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New, Thorough Academic Analysis of In re Flannery Shows Many Flaws in the Far-Reaching SEC Majority Opinion

One of the most important actions by the SEC over the past year was the far-reaching majority opinion of three commissioners in In the Matter of Flannery and Hopkins, SEC Release No. 3981, 2014 WL 7145625 (Dec. 15, 2014). That opinion can be read here: In re Flannery Majority Opinion.

Soon after Flannery was decided, we discussed the extraordinary nature of this opinion in an administrative enforcement action, in which the majority sought to create new, precedential legal standards for the critical antifraud provisions of the Securities Act of 1933 (section 17(a)) and the Securities Exchange Act of 1934 (section 10(b)).  In many respects, the standards they espoused departed significantly from judicial precedent, including Supreme Court and Courts of Appeals decisions.  The majority specifically invoked the doctrine of deference under Chevron U.S.A. Inc. v. Natural Resource Defense Council, Inc., 467 U.S. 837 (1984), as a means of pressing for the courts to defer to these expressed views instead of continuing to develop the parameters of these statutes through judicial standards of statutory analysis.  See SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5.

Since that time, some commentators have addressed aspects of the Flannery decision.  See, for example, ‘‘We Intend to Resolve the Ambiguities’’: The SEC Issues Some Surprising Guidance on Fraud Liability in the Wake of JanusThe decision is currently being briefed on appeal in the First Circuit under the caption Flannery v. SEC, No. 15-1080 (1st Cir.).  You can read the appellant’s brief here: Flannery Opening Appeal Brief in Flannery v. SEC, and the SEC’s opposition brief here: SEC Opposition Brief in Flannery v. SEC.  An amicus brief filed on behalf of the Chamber of Commerce can be read here: Chamber of Commerce Amicus Brief in Flannery v. SEC.

For an opinion this far-reaching, and attempting to make such extraordinary changes in the interpretation and application of two key statutes, there has been sparse commentary and analysis overall.  Perhaps this is because the majority opinion was so expansive in what it addressed (often unnecessarily, purely in order to lay down the SEC’s marker) that it was difficult to analyze comprehensively.  Fortunately, this is about to change.  The first sophisticated and in-depth analysis of key aspects of the Flannery opinion is in the final stages, written by Andrew Vollmer, a highly- experienced former SEC Deputy General Counsel, former private securities enforcement lawyer, and current Professor of Law at the University of Virginia Law School and Director of its Law & Business Program.  Professor Vollmer released a current version of an article (still being revised) on SSRN.  It is worth reading in its entirety, and is available here: SEC Revanchism and the Expansion of Primary Liability Under Section 17(a) and Rule 10(b)(5).

Professor Vollmer had the wisdom to realize that the best in enemy of the good, and limited the scope of his article to analysis of the majority opinion’s effort to expand primary liability under section 17(a) and section 10(b) and its claimed entitlement to Chevron deference.  Other provocative aspects of the opinion are left for hoped-for future analysis (by Professor Vollmer or others).  But the important issues of the majority’s attempt to alter the trajectory of judicial legal developments governing section 17(a) and section 10(b) liability, and the majority’s assertion that its views on these issues are worthy of Chevron deference by the courts, are examined with a depth and sophistication lacking in any other publication to date known to us, and well beyond the level of analysis given to these issues by the Commission majority itself.

For those who want a flavor of Professor Vollmer’s views without delving into the entire 60-page comment, I will quote at some length portions of his useful executive summary:

An exceedingly important question for those facing the possibility of fraud charges in an enforcement case brought by the Securities and Exchange Commission is the scope of primary liability under the two main anti-fraud provisions, Section 17(a) of the Securities Act and Rule 10b-5 of the Securities Exchange Act.  That subject has received close attention from the Supreme Court and lower courts, and recently the SEC weighed in with a survey of each of the subparts of Section 17(a) and Rule 10b-5 in a decision in an administrative adjudication of enforcement charges.

In the Flannery decision, a bare majority of Commissioners staked out broad positions on primary liability under Rule 10b-5(a) and (c) and Section 17(a)(1), (2), and (3) . . . .  The Commission not only advanced expansive legal conclusions, but it also insisted that the courts accept the agency’s legal interpretations as controlling.

The SEC’s decision in Flannery raises thought-provoking issues about the role of administrative agencies in the development, enforcement, and adjudication of federal law. The purpose of this article is to discuss two of those issues.

The first concerns the consistency of Flannery with the Supreme Court and lower court decisions defining the scope of primary liability under Rule 10b-5 and Section 17(a).  This article explains that much about Flannery is not consistent with, and is antagonistic to, a series of prominent Supreme Court decisions that imposed meaningful boundaries around aspects of primary liability under Rule 10b-5.  Those decisions are Central Bank of Denver, NA v. First Interstate Bank of Denver, NA, Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., and Janus Capital Group, Inc. v. First Derivative Traders.

The Commission in Flannery sought to confine and distinguish those precedents, but Part II.A below questions the SEC’s reading of the cases and explores the reasoning and analysis in Stoneridge and Janus to determine whether the opinions were, as the Commission said, limited solely to the reliance element in private cases or to subpart (b) of Rule 10b-5.  That review reveals that the effort of the Supreme Court in the cases was to draw a crisper line between primary liability and aiding and abetting and to define a primary violator as the separate and independent person with final control and authority over the content and use of a communication to the investing public.  The Court’s rationales ran to both Rule10b-5 and Section 17(a).

Part II.B then compares the reasoning and analysis in the Supreme Court cases plus a selection of court of appeals decisions with the Commission’s approach in Flannery.  One point of comparison is that the Commission used a loose and unprincipled policy of interpreting the laws flexibly to achieve their remedial purpose.  The Supreme Court long ago discredited and refused to apply that policy, but Flannery wielded it repeatedly to reach outcomes that grossly exceed the boundaries the Court appeared to be setting in Stoneridge and Janus.

For example, the Commission would extend primary liability to a person who orchestrated a sham transaction designed to give the false appearance of business operations even if a material misstatement by another person creates the nexus between the scheme and the securities market.  According to the Commission, Section 17(a)(1) goes further and covers a person who entered into a legitimate, non-deceptive transaction with a reporting company but who knew that the public company planned to misstate the revenue. These constructions disregarded the lesson of Stoneridge.  A person entering into a transaction with a public company, even a deceptive transaction, that resulted in the public company’s disclosure of false financial statements did not have primary liability when the public company was independent and had final say about its disclosures.  The Commission would extend primary liability to a person who drafted, approved, or did not change a disclosure made by another, but Janus held that a person working on a public disclosure was not the primary actor when another independent person issued and had final say about the disclosure.

A reading of the Flannery decision leaves the definite impression that a majority of SEC Commissioners aimed to use the case as a vehicle to recover much of the territory lost in the enforcement area from the Supreme Court decisions and the lower federal courts that have been following the Supreme Court’s lead.  It was an effort to supersede the court judgments by re-interpreting and extending the prohibitions in Rule 10b-5 and Section 17(a).  If these concerns have merit, the actions of the SEC, an administrative agency within the Executive Branch, are unsettling.  They take the stare out of stare decisis, rattle the stability of legal rules, upset traditional expectations about the role of the courts in the development of the law, and head toward a society ruled by bureaucratic fiat rather than ordered by laws.

 The second issue discussed in this article is whether the courts must or should treat the SEC’s legal conclusions in an adjudication as controlling under Chevron U.S.A. Inc. v. Natural Resources Defense Council, IncFlannery included an overt claim to Chevron deference.  Part III evaluates this bid for Chevron deference and concludes that the courts would have doctrinal and precedential grounds for refusing to accept the Flannery positions as controlling.  Part III.C goes through these reasons, starting with the text of the provision of the Administrative Procedure Act governing judicial review of agency actions and looking closely at the actual practice of the Supreme Court and courts of appeals when they review a legal conclusion in an agency adjudication.  Part III.E discusses particular features about Flannery that would justify a reviewing court in not giving controlling weight to the interpretations of Rule 10b-5 and Section 17(a).

The precedents identify good reasons for not granting Chevron deference to Flannery or similar agency adjudications in enforcement cases.  Giving controlling effect to the SEC’s decision in Flannery would allow the agency both to avoid the teachings of leading Supreme Court authorities and to trump the Supreme Court and other federal courts on significant matters of statutory interpretation.  It would empower the SEC to cut short and silence the normal process in the federal courts for testing and establishing the limits of liability provisions, and it would enable the SEC to tip the scales in enforcement cases by converting its litigating positions into non-reviewable legal interpretations.  The cumulative effect of an agency’s decision to roll back Supreme Court precedent and to consolidate for itself ultimate decision-making power over questions of law traditionally left to the courts would seriously alter a balance between agencies and courts long recognized in our system of government.

These two issues are not the only topics of interest in Flannery.  The Commission opinion raises many more.  Chief among them are the proper interpretations and coverage of each of the sub-parts of Section 17(a) and Rule 10b-5.  That was the main subject of Flannery, and it deserves careful study and analysis by courts, practitioners, and scholars.  The purpose of this article is not to propose conclusions on that important set of questions, although the discussion in Part II below will suggest some considerations and limitations that should bear on an appropriate construction of the statute and Rule.

Flannery touches on other points that are beyond the scope of this article. For example, the Commission majority suggested that the SEC does not need to prove either negligence or scienter for a violation of Section 17(a)(2) or (3).  Strict liability might exist, even though courts of appeals require the Commission to prove negligence.  Another example is the Commission’s position that Section 17(a)(3) prohibits pure omissions without a corresponding duty to disclose.  A third issue that deserves more attention is the Commission’s view that it could use a section of the Dodd-Frank Act to impose a monetary penalty in an administrative proceeding for conduct occurring before the enactment of the Dodd-Frank Act.  All in all, Flannery provides much fodder for rumination by the bench, bar, and academy.

Thanks to Professor Vollmer for picking up the gauntlet thrown down by three SEC commissioners in the Flannery opinion.  This is an important — a critical — battleground on which the scope of future liability for alleged securities fraud is now being fought.  Much of the commissioners’ expansive treatment of primary section 10(b) liability matters little to the SEC itself, because the SEC always has at its disposal allegations of aiding and abetting liability in its enforcement actions.  The crucial impact of the expanded scope of primary section 10(b) liability would be in private securities class actions.  The careful limits on securities class action strike suits against alleged secondary violators in the Supreme Court’s decisions in Central Bank, Stoneridge, and Janus would fall by the wayside under the majority’s expanded view of primary section 10(b) liability.  In no small respect, the three commissioners who penned the Flannery opinion are laying the foundation for the future wealth of the private securities plaintiffs’ bar more than they are creating meaningful enforcement precedent for the SEC itself.  Only the staunch, rigorous analysis of those like Professor Vollmer may stand in the way of that questionable redistribution of wealth.

Straight Arrow

July 9, 2015

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SEC Gambit To Avoid Judge May in Timbervest Case Seems To Have Failed

We previously wrote about the SEC’s desperate effort to avoid the assignment of Timbervest, LLC v. SEC, Civil Action No. 1:15-CV-2106 (N.D. Ga.), to District Judge Leigh Martin May.  See SEC, Desperate To Avoid Judge May, Challenges Related Case Designation in Timbervest Action and SEC Argues Common “Facts” Are Not Common “Issues of Fact” — I Kid You Not.  You recall that Judge May ruled in Hill v. SEC that the appointment of SEC ALJ James Grimes violated the appointments clause of Article II of the Constitution — see Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding.

Well, it appears that the SEC’s motion challenging the “related case” assignment of the Timbervest action to Judge May failed.  There is no order in the docket denying the motion, but a recent scheduling order issued by Judge May suggests she will continue to preside over the case.  See Timbervest v. SEC Scheduling Order.  In the Order, Judge May states that the SEC must respond to plaintiffs’ Motion for a Temporary Restraining Order and/or Preliminary Injunction by June 29, plaintiffs must file a reply brief by July 16, and “the parties will attend a hearing in this matter a hearing” on July 21, in Courtroom 2107.  Courtroom 2107 is listed in the N.D. Georgia directory as Judge May’s courtroom.

In the meantime, in the SEC administrative case brought against Gray Financial Group, In the Matter of Gray Financial Group, Inc. et al., File No. 3-16554, SEC ALJ Cameron Elliot declined to issue a stay of proceedings in response to an unopposed motion founded on the pending federal action for injunctive relief by Gray Financial in the same Georgia federal court, which was also assigned to Judge May.  He said: “Commission Rule of Practice 161 instructs that I ‘should adhere to a policy of strongly disfavoring’ stay requests unless ‘the requesting party makes a strong showing that the denial of the request or motion would substantially prejudice their case.’  17 C.F.R. § 201.161(b)(1).  Respondents have not made such a showing.  I will abide by an injunction if it is issued; however, as of now I have been instructed to resolve this proceeding within 300 days of service of the OIP.”  See Order Denying Unopposed Motion To Stay Administrative Proceeding Against Gray Financial Group.

So, chaos still reigns, and apparently the SEC is unsure about how best to bring it under control.  See SEC Rejects Easy Answers To Admin Court Challenges.  In that article, Law 360’s Stephanie Russell-Kraft reported on a discussion between Judge Richard Berman and a DOJ lawyer representing the SEC.  Judge Berman asked whether, in light of comments by Judge May that it might be easy to cure the appointments clause violation, the similar claims brought before him by Barbara Duka (in Duka v. SEC) could be resolved simply by having the Commission reappoint its current ALJs.  The DOJ lawyer declined to address whether that could be done, leading to the following colloquy:

“Is the commission opposed to an easy fix?” Judge Berman asked.

“The Department of Justice is very actively considering the best litigation approach to address this issue,” Lin answered.

“I’m asking you if [appointing the judges] would solve this issue,” Judge Berman pressed, pointing out that the case pending before him had nothing to do with the SEC’s litigation strategy.

“It’s not like if we pursue one of these options this case or other cases will go away,” Lin answered, adding that changing the way it appoints its judges is not a “meaningful way” to address Judge May’s decisions or a “practical way” for it to approach its long-standing administrative court scheme.

“The commission has to consider all the cases it has,” she said later, to which Judge Berman replied, “I don’t.”

Meanwhile, the SEC’s administrative proceeding against Laurie Bebo continues to be tried, even while the appeal of Ms. Bebo’s injunctive action moves forward in the Seventh Circuit.

The ship is plainly adrift.

Straight Arrow

June 23, 2015

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Update on Status of Proposed Settlement in Gordon v. Verizon Communications, Inc.

I’ve noticed a number of searches seeking further information on the status of the case Gordon v. Verizon Communications, Inc., Index No. 653084/2013, pending before Judge Melvin Schweitzer in the New York Supreme Court, New York County.  This is a putative class action challenging the acquisition by Verizon of Vodafone’s 45% minority stake in Verizon Wireless for $130 billion.  We previously discussed the objections lodged to a proposed settlement in that action, and Judge Schweitzer’s rejection of the settlement, in this post: Commentary on Abusive State Law Actions Following M&A Deals.  That was followed by a post on a scathing judicial statement on the impropriety of such “merger tax” cases (NY Court Flexes Muscles in Rejecting Bogus “Merger Tax” Settlement), which discussed a New York judge’s rejection of a proposed settlement in another knee-jerk merger challenge in the case City Trading Fund v. Nye, No. 651668/2014 (NY Sup. Ct.).  I recently received a note asking about where things stand in Gordon v. Verizon Communications, so here is an update.

The December 2014 opinion rejecting the settlement in Gordon (which can be found here: Decision and Order in Gordon v. Verizon Communications) was followed by the following:

  1.   One of the objectors, New York attorney Gerald Walpin, filed a motion for summary judgment on January 6, 2015, asking that the judge dismiss the plaintiff’s claim with prejudice.  The filing in support of that motion can be found here.  The plaintiff opposed that motion, in papers that can be found here.  Mr. Walpin filed this reply brief in favor of the summary judgment motion.  The briefing on that motion appears to have been completed on January 24, 2015.
  2.   The plaintiff then did two things: (i) on January 21, 2015, she filed a notice of appeal of the decision denying approval of the settlement (the notice of appeal can be found here); and (ii) on February 3, 2105, she filed a motion for reconsideration and reargument of the motion for approval of the settlement (the brief in support of the motion for reconsideration can be found here).  In other words, the plaintiff filed an appeal of the decision and then afterward asked that the same decision be reconsidered.  These are mutually inconsistent steps.  If the decision is appealed, the lower court loses jurisdiction over it and no longer can consider a reconsideration motion.  On the other hand, if a timely motion for reconsideration is filed, the earlier decision cannot properly be appealed until that motion is acted upon.  Filing the reconsideration motion after the notice of appeal might well be sanctionable.  The appeal seems flawed in any event because normally an appeal cannot occur before a case is finally decided.  Since Judge Schweitzer only denied a motion to approve the settlement, leaving the underlying case still pending in his court, there would appear to be no decision by him that is immediately appealable, absent a special order allowing an interlocutory appeal to occur.  The oppositions to the motion for reconsideration and reargument by the two objectors can be found here (opposition by Mr. Walpin), and here (opposition by objector Jonathan Crist).  Plaintiff’s reply brief in support of the motion for reargument is here.
  3.   As far as I can tell, no further action has occurred on either the motion for summary judgment or the motion for reconsideration of the denial of the settlement.  They each appear to be fully briefed.  Until some further action occurs, the proposed settlement is rejected and the case remains pending.

For those interested in the case, and in particular in the hearing held by Judge Schweitzer to consider the proposed settlement, a copy of the transcript of that hearing is available here:  Transcript of December 2, 2014 Hearing in Gordon v. Verizon Communications, Inc. on the motion for approval of proposed settlement.

Straight Arrow

March 2, 2015

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1st Circuit: Scienter Not Alleged Where Materiality Is Questionable and Regulatory Violations Remain in Doubt

The recent First Circuit decision in Fire and Police Pension Ass’n v. Abiomed, Inc., No. 14-1502, is noteworthy for its unusual mix of scienter and materiality analysis to affirm dismissal of a section 10(b) securities class action.  Ultimately, the court affirmed dismissal for the lack of sufficient scienter allegations under the heightened pleading standard of the Private Litigation Securities Reform Act (PSLRA), but it was the court’s mixing of scienter and materiality considerations that provokes interest.  The court also made it clear that a securities fraud claim cannot be based on an alleged failure to disclose misconduct while the resolution of the matters at issue with regulators remain uncertain.  A copy of the opinion is available here: Fire and Police Pension Ass’n v. Abiomed Inc.

The claims were founded on allegations that Abiomed, Inc., which sells medical devices, made misrepresentations about the Impella 2.5, a micro heart pump, which was Abiomed’s most important product. The alleged misrepresentations and omissions related to interactions between Abiomed and the FDA regarding marketing used to promote the Impella 2.5, and the possible promotion of off “off-label” uses of the device, that is, uses for purposes beyond those approved by the FDA.

The gist of the complaint was that Abiomed failed to disclose in its SEC filings several FDA communications warning about possible marketing and advertising improprieties, and failed to disclose that its revenues from the sales of that device were achieved in violation of FDA rules.  After ongoing communications between Abiomed and the FDA in 2010-2012, two things occurred.  In November 2012, Abiomed disclosed that federal prosecutors were investigating Abiomed’s promotional and marketing practices and published revised revenue projections, which was followed by a significant decline in stock price.  And in February 2013, the FDA gave Abiomed a “Close-Out Letter” stating its concerns had been adequately addressed by the company, and afterward, the stock price recovered its earlier losses.

The court noted that although it was “far from clear” that “plaintiffs plausibly alleged that “defendants made false or misleading statements which had a material effect on Abiomed’s stock price,” it was affirming the district court’s ruling that the plaintiffs did not sufficiently allege that defendants made those statements with a “conscious intent to defraud or ‘a high degree of recklessness.’”  Slip op. at 4 (quoting ACA Fin. Guar. Corp. v. Advest, Inc., 512 F.3d 46, 58 (1st Cir. 2008)).

 The court’s consideration of the materiality of the alleged misstatements played a significant role in its scienter analysis. The court wrote:

We do address the strength of the materiality of the statements because “[t]he question of whether a plaintiff has pled facts supporting a strong inference of scienter has an obvious connection to the question of the extent to which the omitted information is material.” . . .   “If it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact.” . . . The materiality of the impugned omission here — Abiomed’s failure to state that some of the increased revenues were due to off-label marketing — is marginal at best. Plaintiffs’ contention that the omission would have mattered to a reasonable investor depends on a long chain of inferences, most of which are not sufficiently substantiated by the allegations in the complaint.

Slip op. at 29 (citations omitted).  The court also took note that Abiomed’s disclosures explicitly warned about the FDA’s marketing concerns, including disclosures that concerns raised in FDA Warning Letters could have serious consequences.  Id. at 31-32.

Defense counsel should take particular note of the court’s response to the allegation that “Abiomed should have affirmatively admitted widespread wrongdoing rather than stating that the outcome of its regulatory back-and-forth with the FDA was uncertain.”  Slip op. at 32.  Class action complaints often allege fraud based on a failure to disclose that matters involving regulatory uncertainty (or other uncertainties) should have been disclosed as company shortcomings.  But the court here correctly noted that this approach would improperly mandate potentially misleading disclosures of uncertain future events:

That would be a perverse result; such an admission would have been misleading, since the off-label marketing issues had the potential to be resolved with no adverse action from the FDA.  We made a similar point in In re Boston Scientific Corp. Securities Litigation, 686 F.3d 21 (1st Cir. 2012), where we noted that “a company may behave ‘irresponsibly’ if it issues an ominous warning about an uncertain risk that ‘had not yet been adequately investigated.’” Id. at 31. … There must be some room for give and take between a regulated entity and its regulator.

 Id. at 32-33.

The opinion also addresses allegations of statements by so-called “confidential witnesses,” whose statements about the company’s operations did not support scienter because the alleged roles of these persons did not put them in a position to provide information about the knowledge and intent of company management. See id. at 35-36.  The court likewise found allegations of stock sales by insiders insufficient to support scienter because the facts alleged did not show unusual or suspicious trading. See id. at 36-38.

But the two key takeaways from this opinion are: (1) that even without showing alleged misrepresentations were immaterial as a matter of law – which is often tough on a motion to dismiss – defendants can use doubts about materiality to support arguments that scienter is not sufficiently supported under the PSLRA standard; and (2) that allegations of failure to disclose regulatory concerns fall short of fraud when the matters are being actively discussed with law enforcement authorities and it remains uncertain whether they can be resolved without any enforcement action.

Straight Arrow

January 12, 2005

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