On December 15, 2014, in a far-reaching opinion arguably extending well beyond what was required to decide the case, three of the five Commissioners of the SEC adopted extensive arguments for a broad reading of Rule 10b-5 and section 17(a) in the enforcement proceeding In re Flannery and Hopkins, File No. 3-14081. A copy of the majority opinion can be read here: In re Flannery Majority Opinion. Two Commissioners dissented, but no dissenting opinion was published as of December 18.
This is an extraordinary document. It attempts to preempt judicial development of the scope of several aspects of the securities laws by interceding and applying “agency expertise” to interpret those laws and regulations extremely broadly. On multiple occasions, these commissioners invoke the purported policy need to maintain as broad and malleable set of governing laws as possible to allow the Commission to address fraudulent conduct in whatever form it may appear. The policy need to provide certainty to people about what their legal exposures are is not mentioned.
The opinion ranges far and wide in discussing the scope of SEC Rule 10b-5 and section 17(a). It is difficult to summarize. But essentially, these commissioners rule that Rule 10b-5(a) prohibits almost any form of participation in deceptive conduct relating to securities as long as a person participates in some form of deceptive act. Although it does not say so outright, it represents an unveiled attempt to negate the Supreme Court decision in Janus Capital Group v. First Derivative Traders, 131 S. Ct. 2296 (2011).
There is much too much here to cover in a single blog piece. The opinion will require multiple reads to understand the many ways in which the three commissioners use this relatively minor case to try to revise the law, essentially by fiat. Some would say that taking such substantial steps to revise and expand the scope of a key regulation, and to interpret a key statutory provision, should occur only after a robust notice and comment process. Instead, what we have is a questionable act of policy-making by a divided Commission with no public input.
The case had been tried to an administrative law judge, who ruled in the initial decision that Flannery and Hopkins did not violate section 17(a) of the Securities Act of 1933, section 10(b) of the Securities Exchange Act of 1934, or SEC Rule 10b-5. The Commission majority ruled otherwise, finding both Flannery and Hopkins liable for violations of some provisions, but also rejecting the Division of Enforcement’s appeal in other respects.
The case involved communications by Flannery and Hopkins with investors about the Limited Duration Bond Fund of State Street Bank and Trust Co. (“LDBF”). LDBF was heavily invested in asset-backed securities, including residential mortgage-backed securities (“RMBS”), and by 2006-2007, its holdings became increasingly concentrated in subprime RMBS. The claim asserted that in various communications with investors, the respondents provided misleading information about the extent of subprime RMBS holdings and the risk profile of the fund.
The Commission majority used this case as a vehicle to present its position on the proper scope of liability under Rule 10b-5 and section 17(a) following the Supreme Court’s decision in Janus. In that case, the Court held that SEC Rule 10b-5(b)’s prohibition against “mak[ing] any untrue statement of a material fact” created liability only for persons with “ultimate authority” over the alleged false statement. People who assist in the preparation of such statements do not “make” them, and therefore are not liable under that language of the Rule.
Since Janus, the courts have hotly debated the scope of liability under other provisions of Rule 10b-5 that do not prohibit only “making” a misrepresentation. Rule 10b-5(a) prohibits the use of a “device, scheme, or artifice to defraud,” and Rule 10b-5(c) prohibits an “act, practice, or course of business which operates or would operate as a fraud or deceit,” each in connection with a purchase or sale of securities. Following Janus, SEC enforcement lawyers often took the position that people not liable under Rule 10b-5(b) under the Janus ruling nevertheless had so-called “scheme liability” under subparts (a) and (c) of Rule 10b-5 because they either used a “device” or “scheme” to pursue a fraud, or used acts that “operated” as a fraud, even if they did not make misrepresentations. These arguments often were resisted because they tended to “prove too much” by creating “primary” liability under Rule 10b-5 for people who did no more than “assist” fraudulent conduct by others. That distinction is important because part of the rationale of the Janus Court was that the broad application of Rule 10b-5 to create primary liability for people who were essentially aiders and abettors conflicted with the Supreme Court’s decision in Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164 (1994), which held that Rule 10b–5’s private right of action did not include suits against aiders and abettors. That case ruled that actions “against entities that contribute ‘substantial assistance’ to the making of a statement but do not actually make it” may be brought by the SEC, but not by private parties. The Janus opinion noted: “If persons or entities without control over the content of a statement could be considered primary violators who ‘made’ the statement, then aiders and abettors would be almost nonexistent.” The Janus decision was plainly motivated in part by the importance of retaining a distinction between primary and secondary violators because the first are subject to private 10b-5 actions and the second are not under Central Bank. This is reflected in the following passage in footnote 6: “[F]or Central Bank to have any meaning, there must be some distinction between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits). We draw a clean line between the two—the maker is the person or entity with ultimate authority over a statement and others are not.”
The Commission majority in Flannery emasculates Janus with the simple view that the Janus Court was expressly addressing only Rule 10b-5(b), which includes the “making” language, but made no determinations about Rule 10b-5(a) or (c), which does not have the same language. In an extraordinary act of administrative legerdemain, the three commissioners negate Janus by ruling first, that its analysis does not apply outside of Ryle 10b-5(b), and second, that Rule 10b5(a) is so broad that it covers everything covered in Rule 10b5(b) plus other forms of deceptive conduct in connection with the purchase or sale of securities that are excluded from Rule 10b-5(b). With apologies for the length of the quoted material, here is some of what the three commissioners say about Rule 10b-5:
The Supreme Court’s recent decision in Janus Capital Group v. First Derivative Traders resolved some of the differences among the lower courts, as it clarified—and limited—the scope of liability under Rule 10b-5(b). The decision was silent, however, as to Rule 10b-5(a) and (c) and Section 17(a), creating confusion in the lower courts as to whether its limitations apply to those provisions, as well. Moreover, Janus’s narrowing of liability under Rule 10b-5(b) has shifted attention to Rule 10b-5(a) and (c), as well as Section 17(a), making the lower courts’ divergence of views on the scope of those provisions especially evident. We appreciate the challenges lower courts have faced, and we recognize the ambiguity in Section 10(b), Rule 10b-5, and Section 17(a). Further, we note that, to date, Commission opinions have provided relatively little interpretive guidance regarding the meaning and interrelationship of these provisions. By setting out our interpretation of these provisions—which is informed by our experience and expertise in administering the securities laws—we intend to resolve the ambiguities in the meaning of Rule 10b-5 and Section 17(a) that have produced confusion in the courts and inconsistencies across jurisdictions. . . .
In Janus, the Supreme Court interpreted Rule 10b-5(b)’s prohibition against “mak[ing] any untrue statement of a material fact.” After concluding that liability could extend only to those with “ultimate authority” over an alleged false statement, the Court held that an investment adviser who drafted misstatements that were later included in a separate mutual fund’s prospectus could not be held liable under Rule 10b-5(b). The adviser could not be said to have “made” the misstatements, the Court reasoned. . . .
Unlike Rule 10b-5(b), Rule 10b-5(a) and (c) do not address only fraudulent misstatements. Rule 10b-5(a) prohibits the use of “any device, scheme, or artifice to defraud,” while Rule 10b-5(c) prohibits “engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit.” The very terms of the provisions “provide a broad linguistic frame within which a large number of practices may fit.” We have explained that Rule 10b-5 is “designed to encompass the infinite variety of devices that are alien to the climate of fair dealing . . . that Congress sought to create and maintain.” . . .
[W]e conclude that primary liability under Rule 10b-5(a) and (c) extends to one who (with scienter, and in connection with the purchase or sale of securities) employs any manipulative or deceptive device or engages in any manipulative or deceptive act. . . . In particular, we conclude that primary liability under Rule 10b-5(a) and (c) also encompasses the “making” of a fraudulent misstatement to investors, as well as the drafting or devising of such a misstatement. Such conduct, in our view, plainly constitutes employment of a deceptive “device” or “act.” . . . We note that, contrary to what some district courts have suggested, Janus does not require a different result. In Janus, the Court construed only the term “make” in Rule 10b-5(b), which does not appear in subsections (a) and (c); the decision did not even mention, let alone construe, the broader text of those provisions. And the Court never suggested that because the “maker” of a false statement is primarily liable under subsection (b), he cannot also be liable under subsections (a) and (c). Nor did the Court indicate that a defendant’s failure to “make” a misstatement for purposes of subsection (b) precludes primary liability under the other provisions. . . .
The [Janus] Court began its analysis with a textual basis for its holding, concluding that one who merely “prepares” a statement necessarily is not its “maker,” just as a mere speechwriter lacks “ultimate authority” over the contents of a speech. Our approach does not conflict with that logic: Accepting that a drafter is not primarily liable for “making” a misstatement under Rule 10b-5(b), our position is that the drafter would be primarily liable under subsections (a) and (c) for employing a deceptive “device” and engaging in a deceptive “act.”
Our approach is also consistent with the Court’s second justification for its holding—that a drafter’s conduct is too remote to satisfy the element of reliance in private actions arising under Rule 10b-5. Investors, the Court explained, cannot be said to have relied on “undisclosed act[s],” such as merely drafting a misstatement, that “preced[e] the decision of an independent entity to make a public statement.” Again, our analysis fully comports with that logic. Indeed, we do not suggest that the outcome in Janus itself might have been different if only the plaintiffs’ claims had arisen under Rule 10b-5(a) or (c). As Janus recognizes, those plaintiffs may not have been able to show reliance on the drafters’ conduct, regardless of the subsection of Rule 10b-5 alleged to have been violated. Thus, our interpretation would not expand the “narrow scope” the Supreme Court “give[s to] the implied private right of action.” But to say that a claim will not succeed in every case is not to say that there is no claim at all. In contrast to private parties, the Commission need not show reliance as an element of its claims. Thus, even if Janus precludes private actions against those who commit “undisclosed” deceptive acts, it does not preclude Commission enforcement actions under Rule 10b-5(a) and (c) against those same individuals. . . .
Several courts have adopted [an] approach . . . effectively holding that any misstatement-related conduct is exclusively the province of subsection (b). For multiple reasons, we disagree with those decisions. . . . [W]e understand their approach to have arisen from a misunderstanding of the Supreme Court’s decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver. In Central Bank, the Court explained that only defendants who themselves employ a manipulative or deceptive device or make a material misstatement may be primarily liable under Rule 10b-5; others are, at most, secondarily liable as aiders and abettors. Lower courts appropriately read Central Bank to require that, in cases involving fraudulent misstatements, defendants could not be primarily liable under Rule 10b-5(a) or (c) merely for having “assisted” an alleged scheme to make a fraudulent misstatement. But they then began to articulate this “more-than-mere-assistance” standard imprecisely, stating that primary liability under Rule 10b-5(a) and (c) must require proof of particular deceptive conduct “beyond” the alleged misstatements. We cannot agree with this construction of our rule, particularly given how far removed it is from its origins in Central Bank. And Central Bank itself certainly does not hold that primary liability under Rule 10b-5(a) and (c) turns on whether a defendant’s conduct is “beyond” a misstatement. Moreover, we note that Janus also does not independently justify such a test. As discussed, Janus does not address Rule 10b-5(a) or (c), let alone suggest that primary liability under those provisions is limited to deceptive acts “beyond” misstatements. Indeed, reading Janus to require such an approach would be inconsistent with the decision’s own emphasis on adhering to the text of the rule.
Slip op. at 14-21.
No doubt about it, this is a slap in the face of the Supreme Court — an assertion that the Supreme Court should get its hands off of SEC regulatory matters and let the SEC decide what is and is not unlawful under the securities laws. To be sure, Rule 10b-5 is an agency rule, not a statute, and the SEC should be able to interpret and apply its rules. But Rule 10b-5 was adopted by the SEC in 1942 without anything approaching the consideration and parsing done by the three commissioners in Flannery. It was originally approved without debate or comment, and it is reported that the full extent of consideration was Commissioner Sumner Pike’s comment: “Well, we are against fraud aren’t we?” The creation of new agency positions on the meaning and scope of this rule without any rulemaking or public comment process, with the specific design to trump the Supreme Court, is risky business indeed.
The regulatory reason for biting off this issue remains less than clear. Very little about what was said actually alters what the SEC can do in the way of enforcement actions. That is because, as noted in the Central Bank decision, the SEC already has acknowledged enforcement authority to bring actions for secondary liability against aiders and abettors. It doesn’t matter whether someone is sued by the SEC as an aider and abettor of a primary violation of Rule 10b-5(b) or a primary violator of Rule 10b5(a) (as the commissioners now hold can be done in many cases). Either way, the SEC can pursue its enforcement goals. The only material difference that would be caused by this new view of the scope of Rule 10b-5(a) and (c) is that it creates a new group of persons with primary liability who can be subjected to private securities actions. Private securities plaintiffs have no cause of action against aiders and abettors, but they can sue primary violators using the implied section 10(b) private cause of action. That difference was a significant aspect of the Central Bank decision, and was noted in the Janus decision as well. Why are the SEC commissioners so keen on expanding the scope of liability in private actions? We don’t know because that consideration wasn’t even mentioned in Flannery.
Much will be written about Flannery. It certainly will go up on appeal, and if it stands there is a more than fair chance that the Supreme Court will consider it. A majority of three commissioners is committed to providing the Commission and the Division of Enforcement maximum flexibility in attacking any conduct they choose to categorize as deceptive or fraudulent. They believe the Nation should put its trust in the ability of SEC commissioners and enforcement lawyers and bureaucrats to decide what may and may not be done in the securities marketplace with as few restrictive parameters as possible. Count me as dubious.
December 19, 2014
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