June 12, 2023

SEC to Issuers: Retaliating Against or Impeding Whistleblowers Is Not Zen

Holland & Knight SECond Opinions Blog Summer Series
Madeline Mariana Tansey | Allison Kernisky
Gavel and scale resting on desk

Holland & Knight's SECond Opinions Blog is excited to debut a Summer Series featuring posts written and researched by the associates in the Securities Enforcement Defense Team. The first blog in this series comes from Houston Associate Maddie Tansey, who focuses her practice on a variety of complex litigation matters, including internal and regulatory investigations and enforcement actions. Maddie assists companies on a wide range of legal and compliance issues involving financial and lending institutions, real estate disputes, healthcare and more.

Public companies should be mindful not to interfere with or retaliate against whistleblowers, and stretching is best reserved for the yoga mat, not the numbers in a company's public disclosures. So says the U.S. Securities and Exchange Commission (SEC) in a recent settlement involving yoga-streaming company Gaia Inc. (Gaia) for allegedly:

  1. overstating the amount of paying subscribers it had
  2. retaliating against a whistleblower who brought the issue to management's – and ultimately the SEC's Division of Enforcement's – attention
  3. attempting, through severance agreements, to prevent whistleblowers from collecting a reward from the SEC in violation of Exchange Act Rule 21F-17

As discussed below, this settlement reinforces that a company's words and actions, both publicly and internally, are of paramount importance to the SEC, and it makes clear that the agency will take action where a company does not comply with federal securities laws, including those established to protect whistleblowers. The settlement further provides important insight into the scope of the Dodd-Frank Wall Street Reform and Consumer Protection Act's anti-retaliation provisions, specifically Exchange Act Section 21(F)(h), which prohibits an employer from retaliating against whistleblowers, and Rule 21F-17 thereunder, which was intended to prevent employers taking any action that impedes a whistleblower from communicating with the SEC about a possible securities law violation.

Namaste to "Paying" Subscribers

As a subscription-based company, the number of paying subscribers Gaia (formerly Gaiam) is a key metric that its management and analysts track closely. In the third quarter of 2018, Gaia surpassed 500,000 paid subscribers and stated in its 2018 Form 10-K that the "subscriber base can be significantly expanded as more and more people enter … niche categories and begin accessing streaming content over the internet." In an earnings call on March 4, 2019, the company announced its plans to switch its billing platform from its legacy home-grown billing software to a third-party system. Gaia's CFO Paul C. Tarell Jr. explained that the switch would have a "one-time impact" in the first quarter of 2019. On the same call, the company announced that it had missed analysts' expectations for, among other things, subscriber growth for the fourth quarter and year-end of 2018, and the CFO cautioned that the company "expect[ed] to report around 560,000 paying subscribers for Q1 [2019]," a quarterly growth of about 10,000 subscribers. The next day, Gaia's stock price dropped approximately 15 percent.

Gaia's transition to the new billing system turned out to be anything but peaceful. The company experienced a number of technical issues that caused confusion among its employees regarding how to tally the number of paying subscribers. Based off historical subscriber attrition rates, Gaia concluded that the transition caused it to lose subscribers who may have otherwise kept their subscriptions. In an effort to retain subscribers, the CFO suggested – and the management team approved and implemented – a plan to gift a free one-month subscription to customers whose credit cards had been declined in the hopes they would update their payment information and reinstate their subscriptions. Of the approximately 20,000 customers who received the email offer, about 4,500 had prepaid for services through the end of the month but their credit cards were declined for future months, 500 former subscribers reactivated their accounts, and approximately 15,000 people neither prepaid nor updated their payment information.

On April 29, 2019, Gaia announced its first-quarter 2019 results in an earnings release and a Form 8-K and reported that it had 562,000 "paying" subscribers as of March 31, 2019, consistent with its previously announced target of "560,000 paying subscribers." The CFO stated in an earnings call that same day that the 562,000 figure excluded "subscribers for whom we were unable to successfully charge on our last renewal due to their credit cards becoming invalid." In reality, however, the 562,000 "paying subscribers" figure was overinflated because it did include the 15,000 subscribers who received a free month-long subscription but had not updated their payment information or paid beyond March 2019, in addition to the 4,500 individuals whose credit cards were declined on the last attempt. The next day, the company's stock price increased almost 14 percent.

A Whistleblower Raises Concerns

Beginning in August 2019 and continuing for the next six months, a Gaia employee (Whistleblower) raised concerns with senior management that the company may have overstated its paying subscribers in the first-quarter 2019 earnings release. Management conducted an investigation and determined that the subscriber count was accurate, and the Audit Committee determined that the issue presented no financial reporting issues. A board member who served on the management team consequently informed the Whistleblower that no action would be taken.

In response, the Whistleblower filed a complaint with the SEC in March 2020, detailing the possible overstatement of paying subscribers. In turn, Gaia terminated the Whistleblower in July 2020 "for cause" for "making unfounded complaints that required a significant expenditure of company resources to fully investigate." Also, over a period of more than three years beginning in July 2018, the company entered into 23 severance agreements with certain departing employees. Each agreement contained a provision that stated:

Nothing in this Section shall be construed or deemed to interfere with any protected right to file a charge or complaint with any applicable federal, state or local governmental administrative agency charged with enforcement of any law, or with any protected right to participate in an investigation or proceeding conducted by such administrative agency. 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 (emphasis added).

Notably, nothing in the settlement order indicates that Gaia attempted to prevent any former employees whose severance agreements contained the above language from communicating with the SEC.

Breathe In and Count to [Section] 17[a]

On May 23, 2023, more than four years after the misstatements at issue, the SEC announced settled charges against Gaia for violating Securities Act Sections 17(a)(2) and 17(a)(3), as well as Exchange Act Section 13(a) and Rules 12b-20 and 13a-11 thereunder, for overstating the number of paid subscribers, and against the CFO for causing the company's violations. The order also found that the company violated the whistleblower protection provisions of Exchange Act Section 21(F)(h) for improperly terminating the Whistleblower and Rule 21F-17 thereunder for including language in certain severance agreements that required them to waive any right to monetary recovery if they lodged a complaint. Without admitting or denying the findings, Gaia agreed to pay $2 million and the CFO agreed to pay $50,000 in civil monetary penalties.

Additionally, the company agreed to remove the prohibited language from its severance agreements and replace it with:

Nothing in this Section shall be construed or deemed to interfere with any protected right to file a charge or complaint with any applicable federal, state or local governmental administrative agency charged with enforcement of any law, or with any protected right to participate in an investigation or proceeding conducted by such administrative agency, or to recover any award offered by such administrative agency associated with such charge or complaint.

The company also undertook to make reasonable efforts to provide the order to former employees, along with a statement that the company does not prohibit employees from accepting a whistleblower award from the SEC.

Breathe Out and Count to [Section] 21[F]

For those loyal readers who have been following this issue (we see you, and thanks for reading this previous Holland & Knight blog post), the SEC's recent focus on Dodd-Frank's whistleblowing and anti-retaliation provisions has been strict and prophylactic. The multi-faceted Gaia settlement presents several notable considerations.

First, as pointed out in a previous Holland & Knight blog post, SEC investigations often have a long life. Here, the violative conduct occurred three to four years ago. It is clear that the SEC is skilled in the art of practicing patience – a trait essential for both yoga and SEC enforcement matters.

Second, this matter is a striking reminder that violations of Section 17(a)(2) and 17(a)(3) of the Securities Act do not need to be intentional. A company's negligent misstatement is sufficient to establish a violation of either section. While yoga instructs to live with intention, best practice calls for heightened mindfulness when making representations in public disclosures and avoiding acting with intentionality or even negligence in this context.

Additionally, the SEC's guidance as to what language will satisfy Rule 21F-17 and, conversely, what language it considers violative, is instructive. As a good practice, issuers may wish to study and consider similar satisfactory provisions in light of their own severance agreements.

Lastly, it is worth noting that, as in other similar matters, the SEC credited Gaia's remedial measures. Specifically, the company agreed to make "reasonable efforts" to contact former employees who signed severance agreements containing the problematic language (as identified by the SEC) and provide them with: 1) an internet link to the order and 2) a statement that Gaia does not prohibit employees from accepting a whistleblower award from the SEC pursuant to Section 21F of the Exchange Act. In addition, Gaia agreed to certify in writing to the SEC when it had completed the foregoing.

The Holland & Knight SECond Opinions Blog will continue to monitor this issue and provide updates on additional developments. If you need further information on this topic or anything related to SEC enforcement or internal investigations, please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team. Namaste.

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