrongdoing by conditioning the return of investor money on confidentiality clauses prohibiting the investors from communicating with law enforcement, including the SEC, about the alleged securities law violations.
In a stock purchase agreement to buy back the stock, there was this provision:
[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 [Collectors Café] or the subject matter herein.
In a settlement agreement with other investors, there was this 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.”
Collectors Café and Kontilai even went a step further and attempted to enforce the illegal confidentiality clause by filing a lawsuit claiming that the victims breached the confidentiality provision by communicating with SEC staff about possible securities law violations.
The SEC action is mostly filled with the alleged fraud at Collectors Café. This came after the SEC contacted the investors trying to find information about their complaint.
The two provisions contain the opposite of what should be in a settlement agreement. We know you can’t stop employees from acting as whistleblowers in severance agreements. It’s also clear that you can’t stop investors from talking to the SEC about securities fraud.
Sources:
- SEC Charges Issuer and CEO with Violating Whistleblower Protection Laws to Silence Investor Complaints
- SEC Amended Complaint
- SEC Charges Issuer and CEO with Violating Whistleblower Protection Laws to Silence Investor Complaints
- SEC Action for Stifling Whistleblowers in Confidentiality Agreements
- The SEC Really Means It About Pretaliation Severance Agreements