Arbitration Agreements and Whistleblower Protections

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed the SEC to establish a “bounty program” for certain individuals who voluntarily provide the SEC with original information that leads to successful SEC actions resulting in monetary sanctions over $1,000,000. Dodd-Frank also prohibits employers from taking retaliatory action against employees who report potential violations to the SEC and authorizes an employee to bring a private action in federal court alleging retaliation.  If successful, the employee may be entitled to reinstatement, double back pay, litigation costs, expert witness fees, and attorneys’ fees.  See 18 U.S.C. § 1514A.

Dodd-Frank also provides that pre-dispute arbitration clauses are invalid and unenforceable.  See id. at § 1514A(e)(2). This means companies and their executives or employees cannot agree to arbitrate Dodd-Frank whistleblower claims. But does this prohibition apply to employment contracts negotiated and entered into pre-Dodd-Frank?  Based upon a handful of district court rulings, the answer is:  possibly.

Most recently, in Khazin v. TD Ameritrade Holding Corp., Civil Action No. 13-4149 (SDW)(MCA), 2014 U.S. Dist. LEXIS 31142 (D.N.J. Mar. 11, 2014), the court granted the defendants’ motion to compel arbitration on the basis that the arbitration agreement at issue was contained in an employment agreement that pre-dated Dodd Frank. The court reasoned that to disregard a pre-Dodd-Frank arbitration provision “would fundamentally interfere with the parties’ contractual rights and would impair the predictability and stability of their earlier agreement.” The court also emphasized the “strong federal policy in favor of the resolution of disputes through arbitration” and cited a number of other federal courts that have reached a similar result. See Weller v. HSBC Mortg. Servs. Inc., No. 13-00185, 2013 U.S. Dist. LEXIS 130544, 2013 WL 4882758, at *4 (D. Colo. Sept. 11, 2013); Blackwell v. Bank of Am. Corp., No. 11-2475, 2012 U.S. Dist. LEXIS 51991, 2012 WL 1229673, at *4 (D.S.C. Mar. 22, 2012), report and recommendation adopted, No. 11-2475, 2012 U.S. Dist. LEXIS 51447, 2012 WL 1229675 (D.S.C. Apr. 12, 2012); Henderson v. Masco Framing Corp., No. 11-0088, 2011 U.S. Dist. LEXIS 80494, 2011 WL 3022535, at *3 (D. Nev. July 22, 2011); Taylor v. Fannie Mae, 839 F. Supp. 2d 259, 263 (D.D.C. 2012).

Several cases, however, view the prohibition on arbitration clauses from a different prospective and conclude that the prohibition has retroactive effect. See Pezza v. Investors Cap. Corp., 767 F. Supp. 2d 225, 234 (D. Mass. 2011); Wong v. CKX, Inc., 890 F. Supp. 2d 411, 422–23 (S.D.N.Y. 2012). In Pezza, the court followed the U.S. Supreme Court’s decision in Landgraf v. USI Film Products, 511 U.S. 244, 271 (1994), which directs courts to examine whether the statute at issue is one “affecting contractual or property rights” (and thus should not be applied retroactively) or is “conferring or ousting jurisdiction” (and thus may be applied retroactively). The court found that 18 U.S.C. § 1514A(e)(2) is more analogous to the latter because it “takes away no substantive right but simply changes the tribunal that is to hear the case.” The court in Wong found the court’s decision in Pezza persuasive and came to this same conclusion.

Employment agreements and their impact on whistleblowing activity is a hot topic at the SEC as well. Last year, a law firm that represents whistleblowers sent a letter to the Commissioners urging them to take action against what they believe were actions intended to prevent employees from reporting potential corporate violations to the SEC. See Letter to SEC Commissioners (alerting SEC of the use of settlement and severance agreements as a means to prevent reporting and whistleblower claims). Recent comments by Sean McKessy, Chief of the SEC’s Office of the Whistleblower, suggest the Commission may have taken those concerns to heart. Mr. McKessy warned, “[W]e are actively looking for examples of confidentiality agreements, separat[ion] agreements, [and] employment agreements that … in substance say ‘as a prerequisite to get this benefit you agree you’re not going to come to the commission or you’re not going to report anything to a regulator.” See article SEC Warns In-House Attys Against Whistleblower Contracts. Mr. McKessy also said that the SEC not only will penalize companies, but the “lawyers who drafted” such an agreement or language. Id. These comments warn employers and their lawyers to proceed with caution (if at all) when they are thinking about using an employment agreement as a means to curtail or deter Dodd-Frank reporting and claims.

SEC v. Jacobs May Signal Limit to Duty of Trust or Confidence Required to Prove Insider Trading Based on Misappropriation Theory

To prevail on an insider-trading claim pursuant to Section 10(b) of the Exchange Act and Rule 10b-5 thereunder based on the misappropriation theory, the SEC must prove that the defendant (1) misappropriated material, nonpublic information; (2) had a duty of trust or confidence; (3) breached that duty; (4) purchased or sold securities, or tipped another who purchased or sold securities, on the basis of that information; and (5) knew or should have known that he or she was trading or tipping others on inappropriately obtained information. Dirks v. SEC, 463 U.S. 646, 660 (1983). The SEC has identified three nonexhaustive circumstances that create a duty of trust or confidence; they are (1) when a person agrees to maintain information in confidence; (2) when there is a history, pattern, or practice of sharing confidences and the recipient knows or reasonably should know that the person communicating the information expects the recipient to maintain its confidentiality; and (3) when a person receives material, nonpublic information from his or her spouse, parent, child, or sibling. See 17 C.F.R. § 240.10b5-2(b).

The existence of “a duty of trust or confidence” and the SEC’s attempt to expand that duty beyond the traditional fiduciary relationship have been the subject of many a motion to dismiss. Courts, however, have routinely ruled that a duty of trust or confidence is not limited to traditional fiduciary relationships. For example, in United States v. Corbin, 729 F. Supp. 2d 607 (S.D.N.Y. 2010), the court acknowledged Rule 10b5-2’s presumption of a relationship of trust and confidence between spouses and held that the SEC adequately alleged that a husband and wife had a history of sharing business confidences that the wife obtained about impending acquisitions while working for a communications firm, and that the pair had a “domestic confidentiality policy” of sorts whereby the husband understood he could not share that confidential information. In United States v. McGee, 892 F. Supp. 2d 726 (E.D. Pa. 2012), the court concluded that the complaint adequately alleged a relationship of trust and confidence where the source of the information and the recipient had become friends through Alcoholics Anonymous and also had an agreement of confidentiality through their involvement with that organization. In SEC v. Conradt, 947 F. Supp. 2d 406 (S.D.N.Y. 2013), the Court concluded that the SEC adequately pleaded a relationship of trust and confidence by alleging that two friends over the course of eight months shared confidences regarding family illnesses, personal legal troubles, and work communications describing sensitive client holdings.

But two recent jury verdicts provide some hope to defendants. In SEC v. Jacobs, Case No. 13-cv-1289 (N.D. Ohio), the SEC alleged that Andrew and Leslie Jacobs violated Section 14 of the Exchange Act and Rule 14e-3, which pertains to insider trading specifically in the context of tender offers, and Section 10(b) of the Exchange Act and Rule 10b(5), which pertains to insider trading generally, when Leslie traded on information provided to Andrew by his close friend and brother-in-law, Blair Ramey. According to the complaint, although Ramey did not tell Andrew about the tender offer specifically, he was certain to have understood Ramey’s company was going to be acquired given the nature of the conversation. Ramey requested that Andrew keep their conversation confidential, and Andrew agreed to do so.

Although the jury found Andrew and Leslie liable under Section 14 of the Exchange Act and Rule 14e-3, it did not find them liable under Section 10(b) of the Exchange Act and Rule 10b(5). The distinction between these two claims is crucial—a finding of liability under Section 14 of the Exchange Act and Rule 14e-3 does not require the existence of a duty of trust or confidence while a finding under Section 10(b) of the Exchange Act and Rule 10(b)(5) does.

And, of course, the jury found entrepreneur Mark Cuban not liable for insider trading, even though the Fifth Circuit had concluded that the SEC adequately pleaded Cuban had a relationship of confidence because he agreed to keep confidential material, nonpublic information and also promised not to trade on the information, SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010).

Notwithstanding the expansive interpretation given to the duty of trust or confidence element by the SEC and the courts, the Jacobs and Cuban verdicts serve as a reminder that the jury may not always accept the SEC’s formulation of liability, even when that formulation has been the basis for numerous successful oppositions to motions to dismiss.