Benjamin Calitri (Photo courtesy of Kohn, Kohn & Colapinto LLP
The SEC recently charged an investment advisor, D. E. Shaw, with Rule 21F-17(a) violations for including clauses in their employment and severance agreements that prohibited whistleblowing. For these violations, D.E. Shaw was fined $10 million. This is a significant development for enforcement of Rule 21F-17(a) as it is over twenty times larger than the previous highest penalty for a Rule 21F-17(a) violation.
It remains to be seen whether sanctions of this size are the new normal for Rule 21F-17(a) actions, but the D.E. Shaw case is undoubtedly a major development. The action dramatically changes the cost-benefit analysis for companies seeking to use contracts to silence whistleblowers and sends a clear message that the SEC is taking violations of Rule 21F-17(a) seriously.
The Current State of the SEC’s Enforcement of Rule 21F-17(a)
The SEC’s Rule 21F-17(a) was enacted following the passage of the Dodd-Frank Act and the creation of the SEC Whistleblower Program in 2010. The rule prohibits any person from “tak[ing] 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.”[1]
The SEC first enforced this rule against KBR, a government technology contractor, in 2015.[2] The SEC alleged that when employees reported suspected securities law violations internally, KBR lawyers would interview them for the stated purpose of investigating the allegations while requiring the employees to sign a confidentiality statement that required them to get prior approval from the company in order to report those allegations to the SEC. The SEC found that the language in these statements thereby impeded the ability of the employees to report the illegal conduct to the SEC. Since then, the SEC has finalized a total of eighteen enforcements of Rule 21F-17(a) violations.[3]
In enforcing Rule 21F-17(a), the SEC has found illegal language in severance or separation agreements, employee contracts, settlement agreements, and compliance manuals.[4] Language in the various types of contracts found to violate Rule 21F-17(a) has included: requiring the prior consent of the company before disclosing confidential information to regulators; preventing the employee from initiating contact with regulators; requiring the employee to waive their right to awards from whistleblowing award programs; including a “non-disparagement clause” that specifically included the SEC as a party the employee could not “disparage” the company to; and requiring the employee to inform the company soon after reporting information to the SEC.[5]
The SEC has been clear and direct on what constitutes violative contractual language since the Commission first enforced Rule 21F-17(a) in 2015 and in the many enforcements since then.[6] The SEC even provides alternative language in their enforcement orders for what should instead be included in contracts. Yet, companies still include illegal language in their employment contracts and severance agreements. This is not accidental. It is a purposeful calculation made on their part.
One reason companies continue to willfully incorporate illegal language in their employment contracts is that the SEC’s penalties for Rule 21F-17(a) violations have not been formidable. For enforcement actions under Rule 21F-17(a) alone, the SEC had not sanctioned a company or individual more than $400,000 prior to the D.E. Shaw action.[7] This $400,000 sanction came in a case against the Brink’s Company, where at least 10,000 employees had illegal clauses in their employment contracts. That’s $40 per violation. $40 per silenced employee.
This makes companies’ calculations of whether to include illegal confidentiality clauses easy. Possible fines well under $1 million are a very low concern compared to the possibility of an employee becoming an SEC whistleblower that can lead to multi-billion dollar fines and a severe drop in public trust and share price.
The most effective way to actually prevent companies’ violations of Rule 21F-17(a) is for the SEC to increase penalties under existing laws for Rule 21F-17(a) violations. This is why the D.E. Shaw penalty of $10 million is so important.
Increasing Penalties under SEC Regulations
The SEC must make penalties severe enough to outweigh the benefit that companies gain by intimidating employees into silence. Civil monetary penalties for Rule 21F-17(a) violations are determined under 15 U.S.C. § 78u(d)(3), consistent with inflation adjustments.[8] Section 78u(d)(3) has three tiers of violations based upon severity of the violation. The first tier is the base level for penalties with no additional circumstances, the second tier is for violations that “involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement;” and the third and highest tier is for violations that “involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement and . . . directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons.”[9] For non-natural persons, 15 U.S.C. § 78u(d)(3) carries a $111,614 sanction for the first tier, a $558,071 for the second tier, and a $1,116,140 sanction for the third tier — for each violation.
Violations of Rule 21F-17(a) should be classed in at least the second tier,[10] as they involve the deliberate disregard of a regulatory requirement. Prior SEC enforcements have shown exactly what is illegal under Rule 21F-17(a), and since the first Rule 21F-17(a) enforcement in 2015, companies have been on notice that these illegal contract clauses are violations of regulatory requirements. Any Rule 21F-17(a) violations since that first enforcement are deliberate.
Rule 21F-17(a) violations should truly be classified in the third tier as they inherently create risks of substantial losses to other persons, as silencing employees and preventing whistleblowing helps companies cover up what may be multi-billion-dollar frauds or wide-spread public safety concerns.[11] By forcing employees to waive any right to recovery from whistleblower award laws for reporting these frauds to the SEC, which is common practice in many employee and severance agreements of prominent companies, whistleblowers are illegally coerced into waiving their right to hundred-million dollar awards.[12] Whistleblowers can also lose their chance for severance payments if they insist upon removing illegal language and risk facing life-crushing litigation for defying these agreements. These are significant effects for both the company’s shareholders and the whistleblower.
Furthermore, each contract in force that silences an employee should be counted as a separate violation. The SEC should fine the company the full amount of $510,962 or $1,116,140 for each violation.[13] Each contract in force that silences an employee or former employee was negotiated separately, entered into separately, and signed separately. Each was a separate decision to deliberately violate Rule 21F-17(a) and should be sanctioned as such. This will create a strong enough deterrence to change companies’ calculations when deciding whether to use these illegal agreements to silence whistleblowers.
A Showing of a Step in the Right Direction
On September 29, 2023, the SEC issued an Order finding that D. E. Shaw violated Rule 21F-17(a) by requiring “new employees to sign agreements that prohibited them from disclosing confidential information to anyone outside the company unless authorized by D.E. Shaw or required by law or court order” and requiring “approximately 400 of its departing employees to sign releases affirming that they had not filed any complaints with any governmental agency, department, or official in order for them to receive deferred compensation and other benefits sometimes worth millions of dollars.”[14] The sanction for this violation was $10 million, over 20 times more than the $400,000 sanction against Brink’s, the prior largest Rule 21F-17(a) penalty.
Notably, the SEC found that D. E. Shaw’s violations were “willful,” which applies to the Advisers Act and gives the SEC authority to “censure, place limitations on the activities, functions, or operations of, suspend for a period not exceeding twelve months, or revoke the registration of any investment adviser.”[15]
The finding of willfulness likely stems from facts laid out very clearly in the Order. First, the earliest Rule 21F-17(a) enforcement from the Commission case happened way back in 2015 and since then the Commission has “instituted nearly twenty additional enforcement actions charging violations of Rule 21F-17.”[16] Importantly the SEC noted that “[t]hese enforcement actions were widely reported in the media.”[17] Second, in 2017, in response to multiple Rule 21F-17(a) enforcement actions, D. E. Shaw sent out a firm-wide email explaining that nothing in their agreements prevented them from providing information to the SEC.[18] However, D. E. Shaw did not add a whistleblower exception to its employment agreements for 2 more years after this, and did not change the language for their severance agreements until June 2023, during the SEC investigation.[19]
The SEC does not explain the reasoning for the substantially increased fine in the Order. However, the explicit finding of willfulness does show that the violation “involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement” putting it into at least the second tier for civil monetary penalties.[20] The Order also states that “[t]he Commission is aware of one former DESCO employee who was initially discouraged from communicating with Commission staff about potential violations of securities laws due to the provisions relating to Confidential Information contained in DESCO’s Employment Agreement and Release.” This concrete example of harm to at least one employee by these contract clauses may have resulted in a finding that D. E. Shaw’s Rule 21F-17(a) violations “directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons,” for the third tier for civil monetary penalties.[21]
This substantially increased penalty for Rule 21F-17(a) substantially changes the cost-benefit analysis for companies seeking to use contracts to silence whistleblowers. Furthermore, since this sanction is for greater than $1 million, a whistleblower who voluntarily provided original information leading to the enforcement action will qualify for an award. With awards available for reporting these types of violations, whistleblowers will be more motivated to come forward to report these illegal clauses in their contracts.
It remains to be seen whether the SEC shall continue to issue increased sanctions for Rule 21F-17(a) violations, but the $10 million fine against D. E. Shaw is a step in the right direction. The Dodd-Frank Act created a highly effective whistleblower program that has significantly increased the effectiveness of the SEC’s regulation. Companies’ targeting of this program through contract clauses that violate Rule 21F-17(a) threatens the entire basis of this system. Until the consequences for these clauses outweigh the benefits for companies, their widespread use by companies will not stop.
Footnotes
[1] Codified at 17 C.F.R. 240.21F-17(a), available at https://www.law.cornell.edu/uscode/text/15/78u.
[2] Order, KBR, Inc., Release No. 7461, File No. 3-16466 (Apr. 1, 2015), https://www.sec.gov/litigation/admin/2015/34-74619.pdf.
[3] Finalized enforcements refers to both Cease and Desist Orders following settlements between the SEC and companies as well as Judgements following trial. The finalized enforcements of Rule 21F-17(a) are: Order, KBR, Inc., Release No. 7461, File No. 3-16466 (Apr. 1, 2015); Order, Merrill Lynch, Pierce, Fenner & Smith Incorporated And Merrill Lynch Professional Clearing Corp., Release No. 78141, File No. 3-17312 (Jun. 23, 2016), https://www.sec.gov/litigation/admin/2016/34-78141.pdf; Order, BlueLinx Holdings Inc., Release No. 78528, File No. 3-17371 (Aug. 10, 2016), https://www.sec.gov/litigation/admin/2016/34-78528.pdf; Order, Health Net, Inc., Release No. 78590, File No. 3-17396 (Aug. 16, 2016), https://www.sec.gov/files/litigation/admin/2016/34-78590.pdf; Order, Anheuser-Busch Inbev Sa/Nv, Release No. 78957, Release No. 3808, File No. 3-17586 (Sept. 28, 2016), https://www.sec.gov/litigation/admin/2016/34-78957.pdf; Order, NeuStar, Inc., Release No. 79593, File No. 3-17736 (Dec. 29, 2016), https://www.sec.gov/files/litigation/admin/2016/34-79593.pdf; Order, BlackRock, Inc., Release No. 79804, File No. 3-17786 (Jan. 17, 2017), https://www.sec.gov/litigation/admin/2017/34-79804.pdf; Order, Homestreet, Inc. and Darrell Van Amen, Release No. 79844, Release No. 3852, File No. 3-17801 (Jan. 19, 2017), https://www.sec.gov/litigation/admin/2017/34-79844.pdf; Judgment As To Defendant Kenneth W. Crumbley, Jr., SEC v. Kenneth W. Crumbley, Jr. And Sedona Oil & Gas Corporation, 3:16-CV-172-L (Sept. 13, 2018), https://www.sec.gov/files/partialjudg16-cv-00172crumbley.pdf; Order, Guggenheim Securities, LLC, Release No. 92237, File No. 3-20370 (Jun. 23, 2021), https://www.sec.gov/files/litigation/admin/2021/34-92237.pdf; Order, David Hansen, Release No. 94703, File No. 3-20820 (Apr. 12, 2022), https://www.sec.gov/litigation/admin/2022/34-94703.pdf; Order, Brink’s Company, Release No. 95138, File No. 3-20904 (Jun. 22, 2022), https://www.sec.gov/litigation/admin/2022/34-95138.pdf; Order, Activision Blizzard, Inc., Release No. 96796, File No. 3-21294 (Feb. 3, 2023), https://www.sec.gov/litigation/admin/2023/34-96796.pdf; Order, Gaia, Inc. and Paul C. Tarell, Jr., CPA, Release No. 11196, Release No. 97548, File No. 3-21438 (May 23, 2023), https://www.sec.gov/litigation/admin/2023/33-11196.pdf; Final Judgement, Securities and Exchange Commission v. Leon Vaccarelli, 17-cv-01471 (CSH) (June 29, 2023), https://www.sec.gov/files/litigation/complaints/2023/judge25763.pdf; Order, Monolith Resources, LLC, Release No. 98322, File No. 3-21629 (Sept. 8, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98322.pdf; Order, CBRE, Inc., Release No. 98429, File No. 3-21675 (Sept. 19, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98429.pdf; Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775 (Sept. 29, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98641.pdf.
[4] Severance and Separation Agreements: Order, Merrill Lynch, Pierce, Fenner & Smith Incorporated And Merrill Lynch Professional Clearing Corp., Release No. 78141, File No. 3-17312 (Jun. 23, 2016); Order, BlueLinx Holdings Inc., Release No. 78528, File No. 3-17371 (Aug. 10, 2016); Order, Health Net, Inc., Release No. 78590, File No. 3-17396 (Aug. 16, 2016); Order, Anheuser-Busch Inbev Sa/Nv, Release No. 78957, Release No. 3808, File No. 3-17586 (Sept. 28, 2016); Order, NeuStar, Inc., Release No. 79593, File No. 3-17736 (Dec. 29, 2016); Order, BlackRock, Inc., Release No. 79804, File No. 3-17786 (Jan. 17, 2017); Order, Homestreet, Inc. and Darrell Van Amen, Release No. 79844, Release No. 3852, File No. 3-17801 (Jan. 19, 2017); Order, Activision Blizzard, Inc., Release No. 96796, File No. 3-21294 (Feb. 3, 2023); Order, Gaia, Inc. and Paul C. Tarell, Jr., CPA, Release No. 11196, Release No. 97548, File No. 3-21438 (May 23, 2023); Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775 (Sept. 29, 2023).
Employee Contracts: Order, The Brink’s Company, Release No. 95138, File No. 3-20904 (Jun. 22, 2022); Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775 (Sept. 29, 2023).
Settlement Agreements: Order, BlueLinx Holdings Inc., Release No. 78528, File No. 3-17371 (Aug. 10, 2016).
Compliance Manuals: Order, Guggenheim Securities, LLC, Release No. 92237, File No. 3-20370 (Jun. 23, 2021).
[5] Order, KBR, Inc., Release No. 7461, File No. 3-16466, ¶ 6 (Apr. 1, 2015) (“I understand that in order to protect the integrity of this review, I am prohibited from discussing any particulars regarding this interview and the subject matter discussed during the interview, without the prior authorization of the Law Department.”); Order, The Brink’s Company, Release No. 95138, File No. 3-20904, ¶ 4 (Jun. 22, 2022) (“The Confidentiality Agreement prohibited employees from divulging confidential information about the company to any third party without the prior written authorization of a Brinks, Inc. executive officer.”); Order, Guggenheim Securities, LLC, Release No. 92237, File No. 3-20370, ¶ 5 (Jun. 23, 2021) (“Employees are also strictly prohibited from initiating contact with any Regulator without prior approval from the Legal or Compliance Department.”); Order, BlueLinx Holdings Inc., Release No. 78528, File No. 3-17371, ¶ 14 (Aug. 10, 2016) (“Employee understands and agrees that Employee is waiving the right to any monetary recovery in connection with any such complaint or charge that Employee may file with an administrative agency.”); Order, Health Net, Inc., Release No. 78590, File No. 3-17396, ¶ 10 (Aug. 16, 2016) (“Employee waives any right to bring a lawsuit against the Company, and waives any right to any individual monetary recovery in any such proceeding or lawsuit or in any proceeding brought based on any communication by Employee to any federal, state, or local government agency or department.”); Order, BlackRock, Inc., Release No. 79804, File No. 3-17786, ¶ 7 (Jan. 17, 2017) (“To the fullest extent permitted by applicable law, you hereby release and forever discharge, BlackRock, as defined above, from all claims for, and you waive any right to recovery of, incentives for reporting of misconduct, including, without limitation, under the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Sarbanes-Oxley Act of 2002, relating to conduct occurring prior to the date of this Agreement.”); Order, Homestreet, Inc. and Darrell Van Amen, Release No. 79844, Release No. 3852, File No. 3-17801, ¶ 39 (Jan. 19, 2017) (“This release shall not prohibit Employee from filing a charge with the Equal Employment Opportunity Commission or discussing any matter relevant to Employee’s employment with any government agency with jurisdiction over the Company but shall be considered a waiver of any damages or monetary recovery therefrom.”); Order, Gaia, Inc. and Paul C. Tarell, Jr., CPA, Release No. 11196, Release No. 97548, File No. 3-21438, ¶ 21 (May 23, 2023) (“You are however waiving your right to any monetary recovery or other individual relief in connection with any charge or complaint filed by you or anyone else.”); Order, NeuStar, Inc., Release No. 79593, File No. 3-17736, ¶ 5 (Dec. 29, 2016) (“I agree not to engage in any communication that disparages, denigrates, maligns or impugns NeuStar . . . including but not limited to communications with . . . regulators (including but not limited to the Securities and Exchange Commission).”); Order, Activision Blizzard, Inc., Release No. 96796, File No. 3-21294 (Feb. 3, 2023) (“Nothing in this Separation Agreement shall prohibit . . . disclosures that are truthful representations in connection with a report or complaint to an administrative agency (but only if I notify the Company of a disclosure obligation or request within one business day after I learn of it and permit the Company to take all steps it deems to be appropriate to prevent or limit the required disclosure).”). There have also been two enforcements based upon retaliatory conduct without any contract involved. Judgment As To Defendant Kenneth W. Crumbley, Jr., SEC v. Kenneth W. Crumbley, Jr. And Sedona Oil & Gas Corporation, 3:16-CV-172-L (Sept. 13, 2018); Order, David Hansen, Release No. 94703, File No. 3-20820 (Apr. 12, 2022).
[6] The SEC also released a Risk Notice in 2016 to put companies on notice of what to expect from the enforcement of Rule 21F-17(a). Examining Whistleblower Rule Compliance, VI National Exam Program Risk Alert 1 (Oct. 24, 2026), https://www.sec.gov/files/ocie-2016-risk-alert-examining-whistleblower-rule-compliance.pdf.
[7] Order, Brink’s Company, Release No. 95138, File No. 3-20904 (Jun. 22, 2022).
[8] 15 U.S.C. § 78u(d)(3), available at https://www.law.cornell.edu/uscode/text/15/78u; Inflation Adjustments to the Civil Monetary Penalties Administered by the Securities and Exchange Commission (as of January 15, 2023), available at https://www.sec.gov/files/civil-penalties-inflation-adjustments_1_1.pdf.
[9] 15 U.S.C. § 78u(d)(3)(B).
[10] 15 U.S.C. § 78u(d)(3); Inflation Adjustments to the Civil Monetary Penalties Administered by the Securities and Exchange Commission (as of January 15, 2023).
[11] See, e.g., the classic examples of the collapse of Enron and WorldCom, which led to the securities laws in place today that are designed to prevent fraud of this scale.
[12] By forcing whistleblowers to waive their right to awards, a major part of the SEC Whistleblower Award program is undermined. This also leaves them with no monetary benefit to show for the retaliation they open themselves up to for their whistleblowing.
[13] Inflation Adjustments to the Civil Monetary Penalties Administered by the Securities and Exchange Commission (as of January 15, 2023).
[14] SEC Charges D. E. Shaw with Violating Whistleblower Protection Rule, Press Release 2023-213, SEC (Sept. 29, 2023); See Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 21c of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775 (Sept. 29, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98641.pdf.
[15] Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 21c of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775, ¶ 21 (Sept. 29, 2023); 15 U.S.C. § 80b-3(e)(5).
[16] Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 21c of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775, ¶ 6-7 (Sept. 29, 2023).
[17] Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 21c of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775, ¶ 7 (Sept. 29, 2023).
[18] Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 21c of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775, ¶ 24 (Sept. 29, 2023).
[19] Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 21c of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, D. E. Shaw & Co, L.P., Release No. 98641, Release No. 6452, File No. 3-21775, ¶ 25-29 (Sept. 29, 2023).
[20] 15 U.S.C. § 78u(d)(3).
[21] 15 U.S.C. § 78u(d)(3).
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