Tag Archives: recklessness

First Circuit Rebuffs SEC in Flannery and Hopkins Case and Vacates SEC Order

The SEC suffered a stunning loss in the First Circuit in a December 8, 2015 decision ruling that the SEC’s findings of securities law violations by two executives in connection with the operation of a State Street Bank bond fund lacked substantial supporting evidence.  The Commission had, by a 3-2 divided vote, overturned a decision by one of its administrative law judges that no violations had occurred, and in doing so wrote a highly controversial opinion in which it staked out aggressive positions on a variety of securities law issues.  See SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5; New, Thorough Academic Analysis of In re Flannery Shows Many Flaws in the Far-Reaching SEC Majority Opinion; and SEC not entitled to deference in State Street fraud appeal – law prof.

The First Circuit panel found, however, that the underlying evidence simply failed to support the finding of any violation on any  theory, even the aggressive interpretations set forth by the Commission in its opinion.  As a result, the First Circuit never ruled on the validity or invalidity of several important legal issues raised by the Commission in its overreaching opinion.  Therefore, the key issue whether the SEC’s attempt at aggressive revisions of the scope of the law are entitled to deference or acceptance was not reached.  The end result, however, which vacates the SEC Order, leaves no SEC precedent in place to support those aggressive opinions.

The First Circuit’s opinion is available here: 1st Circuit Decision in Flannery v. SEC.  The now-vacated SEC opinion is available here: In re Flannery Majority Opinion.

Perhaps the most stunning aspect of the First Circuit opinion is the way in which the court schooled the SEC — the supposed experts on securities —  by explaining why the evidence the SEC found compelling (despite a contrary ruling by its ALJ) was in fact deeply flawed.  Where the Commission majority found evidence of material intentional and negligent misrepresentations, the appellate court found no substance whatever.  What does this say about the competence of the SEC and its staff to consider such issues?  If you read the opinion, you will see that the SEC’s willingness to stretch minimal evidence into supposed violations of law, and to disregard the lack of real evidence of materiality and state of mind proffered during the trial, seems a lot like the strained efforts of plaintiffs’ lawyers to find securities fraud everywhere.  And that is the reality faced by those being investigated and prosecuted by the SEC: the investigation and prosecution proceeds on the basis of a distorted view of what constitutes important information, and intentional or negligent behavior, that puts almost every decision in the SEC’s cross-hairs based largely on backward-looking, “fraud by hindsight” reasoning.

 The First Circuit opinion is based on an analysis of the specific evidence in the record, and therefore is not easily summarized.  The case turned on two sets of events.

The case against Mr. Hopkins turned on a short presentation to investors in which he participated, and, indeed, a single power-point slide in that presentation.  That slide set forth various parameters of the bond fund at issue (State Street’s Limited Duration Bond Fund, hereafter “the Fund”) under the heading “Typical Portfolio Exposures and Characteristics.”  It never purported to lay out the exact characteristics of the Fund at the time of the presentation, although Mr. Hopkins had that information available if any investor asked about them.  The SEC charged Mr. Hopkins with fraud for discussing this power-point slide without providing the exact information about the Fund at that time, which in some respects differed from the “typical” slide, and in others did not.  In particular, the percentage of holdings of different types of asset-backed securities — ABS (asset-backed securities, included residential mortgage-backed securities), CBS (commercial-backed securities), MBS (mortgage-backed securities), and other designations — at the time varied from the “typical” slide by having heavier ABS holdings.

The case against Mr. Flannery focused on two letters sent by State Street to investors regarding the impact of the 2007 financial crisis on the Fund and steps being taken to respond to that.  Mr. Flannery signed one of those letters, but not the other.  Many State Street officials participated in the drafting of these letters, including its General Counsel.  The SEC contended that Mr. Flannery negligently participated in a “course of business” that “operated as a fraud” in his role in connection with these letters.  The alleged misrepresentations in the letters related to whether steps taken to divest the Fund of certain bonds were properly described as lessening its exposure to risk.

As you can see, these are “in the weeds” issues to which the SEC should be able to bring sophistication and expertise.  Instead, they pursued a blunderbuss case that ignored the context of the disclosures, the realities of these types of communications (what they are intended to communicate and what not), and the actual language used.  The SEC essentially waved its hands around and said “this is bad; this is bad” and “look how badly the funds did when the mortgage-backed securities market tanked.”  But it failed to present evidence that what was said was wrong, or that the aspect that it contended was wrong was even important to investors, and ignored substantial evidence to the contrary.

Here is some of what the court said with respect to the case against Mr. Hopkins:

Questions of materiality and scienter are connected. . . .  “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.” . . .

Here, assuming the Typical Portfolio Slide was misleading, evidence supporting the Commission’s finding of materiality was marginal.  The Commission’s opinion states that “reasonable investors would have viewed disclosure of the fact that, during the relevant period, [the Fund’s] exposure to ABS was substantially higher than was stated in the slide as having significantly altered the total mix of information available to them.”  Yet the Commission identifies only one witness other than Hopkins relevant to this conclusion. . . .

[T]he slide was clearly labeled “Typical.”  [The witness and his firm] never asked … for a breakdown of the [Fund’s] actual investment….  Further, the Commission has not identified any evidence in the record that the credit risks posed by ABS, CMBS, or MBS were materially different from each other, arguing instead that the percent of investment in ABS and diversification as such are important to investors.  Context makes a difference.  According to a report [the witness] authored the day after the meeting, the meeting’s purpose was to explain why the [Fund] had underperformed in the first quarter of 2007 and to discuss its investment in a specific index that had contributed to the underperformance.  The Typical Portfolio Slide was one slide of a presentation of at least twenty. Perhaps unsurprisingly, the slide was not mentioned in [the witness’s] report.

Hopkins presented expert testimony . . . that “[p]re-prepared documents such as . . . presentations . . . are not intended to present a complete picture of the fund,” but rather serve as “starting points,” after which due diligence is performed.  [The expert] explained that “a typical investor in an unregistered fund would understand that it could specifically request additional information regarding the fund.”  And not only were clients given specific information upon request, information about the [Fund’s] actual percent of sector investment was available through the fact sheets and annual audited financial statements.  The … fact sheet … six weeks prior to the … presentation [said] the [Fund] was 100% invested in ABS.  The [fact sheet one-month after the presentation said] the [Fund] was 81.3% invested in ABS. These facts weigh against any conclusion that the Typical Portfolio Slide had “significantly altered the ‘total mix’ of information made available.” …

This thin materiality showing cannot support a finding of scienter here….  Hopkins testified that in his experience investors did not focus on sector breakdown when making their investment decisions and that [Fund] investors did not focus on how much of the [Fund] investment was in ABS versus MBS….  He did not update the Typical Portfolio Slide’s sector breakdowns because he did not think the typical sector breakdowns were important to investors.  To the extent that an investor would want to know the actual sector breakdowns, Hopkins would bring notes with “the accurate information” so that he could answer any questions that arose.  We cannot say that these handwritten notes provide substantial evidence of recklessness, much less intentionality to mislead — particularly in light of Hopkins’s belief that this information was not important to investors….

We conclude that the Commission abused its discretion in holding Hopkins liable under Section 17(a)(1), Section 10(b), and Rule 10b-5.

Slip op. at 21-24 (footnotes omitted).

The court said in a footnote: “… We do not suggest that the mere availability of accurate information negates an inaccurate statement.  Rather, when a slide is labeled ‘typical,’ and where a reasonable investor would not rely on one slide but instead would conduct due diligence when making an investment decision, the availability of actual and accurate information is relevant.”  Slip op. at 22 n.8.

And here is some of the discussion about the case against Mr. Flannery:

… At the very least, the August 2 letter was not misleading — even when considered with the August 14 letter — and so there was not substantial evidence to support the Commission’s finding that Flannery was “liable for having engaged in a ‘course of business’ that operated as a fraud on [Fund] investors.”

The Commission’s primary reason for finding the August 2 letter misleading was its view that the “[The Fund’s] sale of the AAA-rated securities did not reduce risk in the fund.  Rather, the sale ultimately increased both the fund’s credit risk and its liquidity risk because the securities that remained in the fund had a lower credit rating and were less liquid than those that were sold.” At the outset, we note that neither of the Commission’s assertions — that the sale increased the fund’s credit risk and increased its liquidity risk — are supported by substantial evidence.

First, although credit rating alone does not necessarily measure a portfolio’s risk, the Commission does not dispute the truth of the letter’s statement that the [Fund] maintained an average AA-credit quality. Second, expert testimony presented at the proceeding explained that the July 26 AAA-rated bond sale reduced risk because these bonds “entailed credit and market risk that were substantially greater than those of cash positions. In addition, a portion of the sale proceeds was used to pay down [repurchase agreement] loans and reduce the portfolio leverage.”

Further, testimony throughout the proceeding indicated that the [Fund’s] bond sales in July and August reduced risk by decreasing exposure to the subprime residential market, by reducing leverage, and by increasing liquidity, part of which was used to repay loans.

To be sure, the Commission maintained that the bond sale’s potentially beneficial effects on the fund’s liquidity risk were immediately undermined by the “massive outflows of the sale proceeds . . . to early redeemers.”  But this reasoning falters for two reasons. First, the Commission acknowledged that between $175 and $195 million of the cash proceeds remained in the LDBF as of the time the letter was sent; it offered no reason, however, why this level of cash holdings provided an insufficient liquidity cushion.  Second and more fundamentally, even if the Commission was correct that the liquidity risk in the [Fund] was higher following the sale than it was prior to the sale, it does not follow that the sale failed to reduce risk.  Rather, to treat as misleading the statement in the August 2 letter that State Street had “reduced risk,” the Commission would need to demonstrate that the liquidity risk in the LDBF following the sale was higher than it would have been in the counterfactual world in which the financial crisis had continued to roil — and in which large numbers of investors likely would have sought redemption — and the [Fund] had not sold its AAA holdings. But the Commission has not done this.

Independently, the Commission has misread the letter. The August 2 letter did not claim to have reduced risk in the [Fund].  The letter states that “the downdraft in valuations has had a significant impact on the risk profile of our portfolios, prompting us to take steps to seek to reduce risk across the affected portfolios” (emphasis added).  Indeed, at oral argument, the Commission acknowledged that there was no particular sentence in the letter that was inaccurate. It contends that the statement, “[t]he actions we have taken to date in the [Fund] simultaneously reduced risk in other [State Street] active fixed income and active derivative-based strategies,” misled investors into thinking [State Street] reduced the [Fund’s] risk profile.  This argument ignores the word “other.”  The letter was sent to clients in at least twenty-one other funds, and, if anything, speaks to having reduced risk in funds other than the [Fund].

Even beyond that, there is not substantial evidence that [State Street] did not “seek to reduce risk across the affected portfolios.”  As one expert testified, there are different types of risk associated with a fund like the [Fund], including market risk, liquidity risk, and credit or default risk.  The [Fund] was facing a liquidity problem, and … the Director of Active North American Fixed Income, explained that “[i]t’s hard to predict if the market will hold on or if there will be a large number of withdrawals by clients.  We need to have liquidity should the clients decide to withdraw.” Flannery noted that “if [they didn’t] raise liquidity [they] face[d] a greater unknown.”  … [The Fund’s] lead portfolio manager, noted that selling only AAA-rated bonds would affect the [Fund’s] risk profile.  After discussion of both of these concerns, the Investment Committee ultimately decided to increase liquidity, sell a pro-rata share to warrant withdrawals, and reduce AA exposure. And that is what it did.…  The August 2 letter does not try to hide the sale of the AAA-rated bonds; it candidly acknowledges it. At the proceeding, Flannery testified that selling AAA-rated bonds itself reduces risk, and here, in combination with the pro-rata sale, was intended to maintain a consistent risk profile for the [Fund].  [Another witness] testified that the goal of the pro-rata sale was to treat all shareholders — both those who exited the fund and those who remained — as equally as possible and maintain the risk-characteristics of the portfolio to the extent possible.  These actions are not inconsistent with trying to reduce the risk profile across the portfolios.

Finally, we note that the Commission has failed to identify a single witness that supports a finding of materiality….  We do not think the letter was misleading, and we find no substantial evidence supporting a conclusion otherwise. 

We need not reach the August 14 letter…. Even were we to assume that the August 14 letter was misleading, in light of the SEC’s interpretation of Section 17(a)(3) and our conclusion about the August 2 letter, we find there is not substantial evidence to support the Commission’s finding that Flannery engaged in a fraudulent “practice” or “course of business.”

Slip op. at 25-30 (footnotes omitted).

As noted above, it is obvious that the court’s decision turned on a close examination of the evidence, and an understanding of what the statements made by Hopkins and Flannery really meant, within their context.  The generalized power-point slide used by Mr. Hopkins, in the context of a broader presentation, and the availability of specific information on request, was so close to immaterial that Mr. Hopkins’ understanding that investors would not place significant weight on the “typical” data could not be reckless.  And the State Street letters to investors in which Mr. Flannery participated were not inaccurate because the SEC did not understand that the transaction described was, in fact, a means of reducing risk exposure.  That last point is a killer: the SEC could not even understand how to evaluate the risk exposures of these types of portfolios!  How good does that make you feel about the Commissioners that are responsible for understanding and protecting our capital markets?

This is a huge loss for the Commission because so much effort was made to make this case a showpiece for enforcement against individuals for supposed securities violations in the sale of the mortgage-backed securities that were devastated in the financial crisis.  The SEC was loaded for bear to hold some individuals responsible, regardless of the evidence.  Thank goodness a court was ultimately available to return us to the true rule of law.

Straight Arrow

December 9, 2015

Contact Straight Arrow privately here, or leave a public comment below:

Some SEC Administrative Law Judges Are Thoughtful and Even Judicious

We have now on several occasions bemoaned the fate of Laurie Bebo, former CEO of Assisted Living Concepts, Inc., to be forced to litigate her professional future before SEC Administrative Law Judge Cameron Elliot, whom we believe to be, shall we say, not the brightest star in the firmament.  See SEC ALJ Cameron Elliot Shows Why In re Bebo Should Be in Federal Court; Bebo Case Continues To Show Why SEC Administrative Proceeding Home Advantage Is Unfair; and SEC ALJ in Bebo Case Refuses To Consider Constitutional Challenge and Denies More Time To Prepare Defense.  And we have argued that the SEC’s home administrative law court is not a fair forum for the resolution of career-threatening enforcement actions against non-regulated defendants, notwithstanding that the Dodd Frank Act permits such cases to go forward.  See Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit; Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions; and Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions.  That might make a reader think we believe that all SEC ALJs lack the ability or temperament to preside over and decide important cases.  So, to set that record straight, allow us to say that, like almost almost any other place, the SEC administrative law courts are administered by appointees with a range of abilities and demeanors.  It is not the lack of judicial ability that makes the SEC’s administrative courts a poor forum for such cases, it is that the forum is bereft of procedural protections that enhance the chance that a respondent will get a fair shake even when the presiding ALJ is one of poor judicial timber.

In federal court, there are also good judges, bad judges, and a range in between.  But the scales of justice have calibrating factors other than the judge.  In a federal court, equal access to potential evidence through liberal discovery; equal opportunity to develop familiarity with the record over a reasonable period of time; evidentiary rules designed to assure that unreliable evidence, and excessively prejudicial evidence, is excluded; and, of course, the fact that a jury sits to consider the evidence, and use their combined common sense to find facts, all combine to make it possible for a defendant to overcome poor judging.  There is a vacuum of such protections in the administrative law court.  That makes the quality, or questionable quality, of the judge/trier of fact, much more important.  When the judge fails to understand, or care, that he or she is essentially the only factor between a fair proceeding and one tilted in favor of the prosecutor, justice suffers.

So, in celebration of the new baseball season, I’d like to throw a change-up today and discuss an SEC administrative law judge who, although appointed only recently, is showing great potential to be worthy of his position.  I’ve not seen SEC ALJ Jason Patil in the courtroom, but I’ve been very impressed with his approach in some recent cases.  He’s shown he can act with independence, thoroughness, attention to detail, and a strong dose of common sense.  So this blog post is to give credit where credit is due.

All the more credit is due because Jason Patil is the proverbial “new kid on the block.”  He was appointed to the SEC’s ALJ bench on September 22, 2014, after receiving a Stanford degree in political science in 1995, a law degree from from the University of Chicago Law School in 1998, and an L.L.M, from Georgetown University Law Center in 2009.  He served at the Department of Justice for 14 years.

Fewer than 3 months after ALJ Patil started at the SEC, the Second Circuit rocked the boat of the DOJ and the SEC with its insider trading decision in United States v. Newman.  ALJ Patil had to consider the impact of that decision in a case before him: In the Matter of Bolan and Ruggieri.  The SEC’s enforcement lawyers made every effort to obtain an early, post-Newman ruling from ALJ Patil in that case that would limit the scope of the Newman opinion through the adoption of a standard that would not apply Newman‘s holding to insider trading cases based on the misappropriation theory, rather than the so-called “classical” insider trading theory on which the Newman and Chiasson prosecution was founded.  ALJ Patil resisted the SEC’s full-court press to make him an early adopter of an approach that essentially ignored key language in the Second Circuit opinion.  He rejected that effort, ruling that, as the Newman court said, the standard for liability was the same under either the classical or misappropriation insider trading theory.  See SEC ALJ in Bolan and Ruggieri Proceeding Rules Misappropriation Theory Mandates Proof of Benefit to Tipper.

That showed intelligence, independence, and, to be frank, guts, for a newly-appointed ALJ.  But it was a later decision that showed me that ALJ Patil seems to have the stuff of a good judge.  In the Matter of Delaney and Yancey, File No. 3-15873, was not a high profile insider trading case, but it was apparent from the Initial Decision he wrote that he was able and willing to evaluate cases fairly and decisively.  His decision in that case is available here: ALJ Initial Decision in the Matter of Delaney and Yancey.  In that case, he wrote a careful opinion, weighing the evidence, distinguishing between the roles and conduct of the respondents, weighing expert testimony, considering (and often rejecting) varying SEC legal theories, and applying a strong dose of common sense.

The case was a technical one, involving charges against two individuals, the President and CEO of a broker-dealer that was a major clearing firm for stock trades (Mr. Yancey), and that firm’s Chief Compliance Officer (Mr. Delaney).  The SEC alleged many violations by the firm of SEC regulations governing the settlement of trades.  Mr. Delaney was charged with aiding and abetting, and causing, numerous violations of SEC regulations by virtue of his conduct as the Chief Compliance Officer.  Mr. Yancey was charged with failing adequately to supervise Mr. Delaney and another firm employee, allowing the violations to occur.  ALJ Patil exhaustively reviewed the evidence to reach reasoned decisions, with cogent explanations supporting his views.  In doing so, he was not shy about chiding the SEC for fanciful theories and woefully unsupported proposed inferences.

The opinion is long, detailed, and more in the weeds than many of us like to get.  The aiding and abetting charge against Mr. Delaney required proof that he assisted the violations through either knowing or extremely reckless conduct (i.e., scienter).  The SEC enforcement staff is quick to accuse people of knowing or reckless misconduct, and is often willing to draw that inference with little in the way of supporting evidence.  ALJ Patil’s review of the evidence presented in support of the scienter element was precise and thorough.  He dissected the evidence piece-by-piece, in impressive detail.  Here is some of what he said:

The Division has failed to show that Delaney acted with the requisite scienter, and
therefore its aiding and abetting claim against Delaney fails.  As an initial matter, I note that the Division is unable to articulate or substantiate a plausible theory as to why Delaney would want to aid and abet [his firm’s violations].  While the Division correctly argues that motive is not a mandatory element of an aiding and abetting claim, numerous courts have noted its absence when finding that scienter has not been proven. . . .    The Division also failed to establish that Delaney had anything to gain from the alleged misconduct.  The Division’s original theory was a wildly exaggerated belief that [the] . . . violations resulted in millions of dollars of additional profits. . . .  The Division was forced to abandon that theory, and in the end agreed that the “only specifically quantified benefit” to [the firm] . . . was a meager $59,000.  I do not find that sum would have given Delaney any motive to aid and abet the . . . violation. . . .  Although the Division also argues that there would have been “substantial costs to [the firm] . . . that . . . could expose the firm to significant losses,” the Division produced no evidence to quantify the costs or losses, and the testimony to which the Division points is general and speculative. . . .  As the Division did not provide any evidence quantifying the purported costs or losses, I am unable to determine whether there were any.

One of the SEC’s major points was the contention that Mr. Delaney’s knowing misconduct was apparent because he was shown to be a liar by misstatements in the Wells Submission submitted to the SEC on his behalf by his lawyers.  ALJ Patil forcefully torpedoed this theory:

I disagree with the Division’s conclusion that “Delaney has not been honest or
truthful” and “[i]nstead . . . has been evasive and inconsistent.”. . .  The Division’s
primary evidence for this alleged dishonesty are statements made in Delaney’s Wells
submission.  The Division argues, “either the statements Delaney approved about his knowledge and actions were lies to the Commission in his Wells submission or his repudiation of those statements are lies to the Court now.”. . .  Based on my careful review of that document, I conclude that it is primarily comprised of argument by counsel and grounded in incomplete information. . . .  It is based not just on Delaney’s understanding at that time, but on his counsel’s characterization of other evidence selectively provided to Delaney by the Division. . . . .  In contrast to that argumentative submission, Delaney testified five times under oath, including at the hearing. . . .  I find that Delaney’s testimony was overwhelmingly consistent, and the handful of inconsistencies alleged by the Division in such testimony either do not exist or are easily explained by the circumstances. . . .  In this case, where Delaney testified multiple times under oath at the Division’s request, as did other witnesses, I have decided to base my decision on that testimony and other documents in the record, which I find more probative than past characterizations made by Delaney’s counsel. . . .  I do not accept the Division’s insistence that everything in the [Wells Submission], particularly the statements in the legal argument section, should be taken, in essence, as testimony of Delaney.

Perhaps most telling was ALJ Patil’s careful review of supposed inconsistencies in testimony by Mr. Delaney.  His evaluation of that testimony reflected thoughtful consideration of the facts and circumstances both when the events at issue occurred, and when the testimony was given.  The decision took the SEC lawyers to task for arguing that testimony was inconsistent when the supposed inconsistencies were more plausibly explained by poor questioning by the SEC staff during their numerous examinations of him:

To the extent that Delaney’s testimony could be at all be characterized as “evasive” or
“inconsistent” . . . , it may be because he lacks a completely clear recollection of what
took place years ago regarding his alleged conduct.  Delaney credibly and convincingly
explained that his initial testimony was given with virtually no preparation or opportunity to
review documents, thus preventing him from having a full and fair recollection of the events he was asked about. . . .  While his conduct with respect to [the Rule at issue] is especially
important in the present action, at the time of such conduct, Delaney was in the business of
putting out “fires,” . . . and [the Rule], though undeniably important, was most assuredly not the top priority for the compliance department. . . .  [T]he Division argues that “Delaney quibbled about whether he had seen the release [for the Rule] in the same exact format as that in the exhibit used at the hearing and during his testimony.” . . .  Several exhibits copy or link to the text of the releases . . . with the appearance and formatting of each differing dramatically from the way the text of such releases is ultimately arranged in the printed version of the Federal Register, the document Delaney was shown at the hearing. . . .  When someone is testifying about a document that may not look anything like the version he had read, it is not “quibbling” to explain that one has never seen something that looks like the exhibit.  I in fact thought that the Federal Register version of the releases looked considerably different from the other copies and would have been hesitant to say I had read the exhibit without first looking it over. . . .  Despite his exasperation at the Division’s repeated insinuations that he was lying, I found Delaney a credible and convincing witness. My perception, that his hours of testimony were sincere and truthful, is consistent with the attestation of all the hearing witnesses regarding Delaney’s honesty and integrity.

Finally, the Division asserts that Delaney contradicted himself because, on the one hand,
in August 2012 he did not recall being concerned about the contents of [a FINRA letter] and, on the other hand, in July 2013 he testified that a disclosure in that letter would be a big deal for [his firm]. . . .  However, because Delaney was asked somewhat different questions on the two different occasions (as opposed to being asked the same question on both occasions), his answers were consistent.  In August 2012, Delaney was asked whether he was concerned about the letter, not the conduct at issue. . . .  When asked about the purported contradiction at the hearing, Delaney reasonably explained that he was not concerned about the letter disclosing the conduct, which was accurate as he understood it, but at the same time was concerned about the underlying rule violations. . . .  It is telling that the Division, who has had Delaney testify so often, seizes on such minor supposed contradictions.  I find all of the purported inconsistencies identified by the Division are
either immaterial or have been adequately explained by Delaney.  I found, on the whole,
Delaney’s testimony to be credible, with the exception, noted previously, that he may not recall comparatively minor events and discussions that took place up to six years before the hearing.

Having found no evidence of knowledge, ALJ Patil went on to reject the SEC staff’s suggestions that Mr. Delaney’s conduct was nevertheless “reckless.”  He carefully distinguished between evidence of negligence and “extreme recklessness.”  He then dissected individual emails presented by the staff as “red flags” to show, one-by-one, that they were no such thing.

ALJ Patil nevertheless found Mr. Delaney liable for “causing” some of the firm’s violations, based on his conclusion that Mr. Delaney acted negligently.  He found violations “because the evidence supports that Delaney contributed to [the firm’s] violations and should have known he was doing so.”  He did so on the basis of testimony “that according to SEC guidance, in situations ‘where
misconduct may have occurred’– as opposed to ‘conduct that raises red flags’ – compliance
officers should follow up to facilitate a proper response.”  He provided a lengthy and lucid explanation of why he reached the conclusion that Mr. Delaney faced such a situation and failed to act prudently.

The case against Mr. Yancey failed entirely.  ALJ Patil found that Mr. Yancey, as CEO, was Mr. Delaney’s supervisor, but the evidence did not show intentional conduct by Mr. Delaney, and a supervisory violation can occur only when “[t]he supervised person must have ‘willfully aided, abetted, counseled, commanded, induced, or procured’ the securities law violation.”  But even if Mr. Delaney had willfully aided an abetted the firm’s rules violations, “the Division has failed to show that Yancey did not reasonably supervise Delaney . . . because “[a] firm’s president is not automatically at fault when other individuals in the firm engage in misconduct of which he has no reason to be aware.”  He concluded: “Yancey had no reason to believe that any ‘red flags’ or ‘irregularities’ were occurring at [the firm] that were not already the subject of prompt remediation.  Given the absence of such evidence, I find that the Division did not prove that Yancey failed reasonably to supervise Delaney, even were such a claim viable here.”

As for the supervisory charge regarding the second firm employee, who was a registered representative who did act willfully, Yancey “persuasively dispute[d]” that the employee was not subject to the CEO’s “direct supervision.”  “[A]s an initial matter, a president of a firm ‘is responsible for the firm’s compliance with all applicable requirements unless and until he or she reasonably delegates a particular function to another person in the firm, and neither knows nor has reason to know that such person is not properly performing his or her duties.’ . . .   I find that Yancey is not liable for [the employee’s] intentional misconduct because the record supports that Yancey reasonably delegated supervisory responsibility over [him] . . . and then followed up reasonably.”  ALJ Patil rejected several theories of the SEC staff why Mr. Yancey should nevertheless be considered a supervisor.  He ultimately found no liability for Mr. Yancey.

On the issue of sanctions, ALJ Patil did not rubber stamp SEC staff requests.  He gave a reasoned explanation for issuing a cease and desist order against Mr. Delaney, found he could not issue a bar order against him because he did not act willfully, and imposed what seem to be reasonable civil penalties, totaling $20,000, for the conduct involved.  His order on the SEC’s disgorgement request was, perhaps unintentionally, amusingly tongue-in-cheek: “I have opted not to order disgorgement in this case, because the amount at issue is negligible. The Division contends, in effect, that Delaney must pay back the portion of his $40,000 in bonuses during the relevant time period that arose from the Rule 204T/204 violations.  The quantified benefit of the violations, $59,000, is approximately 0.008 percent of [the firm’s] revenue during that period. . . .  Even if all of Delaney’s bonuses were based on [the firm’s] performance (which, they are not, since the parties seem to be in general agreement that such performance was only one of three factors in bonuses), based on the preceding figures, the percentage of Delaney’s bonuses tied directly to the quantifiable benefit . . . is three dollars and twenty cents.  Even accounting for prejudgment interest, a disgorgement order is unwarranted.”

Kudos to ALJ Patil for what appears to be a fine job of adjudicating a tiresome case.  In a careful ruling, he handed the SEC a substantial defeat and a partial victory.  If he keeps this up in his tenure as an SEC ALJ, we should see some high-quality, thoughtful, and independent decisions penned by him.

Straight Arrow

April 14, 2015

Contact Straight Arrow privately here, or leave a public comment below:

4th Circuit Finds Section 10(b) Scienter Allegations Sufficient with No Motive in Zak v. Chelsea Therapeutics

In Zak v. Chelsea Therapeutics Int’l, No. 13-2370, a split Fourth Circuit panel found allegations of securities fraud sufficient in a putative section 10(b) class action.  The district court dismissed the complaint for failing to make allegations sufficient to support a strong inference of scienter under the Private Securities Litigation Reform Act (PSLRA) standard.  The majority of the panel reversed, despite an apparent lack of facts showing any real objective for the alleged fraud.  The opinion is available here: Zak v. Chelsea Therapeutics Intl.

The case involved a now-common fact situation in securities class actions against pharmaceutical companies.  Chelsea was trying to gain approval for a drug treatment for “symptomatic neurogenic orthostatic hypotension,” which is “a condition in which a dramatic drop in blood pressure occurs when a person stands.”  During the course of testing for the efficacy of the drug, Chelsea executives expressed optimism about how the tests were going, and for the prospect of getting the drug approved by the FDA.  At the same time, the actual testing showed mixed results.  One trial was successful and others were inconclusive.  All of the trial results were disclosed, however.  A meeting with FDA officials was also inconclusive — they indicated that the application for the drug could move forward on the basis of the one study, which was short-term, but that it was an obstacle to approval that other studies had not shown the drug’s efficacy over a longer period.  Management optimistically described this conversation as the officials agreeing that the application could move forward on the basis of the one successful trial.

There were other instances of management expressing overly-optimistic views on the approval of the drug, without also acknowledging that there were serious obstacles.  One of these included the contents of an FDA staff report.  Management received this report, in which a staffer recommended that the drug not be approved, 8 days before it was publicly disclosed.  The company’s published description of the report said it raised questions about the sufficiency of the support for approval of the drug, but failed to state that the staffer recommended against approval.  The stock price nevertheless declined 38%.  The press release also provided the web address to obtain to actual report when it was released by the FDA, which occurred 8 days later.  At that time, the stock price declined an additional 21%.

Three days later, an FDA advisory committee recommended approval of the drug in a non-binding recommendation.  The FDA itself, however, ultimately declined to approve the drug a little over a month later.

One interesting aspect of the case is the district court’s use of Chelsea’s public SEC filings in its consideration of whether these facts adequately pled scienter under the PSLRA.  The defendants submitted SEC proxy and Form 4 filings to show that there was no evidence that management or directors tried to take advantage of any arguably misleading statements by cashing out their stock.  Although the complaint did not plead insider stock sales as a motive for the fraud, the court took judicial notice of the SEC filings and based its decision in part on the lack of evidence of efforts to profit on any of the alleged misrepresentations or omissions in the complaint.

The entire 4th Circuit panel agreed that this was improper.  The opinion acknowledges the commonly accepted rule that on a motion to dismiss, the court can consider materials outside of the complaint if they are incorporated by reference or implicated by the allegations in the complaint.  But, since insider stock trading was never alleged in the complaint, it found judicial notice of materials addressed to that issue was improper.

The majority of the panel went on the conclude that the allegations of repeatedly optimistic statements about the drug approval process which left out key developments suggesting approval was in doubt were enough to support the required strong inference of scienter.  Two things are important about this.  First, it comes from the 4th Circuit, which rarely sees a class action complaint it thinks is sufficient.  Second, it allows a complaint to proceed on the basis of a fraud which, at least from the descriptions in the opinion, shows absolutely to motivation for committing the alleged fraud.  Usually, fraudulent misrepresentations or omissions are part of an effort to obtain some advantage from the misleading disclosures.  Here, there is no such apparent motive.  That may be why the district court went beyond the complaint to the trading data.  Surely a fraud must have an objective — but none is apparent here.  This is especially so as to the most troublesome of the alleged misleading disclosures: the misleading description of the staff report about possible approval of the drug.  Since the report itself was going to be published about a week after the company’s press release about it, and the press release provided the web address for someone to read the actual report one week later, what is the purported object of a fraudulent description of that document, which would last only a week.  There appears to be none, since no action during that period suggests an effort to take advantage of the misleading disclosure.

Perhaps this goes more to the issue of materiality than scienter, which, as we have seen before, can be interrelated (see 1st Circuit: Scienter Not Alleged Where Materiality Is Questionable and Regulatory Violations Remain in Doubt).  But it would seem to encompass both; how do you find a strong inference of intent to defraud in the absence of any apparent motive?

Dissenting Judge Thacker certainly had problems with finding fraudulent conduct alleged here.  He reminded the court that even if recklessness can be sufficient to support scienter — and he reiterated that the Supreme Court still has not accepted that theory (slip op. at 33 n.2) — in the 4th Circuit i”we insist that the recklessness must be ‘severe’ — that is, ‘a slightly lesser species of intentional misconduct.'”  Slip op. at 35.  He argued that the company’s statements were not “literally” inaccurate, and there was enough support for management to express an optimistic view without committing fraud.  He concluded : “Today’s decision clears the way for more litigation, heightening the risk that shareholders will exploit the judicial process to extract settlements from corporations they chose to fund. This is exactly what Congress sought to prevent when it enacted the PSLRA.”  Slip op. at 43.

This case is a very close call.  Based on the fact descriptions in the opinion, it looks like management erred on the side of optimism, and may have elevated wish above reality, putting the best light on everything while hoping for approval of the drug.  It should give us pause on the fraud issue that the advisory committee actually did recommend approval of the drug, even with the alleged shortcomings of the trial studies.  In the end, it is the absence of any apparent planned gain or advantage from the alleged misleading disclosures that suggests to me that whatever happened here, intentional fraud was not what it was about, especially under the high scienter pleading standard of the PSLRA.

In any event, the class plaintiffs seem to have some serious uphill fighting on the materiality front.

Straight Arrow

March 17, 2015

Contact Straight Arrow privately here, or leave a public comment below:

An Open Memo to SEC Commissioner Aguilar on the Use of Officer and Director Bars

Memo for SEC Commissioner Luis Aguilar:

Dear Commission Aguilar,

In your speech at the SEC Speaks 2015 PLI Conference (if you’ve forgotten what you said, it’s here), you advocated for increased imposition of officer and director bars against SEC enforcement targets.  It was a brief discussion in a speech covering several topics, but it reflects a shameful insensitivity to the power and impact of imposing the SEC’s “nuclear” remedy to ruin people’s lives.  I very much doubt you believe in the use of lengthy harsh prison sentences or lifetime deprivations of rights more generally in our law enforcement process.  In fact, there is a growing bipartisan recognition among our politicians that ever heavier and lengthier penalties is one of the blights of our criminal system.  Yet, when it comes to our securities laws, you seem to crave being a “hanging judge.”

As a reminder, here is what you said on the subject (footnotes omitted):

The Commission has a number of tools available when it finds that fraudulent misconduct has occurred – it can seek to enjoin such activity, disgorge ill-gotten gains, and impose civil penalties against the wrongdoers.  In addition, the Enforcement Division can use trading suspensions and asset freezes to achieve immediate impact and halt ongoing fraudulent activities.  These are all important remedies.

In my view, however, one of the most potent remedies is for the Commission to prevent wrongdoers from being allowed to remain in a role that permits them to continue to hurt investors.  To that end, the Commission needs to be more aggressive in seeking permanent industry bars and officer and director bars.  These bars, not only serve to punish the wrongdoer, but also protect investors from future misconduct by such person. These bars send a clear message to the next potential fraudster.

An SEC enforcement action should not be viewed merely as a cost of doing business; rather, it should cause individuals and companies—whether or not they are part of the Commission’s specific action—to seriously reflect on their own conduct.  This is particularly true in the case of recidivist violators.  If our remedial sanctions were ineffective in reforming a fraudster, then we must seriously consider removing them from the industry—permanently.  The SEC must do this to protect American investors.

During my time as a Commissioner, I have witnessed defendants fight charging decisions on all fronts, including fighting tooth-and-nail to avoid being prevented from serving as officers or directors of public companies or from being suspended from appearing or practicing before the Commission pursuant to Rule 102(e).  They much rather have their company pay a sizable penalty to continue to do what they do, unaffected and undeterred.  Recently, this was demonstrated in the Gupta matter, where a director convicted of insider trading and given a lifetime officer and director bar, tried to appeal that bar to the U.S. Supreme Court.  As you may know, the Court rejected that appeal by denying cert.  It is interesting to note that the $13.9 million civil fine imposed against Gupta was not appealed to the Supreme Court.

Defendants’ vigor to avoid being barred is to be expected, as those bars and suspensions take fraudsters out of the industry, and often have a far more lasting impact than the imposition of a monetary fine.  Their fight is the best indicator that the Commission’s ability to bar wrongdoers is an effective tool that should be used whenever appropriate.

The importance of a strong and robust Enforcement program is vital to an effective capital market on which investors can rely.  The Commission has to use all of the tools at its disposal, including imposing permanent industry bars and officer and director bars.

Boy, do you have it wrong.  Although I think you  are likely to be considerably too willing to impose the “permanent industry bars” you favor — by which I assume you mean bars from industries regulated by the SEC — that at least falls within the overall regulatory framework of the SEC’s governance over the securities industry.  But your advocacy for penalties that prevent people from pursuing their livelihoods in non-regulated businesses is a shameful example of self-righteous hubris that unfortunately infects not only you, but many SEC employees.

To begin, it is at least refreshing that you recognize that officer and director bars are, in fact, a form of punishment (“These bars … serve to punish the wrongdoer”).  The SEC’s enforcement staff would prefer if you had left that admission out of your speech.  You see, the problem is that you’re not supposed to admit that the SEC is really punishing people.  We all know it’s true, but your enforcement staff does not accept that this “relief” is a form of punishment, and they argue the opposite in the courts all the time because the equitable remedies available to the SEC are, under the law, available only for remedial purposes, not punishment.  So, thank you for at least recognizing in this one respect that the Emperior has no clothes.

Your argument that permanent officer and director bars are needed to prevent “recidivist fraudsters” from plying their fraudulent trade is, with respect, a laugher.  I don’t want to question how you do your job, but do you actually look at the settlements and judgments that you approve that include officer and director bars?  It is rare that an officer/director bar is aimed at a recidivist violator.  In fact, it is effectively SEC enforcement policy to demand officer/director bars in every case involving alleged violations of section 10(b).  That’s like sending a first-time drug offender to jail for 30 years.  Do you think that’s the right thing to do?

More importantly, I’m disappointed that you show no cognition of what is really going on in many of the cases you are responsible for overseeing.  You mention with apparent pride that “defendants fight charging decisions on all fronts, including fighting tooth-and-nail to avoid being prevented from serving as officers or directors of public companies.”  I bet you would do the same if you were faced with being barred permanently from public employment for an alleged defalcation you contested.  Perhaps you don’t realize that the SEC uses the unlimited resources of the Government constantly to bludgeon individuals who can’t afford to defend themselves into accepting a penalty that destroys their future and the future of their families.  It is only the lucky ones that have the resources to fight the SEC’s demand for such “relief.”

And, no, Mr. Aguilar, these are not all “fraudsters” just getting what they deserve.  Even you, I expect, have some understanding of the value of due process in determining whether someone is a “fraudster.”  And the SEC staff’s distorted way of looking at fraud, in which unfortunate mistakes or oversights are regularly argued to be “reckless disregard of the law,” leaves a lot more than “fraudsters” as victims of the SEC’s love affair with the “nuclear” officer/director bar “remedy.”

Mr. Aguilar, I’d ask that you consider the possibility that depriving a person of a large portion of her savings, and leaving her branded as a securities law violator is not just “a cost of doing business,” and may actually be enough “punishment” without seeking to deprive her permanently of future employment in a (privately-owned and managed) public company.  I daresay that if you faced accusations of stepping over the line, you would appreciate it if your accusers understood that they too have human foibles, and that “the quality of mercy is not strain’d”:

That in the course of justice none of us
Should see salvation: we do pray for mercy;
And that same prayer doth teach us all to render
The deeds of mercy.

Best Regards,

Straight Arrow

February 23, 2015

Contact Straight Arrow privately here, or leave a public comment below:

I h


9th Circuit Adopts Demanding Loss Causation Pleading Standard in Weak Opinion

On December 16, 2016, the Court of Appeals for the Ninth Circuit affirmed the dismissal of class action securities fraud claims against Apollo Group in Oregon Public Employees Retirement Fund v. Apollo Group.  The complaint alleged that Apollo’s disclosures about its for-profit post-secondary education business (predominantly the University of Phoenix) were materially misleading in the way they described the for-profit education business model, business and recruiting practices, and treatment of financial defaults by students, among other things.  The appellate court affirmed dismissal on multiple independent grounds, finding the allegations failed to state elements of materiality, scienter, and loss causation.

Loss Causation Pleading

The most important aspect of the decision was the Ninth Circuit’s determination that the Fed. R. Civ. P. 9(b) particularity pleading requirements apply to allegations of loss causation in securities fraud claims.  The court wrote: “Although it is clear that Rule 9(b) and the PSLRA apply to almost all elements of a securities fraud action, the law is less clear about the pleading standard that applies to the loss causation element.”  Slip op. at 8.  Although the Ninth Circuit previously resisted addressing this issue when it was not dispositive to its decision, it took a different approach here.  Although it ultimately held that loss causation was insufficiently pleaded under either a Rule 9(b) or Rule 8(a) pleading standard, the court decided it was time to put the pleading standard issue to rest, at least in that circuit.

The court identified the Fifth, Seventh, and Second Circuits as having previously adopted some form of heightened particularity pleading requirement for loss causation in section 10(b) cases, and noted the Fifth Circuit had gone the other way, applying Rule 8(a) to that aspect of pleading section 10(b) claims.  See id. at 9-10.  It then announced its choice to apply Rule 9(b) to that loss causation pleading: “We are persuaded by the approach adopted in the Fourth Circuit and hold today that Rule 9(b) applies to all elements of a securities fraud action, including loss causation.”  Id. at 10.  The court gave three reasons for this choice:

(1)        “[T]he law on securities fraud is derived from common law fraud.”  The case law developed by the Supreme Court regarding section 10(b) is based on doctrines of common-law fraud and deceit.  “The requirement of loss causation, in particular, is founded on the common law of fraud and deceit.”  Since Rule 9(b) applies “to all circumstances of common-law fraud, . . . and since securities fraud is derived from common law fraud, it makes sense to apply the same pleading standard to all circumstances of securities fraud.”  Slip op. at 10-11.

(2)        Rule 9(b) requires pleading with particularity of “the circumstances constituting fraud or mistake.”  Securities fraud encompasses six elements, including loss causation.  As a result, loss causation is part of the “circumstances” constituting fraud because, without it, a claim of securities fraud does not exist.  Id. at 11.

(3)        This approach “creates a consistent standard through which to assess pleadings in 10(b) actions, rather than the piecemeal standard adopted by some courts.”  Id.


In analyzing the complaint itself, the court first turned to materiality.  It found that plaintiffs’ allegations fell short on materiality “because the material misrepresentations the Plaintiffs allege are not objectively false statements.”  The court distinguished “puffing” from misrepresentation, noting that “’[p]uffing’ concerns expressions of opinion, as opposed to knowingly false statements of fact.”  Investors do not rely on “vague statements of optimism” or “feel good monikers.”  In contrast, statements “that are capable of objective verification are not “puffery” and can constitute material misrepresentations.”  Id.  at 12.

The alleged misrepresentations in this case were found to be “inherently subjective ‘puffing’ and would not induce the reliance of a reasonable investor.”  In particular, statements that start “we believe,” and vague descriptions of things as “significant events” are not objective facts.  “Unlike accounting calculations or ignorance of rule violations, the statements by Apollo were subjective and preceded by qualifiers, such as ‘We believe.’”  Id. at 13-14.


On the issue of pleading scienter, the court said that where plaintiffs “seek to hold individuals and a company liable on a securities fraud theory, we require that the Plaintiffs allege scienter with respect to each of the individual defendants.”  Employing a “holistic view,” the court concluded there were insufficient facts alleged to establish that the defendants knew or were “consciously reckless” of their deceptive practices.  At best, plaintiffs alleged examples of flawed practices “rather than widespread deception, which would be necessary to establish fraudulent intent or reckless ignorance based on a holistic analysis.”  Id. at 16.

Loss Causation

As to loss causation, the court found the allegations failed under either a Rule 8(a) or Rule 9(b) standard because plaintiffs “do not allege specific statements made by the Defendants that were made untrue or called into question by subsequent public disclosures.”  The complaint left it unclear which of the previous disclosures were later shown to be inaccurate.  Moreover, general “expressions of concern” in a government report about the nature of Apollo’s student recruitment do not “constitute a corrective disclosure and a public admission of Apollo’s alleged fraud.”  Likewise, a GAO report discussing the industry as a whole does not “specify which of the Defendants’ statements” were untrue.  “As a result, the Plaintiffs have not adequately alleged that there was a causal connection between the public information contained in the GAO Report and subsequent market activity.”  Slip op. at 17-18.


Because the Apollo decision stands as a new circuit court judgment on the pleading standard for loss causation in section 10(b) cases, it is significant.  But in other respects it seems unlikely to be influential on future appellate decisions.  The reasoning is brief, and the analysis limited.  The notion that stock price declines cannot be proximately caused by public disclosures that raise general issues about the truth of previous company disclosures, without specifically identifying any of them as wrong, seems overly narrow, and appears to deprive a fact-finder of an opportunity to consider evidence that could bear on the issue.  The scienter discussion, based on a nebulous “holistic” standard, does not advance the ball much, and certainly lacks the kind of serious consideration reflected in the recent Sixth Circuit decision in Ansfield v. Omnicare, Inc., No. 13-5597 (Oct. 10, 2014) (other aspects of which are discussed in this prior post).  That Sixth Circuit analysis, correct or not, is at least provocative, and has been the subject of much discussion.  And the notion that starting a disclosure sentence with the words “we believe” has a significant impact on materiality seems, at a minimum, overly simplistic.  That very approach was rejected by the Sixth Circuit in an earlier Omnicare decision now awaiting decision on appeal in the Supreme Court on when a “we believe” statement can be materially false (although the Sixth Circuit probably reached the wrong result there for other reasons, as discussed previously here).  In short, this is an unimpressive effort that supplies a data point on the pleading standard issue, but not much more.

 Straight Arrow

December 17, 2014

Contact Straight Arrow privately here, or leave a public comment below:

Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions

The SEC has been besieged by criticism of the Division of Enforcement’s new determination to bring more antifraud civil prosecutions in the SEC’s administrative court, and was stung by a speech from Judge Jed Rakoff criticizing that decision in no uncertain terms.  The day after Judge Rakoff’s talk, Andrew Ceresney, the current Director of the Enforcement Division, tried to defend the decision.  He plainly needs more practice; or perhaps he could start with a better understanding of his own administrative proceedings.  The arguments he made were so off-base that they can be explained in only two ways: he either doesn’t know very much about defending SEC enforcement actions (which I hope is not true), or he is just presenting makeweight arguments in the hope that by mere repetition they might be believed.

In a PLI conference panel discussion the day after Judge Rakoff’s speech at the same conference, Ceresney attempted a rejoinder to the Rakoff criticism.  Essentially, he argued that the SEC has no comparative advantage when it litigates in front of its own administrative law judges.  You can see a description of his comments here.  I don’t mean to be dismissive, but that’s a bunch of hooey.

He argued that respondents in these proceedings are not disadvantaged by the fact that they get no discovery, have limited subpoena power controlled by the ALJ, have very little time in which to prepare a case, are unprotected by the rules of evidence, and have no independent (that is, independent of the SEC, the prosecutor in these cases) review of the sufficiency of the “evidence” that gets presented in the administrative court.  His arguments are, to be kind, unconvincing.

Discovery.  Ceresney says the lack of discovery doesn’t matter because the SEC delivers all of its files to the other side.  That’s bunch of malarkey; a fiction; a mere pretense.  The SEC delivers to respondents a part of the official enforcement “case file,” but that may not include vast amounts of important information the SEC has bearing on the claims asserted.  For example, say the SEC were to bring an action alleging a company violated the antifraud provisions of the securities laws because its release of material information used a process that allowed certain investors to get a slightly faster data feed.  The enforcement division is investigating such potential charges in connection with high frequency and algorithmic trading right now.  The documents the SEC would deliver to respondents would be only the SEC’s own formal case file.  It would not include any information about the SEC’s own distribution of information, and how it may be doing the same thing (releasing information in a way that benefits certain traders) that it is charging as a fraud.  Such information would likely be obtainable in discovery in a federal court, but would not be delivered by the SEC in an administrative case and almost certainly would not be ordered to be produced by an administrative law judge (ALJ).  The SEC gains from the choice of an administrative court; the respondent loses.

Another example.  The SEC brings fraud charges against a public company alleging an improper accounting treatment to account for certain expenses.  The accounting approach, however, is in a gray area and is common in the industry.  The SEC’s enforcement file will include only its inquiry into the respondent’s accounting determinations.  What it will not include is information the SEC gathered about other industry participants, which would be relevant to determining the “generally accepted” approach in that industry.  Because that information is plainly relevant to the issue of scienter — whether the respondent knowingly or recklessly chose an incorrect accounting treatment — it would likely be obtainable in discovery in a federal district court, although the SEC would surely contest it.  But the chance of obtaining such information through an order by an ALJ is close to zero.  Once again, the SEC gains from being in the administrative court; the respondent loses.

Apart from the narrower scope of documents the SEC must deliver to respondents in an administrative proceeding, Ceresney ignores the SEC’s inevitable, overbroad assertions of work-product and “deliberative-process” privilege.  The SEC does not deliver to opponents documents in the “case file” over which they claim work-product or deliberative-process protections.  Often, these are the most important documents in the file.  In courts, the refusal to provide those materials in discovery can be (and has been) overruled, but the ALJs don’t do this.  For example, the SEC may have gathered 5 million pages of documents in electronic form.  They examine those materials for months, or more likely years, and identify the ones they think best support their case as well as ones that are harmful to their case.  When the “case file” is delivered, all the respondent gets is the 5 million pages (other information being withheld under claim of work product protection), and a short time before trial to try make head or tail out of them.  The SEC identifies as its exhibits the documents it found to be helpful and hopes the documents harmful to its case remain buried in the 5 million pages.  Federal courts can, and have, ordered that the SEC provide documents in the form they are kept in the SEC’s files (that’s what the Federal Rules of Civil Procedure require) — including files identifying what documents may be useful or harmful in certain areas.  ALJs are highly unlikely to do this.  The SEC gains; the respondent loses.

Likewise, the SEC will not deliver key interview material if there is no official transcript, claiming work-product privilege.  SEC lawyers often call potential witnesses during their investigation to learn what they might have to say on relevant issues.  They take notes of those interviews.  Some of those witnesses are subpoenaed for investigative testimony, which is transcribed.  But many of those potential witnesses are not subpoenaed for testimony, often because what they told the SEC lawyers is not helpful to prosecuting a case.  (The SEC investigative lawyers’ bias in creating an investigative record is another huge problem, but not the subject of this discussion.)  The SEC delivers the investigative transcripts as part of the case file, but keeps for itself all non-transcribed witness interviews.  As a result, evidence helpful to a respondent remains hidden.  In a federal court, discovery will likely allow the defendant to get copies of these untranscribed interviews, but an ALJ will never issue such an order.  The SEC gains; the respondent loses.

Ceresney says: “There is no discovery in criminal prosecutions, and I don’t think anyone claims due process violations there.”  That is wrong in many respects.  First, one justification for this is the considerably higher burden of proof the government faces in criminal cases.  Second, there are forms of discovery in criminal cases and judges to determine whether requested discovery should be permitted.  Third, criminal procedure rules mandate that materials obtained by prosecutors be delivered to defendants if they are exculpatory or can be used to impeach witnesses.  That is what is known as so-called “Brady material” (after the Supreme Court case Brady v. Maryland).  But the SEC, in its civil prosecutions, refuses to comply with Brady v. Maryland.  For administrative proceedings, there is a strange provision in the SEC Rules of Practice that lists documents the SEC must disclose, and those it may withhold, and then says the SEC may not “withhold, contrary to the doctrine of Brady v. Maryland, 373 U.S. 83, 87 (1963), documents that contain material exculpatory evidence.”  SEC Rule of Practice 230.  But the staff takes a narrow view of what is “exculpatory,” and does not look for exculpatory material outside of its own investigative file.  That, combined with the fact that the SEC administrative law judges are highly restrictive on what they consider “exculpatory,” means that much evidence that could be used by the defense to disprove SEC claims is never made available.  See, e.g., In the Matter of Thomas C. Bridge et al.,  File No. 3-12626 (Aug. 27, 2007).  When that happens in a federal court, a defendant at least has the chance to gather that same information in the civil discovery process.  But in the administrative court the SEC gets to try to bury evidence that a respondent can use to defend himself or herself.  The result?  You guessed it: the SEC gains; the respondent loses.

So much for Ceresney’s claim that the lack of discovery in administrative proceedings doesn’t harm respondents because the SEC delivers its case file.

ALJs as securities law experts.  Ceresney says the SEC administrative courts are better for these cases because they involve highly technical securities law issues that judges and juries just can’t understand as well as ALJs with securities law expertise.  To begin, there is no requirement that an SEC ALJ have securities law experience when he or she gets appointed.  Many of them learn on the job.  Beyond that, however, there is a kernel of truth in Ceresney’s argument, but not much more.  Over time, SEC ALJs may develop expertise in areas involving technical regulatory rules and industry practices.  But that expertise applies only to enforcement actions against SEC-regulated entities like broker-dealers or investment advisers.  The rules governing those businesses are detailed and non-intuitive, so previous experience with these cases can be helpful.  That is why for many, many years the only cases brought by the SEC in its administrative courts were those involving its own regulated entities.  But the issue raised by Judge Rakoff involves not those cases, but the broader, higher impact fraud cases like, for example, insider trading cases.  As Judge Rakoff noted, trying those cases in administrative courts is a relatively new phenomenon.  And because the SEC has resisted any clear statement of what are and are not fraudulent practices, and fraud cases that get tried (and not settled) often explore the outer edges of the fraud concept, ALJs have no meaningful technical edge on federal courts.  To the contrary, judges and juries are far more capable of applying the concept of fraud than ALJs are likely to be because in such case, technical skills are far less important than more intuitive understanding and application of common sense and community standards.

Timing advantages.  Ceresney says it is no great advantage that the SEC has been able to take months or years to prepare its case and the defense has no such luxury.  He argues that the defense has probably been doing its own investigative work during that period.  But defense counsel have no power to get people to talk to them or deliver documents.  When the SEC lawyers call people subject to SEC regulatory power, say they represent the U.S. government, and ask them to chat off the record, you can bet they get cooperation that defense counsel are unlikely to get.  That is especially true if the people contacted are subject to SEC investigation themselves.  SEC lawyers are not shy about playing on the fear of prosecution to encourage people to talk freely with them.  In fact, the Enforcement Division touts its policy of giving credit to cooperators.  Defense lawyers have no such leverage.  They get their leverage only through the use of subpoena power in a federal civil action, where ample time is allowed for discovery before trial.  Theoretically, defense lawyers can get subpoenas in administrative cases, but the time-frame is much shorter, making use of this process much more difficult.  And ALJs are reluctant to approve the issuance of subpoenas, each of which requires their approval, which almost always must come over SEC objection.  Finally, as noted above, defense lawyers also get hit with large volumes of materials a short time before trial.  The SEC has had months and years to examine and choose the few documents that favor their case.  The defense lawyers are left trying to scour those documents for the ones harmful to the SEC case, which the SEC has intentionally left in the haystack.  Try examining 5 million pages of electronic materials to prepare a case in a month or two.

Due process.  Cereseny says the respondents get great due process with multiple levels of protection. But the only meaningful levels of review of the evidence come from the SEC itself.  The ALJ is an SEC employee and deals every day with the SEC litigators but only rarely with each set of defense lawyers.  The ALJ’s ability to consider even complex cases is limited by the SEC, which sets time limits on the completion of decisions.  Once the ALJ has ruled, the only avenue of appeal is to the SEC itself.  Yes, that’s the same folks who decided to bring the case in the first place.  The Commissioners are supposed to take off their prosecution hats and don judicial hats.  Perhaps in some bizarre utopia this is viewed as due process, but in the real world, prosecutors don’t do so well at deciding they were wrong to bring a case (and incur the major expense in doing so).  And beyond that, the Commissioners will typically defer to the fact-finding of ALJs because they weren’t there to see and evaluate witnesses (like an independent judge or jury is in a federal court case).  After the SEC approves its employee’s decision, the respondent finally gets a chance to have an independent review  — only, of course, if he or she has the financial resources to continue this quest against the government, and many do not.  Even then the court of appeals that reviews the SEC decision is required to defer to SEC judgments unless it can find them unreasonable.  So the value of independent review is diminished by imposing a high bar before the SEC decision can be rejected.

All of those layers of protection touted by Ceresney are more like layers of inquisition.  The expense is enormous.  The review is limited.  The likelihood of reversal is small.  And the only independent review is done under standards that shackle the reviewers.  Compare that to being before an independent judge for the pretrial process and then having an independent judge and jury hear and consider the evidence.  No contest.  Once again, in the administrative process, the SEC wins and the respondent loses.

Despite his statements to the contrary, Ceresney knows the truth here.  He himself admitted it when he announced the new SEC policy of administrative prosecutions.  He said that the rationale for the SEC’s use of its captive courts is that it has a higher success rate in prosecutions brought there.  See here.  The SEC’s improved success rate is not because the administrative courts are fairer, it’s because the playing field is tilted in the SEC’s favor.

Straight Arrow

November 11, 2014

Contact Straight Arrow privately here, or leave a public comment below:

SEC Loses Another Case, but SEC Decision To Pursue Moshayedi Case Does Not Seem Unreasonable

On June 6, 2014, the SEC lost another enforcement action jury trial in SEC v. Moshayedi, Case No. 12-CV-01179, in federal court for the Central District of California.  Moshayedi was an insider trading case; it followed the loss just a week earlier in another insider trading case, SEC v. ObusSee SEC Enforcement Takes Another Blow in SEC v. Obus.

Moshayedi, however, was a very different kind of case than Obus.  It involved alleged stock trading by an insider himself – indeed, by the CEO and his brother, who were co-founders of sTec, Inc., which manufactured and sold to solid state drives (SSDs) to computer makers.  The SEC alleged that the CEO knew that one of sTec’s key customers bought more SSDs than it needed in the third quarter of 2009 (under pressure from sTec to do so) and was going order fewer SSDs going forward, at least in the short run.  The CEO and his brother went ahead and sold $268 million in shares in a secondary stock offering without disclosing this alleged knowledge.  The SEC alleged that when the customer’s decreased demand for SSDs was revealed, sTec’s stock price dropped precipitously, which showed how important the information was.

Based on the information available in the court records, it is hard to take issue with the SEC’s decision to bring the case and take it to trial.  Unlike Obus, the facts and circumstances did not, on their face, undercut the insider trading theory.  (In Obus, the supposed culprit was an investor who allegedly revealed his nonpublic information in a call to the CEO, which made no sense at all if he was a supposed insider trading schemer.)  As far as one can tell in reviewing the court record, there was substantial evidence that the CEO may have known about a likely change in future SSD orders from its key customer when he sold his stock.  To be sure, there were legitimate disputes about what he precisely knew and how important that was to investors, but the fact pattern and the arguably huge loss avoided by the CEO provided strong reasons for the SEC to take the matter to the mat.  Without some highly disputed issues of fact, cases like this never go to trial.  But overall, this case seems like one the SEC is justified in bringing.

At this stage, it is hard to know why the jury rejected this SEC’s claims, finding the CEO and his brother not liable.  It is certainly troubling that in a case in which the cards seem to be stacked in the SEC’s favor, it was unsuccessful.  One would not expect the CEO’s argument in these circumstances – that what he knew was not that important, or that what appeared to have a large stock price impact was really something he didn’t know – would have a lot of jury appeal.  It is possible that most of the witnesses, many of whom were former sTec employees (sTec has since been acquired by Western Digital) were well-disposed to the defendants and made it difficult for the SEC lawyers to make their case.  The SEC is essentially forced to make its case through the testimony of company employees, and one should not underestimate the importance of whether witnesses appear willing, or reluctant, to present the SEC’s evidence.  But at least based on what we can tell now, this does not appear to be another example of inexplicable overreaching by the SEC’s Enforcement Division.  It would probably be a mistake simply to add this case to the growing list of recent SEC enforcement trial losses as evidence that the SEC enforcement litigation program is seriously askew.

Straight Arrow

June 9, 2014

Contact Straight Arrow privately here, or leave a public comment below: