Public companies should revisit their template severance agreements, in light of two recent orders by the Securities and Exchange Commission (SEC).[1] Standard severance clauses covering (1) confidential information and (2) prohibitions against receiving additional monetary awards have been deemed unlawful by the SEC, resulting in settlements and fines exceeding $600,000, plus other sanctions.

The SEC’s allegations in both cases were based on the Whistleblower Incentives and Protection section of the amended Securities and Exchange Act, which reads:

(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.

This section, contained in Rule 21F-17, was enacted as part of the Whistleblower Program contained in the Dodd-Frank reforms of 2010.

The alleged violations in these two cases were not that the company’s standard severance agreement prohibited individuals from making reports to the SEC. To the contrary, both companies’ agreements made clear that the outgoing employees could raise allegations with a government agency.

The violations, rather, were (1) that the individuals had to waive their right to any further recovery if they were to raise allegations with a government agency, and (2) that if the filing of a charge (or the raising of allegations) involved disclosing confidential company information to the agency, the individuals would have to provide notice to the company first.

(1) “No further recovery” clauses

“No further recovery” clauses have become commonplace in severance agreements because companies cannot prohibit their employees (or ex-employees) from making complaints of wrongdoing to government agencies, even where the employees have waived their right to bring a civil suit based on the same facts. To disincentivize employees from making such complaints to government agencies, severance agreements often include clauses in which employees agree that, even if they make such allegations, they will not accept any monetary award beyond what they are receiving as severance pay.

The SEC, however, considers the financial incentives made available to whistleblowers by Dodd-Frank to be a “critical component” of the Whistleblower Program. It deems these financial rewards as necessary to offset the “enormous risk [to an individual] of blowing the whistle in calling attention to fraud.” The SEC found that requiring individuals to waive these payouts as a condition of accepting severance is a violation of Rule 21F-17. Such a requirement, the SEC concluded, “impedes individuals” from participating in the SEC’s whistleblower program. The waiver of additional financial recovery removes “important financial incentives that are intended to encourage persons to communicate directly with the Commission staff about possible securities law violations.”

(2) Confidentiality Clauses and Employer Notification Requirements

Confidential information clauses have also become commonplace in severance agreements, serving to remind employees of the importance of preserving company confidential information. These clauses often include carve-outs recognizing that the disclosure of confidential information may sometimes be required by law or by a subpoena. Under such circumstances, however, a typical confidentiality clause might also require the individual to provide the company with advance notice before disclosing the confidential information. Such clauses are intended to provide the company with an opportunity to object to the subpoena or to seek an appropriate protective order before the individual discloses confidential information.

The SEC found that these clauses, requiring prior notice before disclosure, also violate Rule 21F-17. A “critical” whistleblower protection provided under Dodd-Frank is the ability of whistleblowers to remain confidential, according to the Commission. Prior disclosure requirements are illegal, the SEC wrote, because they force individuals to choose between identifying themselves to the company as whistleblowers (i.e., agreeing to notify the company before blowing the whistle) or forfeiting a severance package.

The SEC noted that the confidentiality and prior notice clauses at issue did not contain any exception that would permit disclosure to the government without prior notice to the company. Had the severance agreement included such an exception, it likely would have withstood the SEC’s scrutiny.

Action Items for Public Companies

In light of these two settlements and the accompanying findings by the SEC, public companies should review their severance agreements and modify or remove language that the SEC would find objectionable.

“No further recovery” clauses may need to be removed or redrafted to permit recovery of whistleblower bounties under Dodd-Frank.

Confidentiality clauses may require redrafting as well. Such clauses may need carve-outs that permit disclosure to the SEC or other government agencies, without requiring prior notification to the company.

The SEC’s targets in these two actions were a health care company in California and a construction company in Georgia. The settlement agreements and accompanying orders were released within six days of each other. The diversity in industries and locations of these two companies sends a signal that the SEC’s enforcement initiative regarding these types of clauses is not limited to a particular type of public company. In one of the cases, the SEC noted that it had no evidence that the severance clauses actually discouraged any individual from making a report to the SEC. The mere existence of the clause was deemed sufficient, in the view of the SEC, to violate Rule 21F-17.

All companies whose activities are subject to SEC requirements should consider proactive steps to avoid becoming the target of a similar action.