Tag Archives: Janus Capital Group v. First Derivative Traders

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’s Amicus Brief in U.S. v. Newman Fails To Improve on DOJ’s Effort

Earlier this week, the SEC filed an amicus brief in support of the DOJ’s petition for rehearing en banc of the panel decision overturning two insider trading convictions in United States v. Newman.  The Newman decision is discussed here: US v. Newman: 2d Circuit Hands Government Stunning, Decisive, and Far-Reaching Insider Trading DefeatThe DOJ’s petition for en banc review is discussed here: DOJ Petition for En Banc Review in Newman Case Comes Up Short.  The SEC’s amicus filing did little to show why the Second Circuit should take the extraordinary step of reviewing en banc the unanimous panel decision.  The SEC’s brief can be found here: SEC Amicus Brief in US v Newman.

The SEC started from the same flawed foundation as the DOJ, contending that existing law mandated that an insider “engages in prohibited insider trading” merely by “disclosing information to a friend who then trades.”  SEC Brief at 1.  That supposedly is “because that is equivalent to the insider himself profitably trading on the information and then giving the trading profits to the fried.”  Id.  This makes me want to scream out loud: Just because you say something over and over again does not make it true!  This proposition leaves out the key requirement in the law, flowing directly from the language of the Supreme Court in Dirks v. SEC, that a tipper-insider must “personally … benefit … from his disclosure” (463 U.S. at 662), and that this benefit could arise out of “a gift of confidential information to a trading relative or friend”  463 U.S. at 664 (emphasis added).  The DOJ and SEC continue to pretend that every disclosure of confidential information to a friend is of necessity, a “gift,” and therefore no further evidence is required to show that a “gift” was intended.  In other words, the required “personal benefit” flowing to the tipper is conclusively presumed whenever the tippee is a “friend.”  No aspect of Dirks suggests such a result.

The holding of the Newman court was not an extraordinary extension or expansion of the “personal benefit” requirement.  The court did no more than examine the evidence – or actually, lack of evidence – of any real benefit flowing to the tippers in the case, and insist that there actually be such evidence before there is tippee liability, because, as Dirks made clear, there can be no tippee liability if there is no tipper liability.

This passage from Dirks makes that clear: “Determining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts.  But it is essential, we think, to have a guiding principle for those whose daily activities must be limited and instructed by the SEC’s inside trading rules, and we believe that there must be a breach of the insider’s fiduciary duty before the tippee inherits the duty to disclose or abstain.  In contrast, the rule adopted by the SEC in this case would have no limiting principle.”  Dirks v. SEC, 463 U.S. 646, 664 (1983).  As for the wisdom of allowing law enforcement authorities decide the lines to be drawn for enforcement actions, the Dirks Court wrote: “Without legal limitations, market participants are forced to rely on the reasonableness of the SEC’s litigation strategy, but that can be hazardous, as the facts of this case make plain.”  Id. n.24.

True to this Supreme Court insight, ever since Dirks was decided, the SEC and DOJ have been trying to water down the “personal benefit” element of tipper liability to the point that they now argue that this element has no substance at all – mere proof of “friendship” – which, by the way, is itself an extraordinarily stretched concept, in the SEC and DOJ view – is all you need to show “beyond a reasonable doubt” that a tipper personally benefited from a disclosure.  The law enforcement authorities have tried over many years to negate Dirks (and its predecessor decision Chiarella v. United States, which provided the foundation for Dirks) by stretching “personal benefit” to the point of near infinite elasticity if a “friend” is involved, and stretching the concept of “friend” to be the equivalent of “acquaintance.”  The Newman panel simply said, in no uncertain terms, they’d had enough of this.

In this context, it is more than a little “rich” for the SEC to argue that the “panel decision also creates uncertainty about the precise type of benefit … an insider who tips confidential information must receive to be liable.”  SEC Brief at 2.  For years, the SEC has tried, mostly successfully, to make the standards of insider trading liability as amorphous as possible, and has resisted efforts to develop precise definitions.  Its explanation for this is that if you give a precise definition, you allow someone to evade liability with sharp practices that fall outside of the definition.  In the SEC’s view, the Commission and the Division of Enforcement should decide which trading practices should be unlawful, almost always in after-the-fact enforcement actions.  They view themselves as “keepers of the faith,” who, of course, will always act in the public interest, and therefore do not need precise legal standards to govern their enforcement actions.  Suffice it to say that many of us who have represented clients on the other side of SEC investigations do not have quite this level of confidence in the SEC staff’s determination of the “public interest.”  That is in part because the Division of Enforcement is a huge aggregation of weakly-managed lawyers whose judgments on these issues are usually deferred to, but many of whom exercise questionable judgment, and give more weight to their personal views of the world than the actual evidence in the case.  See, e.g., SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law, and SEC Enforcement Takes Another Blow in SEC v. Obus.

Hence, the SEC believes that an argument for rehearing the Newman decision is that the SEC has brought many enforcement actions “where the only personal benefit to the tipper apparent from the decisions was providing inside information to a friend” and Newman’s insistence on evidence of “personal benefit” to the tipper beyond this would “impede enforcement actions.”  SEC Brief at 12.  But what if those prosecutions were overly aggressive under the law, as laid out in Dirks?  The SEC is always trying to stretch the law so that it has increased discretion to determine what to prosecute “in the public interest” (and to get added leverage in efforts to force settlements of enforcement actions with questionable factual support).  One example of this is the recent extraordinary effort of the Commission in In re Flannery and Hopkins to expand the scope of Rule 10b-5 by edict (not by rulemaking), and thereby negate the impact of the Supreme Court’s decision in Janus Capital Group v. First Derivative Traders, as discussed here: SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5.)  The attempt to negate the “personal benefit” requirement, and expand the Dirks reference to “a trading relative or friend” beyond reasonable recognition, are part and parcel of that “we know it when we see it” approach to the law.  But, especially in criminal cases, there is no place for allowing prosecutors such discretion and providing citizens no reasonable notice of the parameters of the law.

U.S. v. Newman does not represent a significant limit on the ability of the DOJ or SEC to bring meritorious insider trading claims.  It merely requires that before tippees are held criminally liable, or subjected to severe civil penalties and employment bars, law enforcement authorities present evidence sufficient to support a finding that a tipper-insider actually benefitted from the tip, and that the defendants had the requisite scienter.  If, as the SEC argues, friendship and “gifting” are almost inevitably synonymous, this is not a high burden, especially in SEC enforcement actions, which need only satisfy a “preponderance of the evidence” standard of proof.

Straight Arrow

January 29, 2015

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SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5

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.

Straight Arrow

December 19, 2014

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