Tag Archives: section 17(a)

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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There They Go Again: SEC Wasting Taxpayer Dollars on Trivial Perquisite Enforcement Litigation in SEC v. Miller

My first thought was that it could be an April Fools joke . . . but no, that’s not the SEC’s style.  I was reading about the SEC’s newest enforcement complaint alleging violations of the perquisite disclosure requirements in Item 402 of Regulation S-K, SEC v. Miller, No. 15-cv-1461 (N.D. Cal. Filed Mar. 31, 2015).  On second thought, I knew this was no joke – it made sense that the SEC enforcement staff was continuing the unfortunate habit of bringing minor cases and overcharging them as supposed frauds of the century, setting themselves up for another litigation embarrassment, and, more importantly, misallocating enforcement resources and wasting taxpayer funds.  The complaint is attached: SEC v. Miller Complaint. The joke is on the American taxpayers and Polycom shareholders.

Andrew M. Miller Former Polycom, Inc. CEO

Andrew M. Miller
                          Former Polycom CEO

This is another in a line of SEC cases for an alleged failure to disclose executive perquisites as “other compensation” in the company’s annual proxy statement.  The SEC has had a bee in its bonnet for years about making sure that trivial amounts of money paid to executives be properly disclosed.  I get the idea that large expenses for the personal use of company jets or yachts, or even multimillion dollar company-owned luxury apartments, might be interesting (or, more accurately, titillating) to shareholders, although rarely “material” in any true investment sense.  If the SEC limited its perks enforcement activities to gross failures of that nature, I guess it would not be a total waste of taxpayer money.  But outrageous undisclosed perks are few and far between nowadays, so the SEC enforcement staff gets itself in high dudgeon over trivial amounts of undisclosed company-paid personal expenses.  Why?  If the SEC staff were focused on maintaining fair and efficient securities markets it would be inexplicable.  But many of them are not.  Many of the enforcement staff specialize in being self-righteously judgmental, and they’ll be damned if rich, pampered, company executives avoid punishment for failing to disclose that the company paid for them to take friends, wives, or (perish the thought) “girlfriends” to the theater.  That would be fine if the SEC staffers were spending their own money to satisfy their personal piques.  But they are spending taxpayer money – and a lot of it – to pursue such trivial matters.

If you thing I’m going overboard, check out SEC v. Miller.  The SEC is “making a federal case” out of the failure of Polycom, Inc. to disclose in its proxy statement that its former CEO, Andrew Miller, used Polycom money to fund personal expenses to the tune of “at least $190,000” over four years.  I’m not missing any commas there; the crux of the case is the following allegation: “as Miller knew, Polycom omitted from its compensation disclosures at least the following amounts of Miller’s personal expenses, by fiscal year: approximately $15,435 in 2010; approximately $28,478 in 2011; approximately $115,683 in 2012; and approximately $30,474 in 2013.”  This, per the agency that ignored red flags evidencing the huge Madoff and Stanford Ponzi schemes without ever being held accountable, constitutes “a long-running scheme to surreptitiously use Polycom funds to pay for his personal expenses, including lavish meals, foreign and domestic travel, clothing, gifts and entertainment for himself, and his relatives and friends.”

So, let’s see how terrible it really was.  In 2010, the SEC alleges $15,435 in personal expenses were not disclosed as perquisites.  In that year what was disclosed was “$4,341,868 in total compensation, including $111,493 in perks.”  In 2011, the proxy allegedly failed to include $28,478 in perk disclosures, but did disclose “that Miller had received $5,016,646 in total compensation, including $112,998 in perks.”  In 2012: “Polycom reported that Miller had received $7,356,905 in total compensation, including $31,430 in perks,” but allegedly failed to disclose $115,683 in perks.  (That included two tickets to Les Miserables and Jersey Boys allegedly used by Miller and his “girlfriend.”)  And in 2013, “Polycom reported that Miller had received $7,682,509 in total compensation, including $5,180 in perks,” but allegedly failed to disclose $30,474 in perks.

In other words, in the four years of this “long-running scheme,” Polycom allegedly failed to disclose roughly 0.3%, 0.6%, 0.4%, and 0.5% of Miller’s compensation.  The alleged failure to disclose $190,000 in perks over four years compares to the actual disclosure of compensation to Mr. Miller totaling $24.4 million over that period.  And corporate revenues during that period were roughly $5 billion.  That represents the most the SEC could allege; the great likelihood is that if the evidence is ever presented, the actual shortfalls will be considerably lower, because the SEC enforcement staff generally doesn’t have a clue about when expenses are for business or non-business purposes.  For example, the complaint goes on about a purported “personal” trip to Bali as part of a “CEO Circle” event, but I’ll bet you disclosure experts will agree that such events may be properly treated as business-related expenses, and not perquisites, because they are, under the SEC’s guidance, “integrally and directly related to the performance of the executive’s duties,” which include keeping the company’s most productive employees, and/or customers, happy campers.  The SEC’s guidance makes it clear that how expensively those duties are performed has no bearing on whether they are perquisites, so whether the trip was to Bali or Fresno doesn’t matter for perquisite purposes.  In any event, even in the unlikely event that the allegations are totally accurate, the SEC has already spent at least high six figures in taxpayer dollars to investigate and bring the case (and caused Polycom to foot the bill for more than that).  If the case is tried, the SEC staff’s fixation on Mr. Miller’s peccadilloes will end up costing the taxpayers, and Polycom shareholders, millions more.

In fact, Polycom has already paid a hefty price – well more than the $190,000 supposedly taken from the company by Mr. Miller.  For a bizarre reason, even though the SEC contends that Mr. Miller cheated the company, it brought an enforcement action against the company as well, which Polycom was forced to settle for $750,000.  That is in addition to the legal fees incurred in the course of the SEC’s investigation, which probably means the SEC has already imposed costs on Polycom as much as 10 times greater than Mr. Miller’s allegedly improper expenses.  Altogether now, the Polycom shareholders should join in: “Thank You, SEC, for protecting our interests.”  See Polycom Inc. Agrees To Pay $750,000 To Settle SEC Civil Charge, and In the Matter of Polycom Settled SEC Administrative Action.  This is Alice in Wonderland stuff.

But that is not the most outrageous thing about this case.  The outrage is that the bad things the SEC is focused on are primarily matters of state law and corporate governance.  What is alleged here is that the CEO of Polycom did some bad things.  He spent some company money on things he shouldn’t have, and hid those things from the company, portraying them as legitimate business expenses.  We can all agree those are bad things, but they don’t have much to do with the federal securities laws.  They represent multiple breaches of fiduciary duty by the CEO to the company, and possibly outright theft, all of which is normally the focus of state law causes of action by the company (or possibly its shareholders if the company chooses not to act without good cause), or local law enforcement proceedings.  Why is the SEC wasting resources on this kind of corporate trivia when there are real frauds going on out there — ones the SEC doesn’t find until shareholders are already under the bus?  Instead, it is the SEC that is pushing the Polycom shareholders under the bus.

The federal securities laws are implicated only because SEC regulations mandate the disclosure of perks in the company’s annual proxy statement.  So, you would expect the SEC to state causes of action against Mr. Miller for his alleged role in causing the company to file inaccurate proxy statements, and maybe for his alleged role in causing the company’s books and records to be inaccurate, because they purportedly included personal payments to the CEO as “business expenses” rather than compensation (although it is not at all clear that this would be a so-called “books and records” violation).  There is no indication that the company failed to record these expenses on its books, in which case there would be no inaccuracy of even trivial amounts in Polycom’s financial statements.  In short, the most appropriate SEC enforcement action would be one that charges violations of SEC rules by Mr. Miller, or that he caused Polycom to violate those rules.  That would be sufficient to justify an embarrassing action against Mr. Miller accompanied by an injunction, a monetary penalty, and some form of disgorgement.  And I’ll bet you the house that if that’s all the SEC staff proposed, there would now be a settled action that could minimize unnecessary taxpayer and shareholder expense.

But if the SEC enforcement staff stopped there, there would be no “securities fraud” charges, and the staff has this thing about wanting to charge people with “fraud” whenever they can, whether the evidence supports it or not.  See SEC’s Single-Minded Focus on Fraud Theory Results in Loss on Appeal.  As alleged, there was a “fraud,” but it was a fraud allegedly perpetrated by Mr. Miller against Polycom, by using deceit to get the company to pay for his personal expenses.  That is not a “securities fraud,” and therefore is not an available color on the SEC’s enforcement palette.  Only the company can pursue a claim that the CEO cheated it of some money.  The only way the SEC can charge federal securities fraud – violations of section 10(b) of the Securities Exchange Act of 1934 or section 17(a)(1) of the Securities Act of 1933 – is if there was fraud in connection with a purchase, sale, or offering of securities.  But scoring tickets for Les Miserables and Jersey Boys at company expense does not involve the purchase or sale of securities, even under the SEC’s broadest possible conception of what might be a security.  The only securities involved here are Polycom stock or bonds.

That did not stop the SEC staff.  They wanted a securities fraud charge, even if it required squeezing a square peg into a round hole.  So, the SEC had to find a way to convert misstatements of CEO compensation by 0.3% to 0.6% into a fraud in connection with the purchase or sale of Polycom stock or bonds.  No problem.  The SEC does that sort of thing all the time by making unsupported allegations that alleged misstatements or omissions on even trivial matters were material to investors who purchased and sold Polycom securities.  True to form, they allege in this complaint that the inaccurate perk disclosures were material to investors.  (It’s impossible to tell if they maintained straight faces while concocting this theory.)  Of course, the SEC litigators will never be able to prove that a reasonable investor could give a hoot that the compensation disclosures for the CEO were off by a fraction of a percent.  But in the view of the SEC staff, if they contend something is material, it becomes material, regardless of whether investors care.  In fact, although the Supreme Court precedent plainly states that materiality depends on whether information is important to a reasonable investor, the SEC regularly argues in court that any violation of an SEC disclosure mandate is material as a matter of law, because if the SEC requires it, it must be important to investors.  QED.

Right now, there is a trial lawyer for the defense team licking his chops over the prospect of cross-examining an SEC expert trying to explain why a misstatement of an expense by 0.5%, and which represented, by my calculation, 0.004% of revenues, was material to a reasonable investor.  If the judge does his job right, that potential testimony will not survive a Daubert motion.

To put icing on the cake, the SEC tries to stick it to Mr. Miller by alleging that when he sold Polycom shares during this period knowing that the perk disclosures for him were understated, he was engaging in securities fraud by trading stock while in possession of material nonpublic information, i.e., that compensation disclosures for him were understated by as much as 0.6%.  That is a laughable theory; one can only hope that the district court judge will see it for the charade it is and dismiss that aspect of the case right out of the box.  Historically, judges give the SEC the benefit of the doubt on fraud charges, dispensing with the usual requirements for pleading fraud under Rule 9(b) of the Federal Rules of Civil Procedure.  But this contention is so far off the mark, and so incendiary if allowed to proceed (which was the point of making the allegation), that a decent judge should give it an early burial.

This is a case that any judicious law enforcement agency would have resolved with modest penalty and disgorgement payments, plus an injunction against future violations.  The public airing of Mr. Miller’s hubris and poor judgment, if that’s what it was, would have shamed him, and made him damaged goods in the corporate executive marketplace.  If what he did was actually theft from the company, let local law enforcement officials sort that out.  That is how cases like this were resolved by more enlightened SEC enforcement lawyers in the heyday of perk cases many years ago.  But in the ever-increasing ratcheting-up of punitive enforcement measures, the SEC is no-doubt looking for vastly overstated penalties, plus the return of profits from supposedly unlawful trading, topped off with a request that Mr. Miller be barred from ever serving in the future as an officer or director of a public company.  Why not let fully informed boards of directors and shareholders decide for themselves in the future if his conduct warrants such a disqualification?

All of this, of course, forces Mr. Miller to defend his case to the hilt, pushing the SEC to present evidence of materiality and securities fraud it likely does not have.  The table is set for another SEC enforcement loss on the fraud charges if this goes to trial.  The last time the SEC took a case like this to trial it suffered a dismal loss.  In November 2013, a jury ruled in favor of the defendant on all claims in SEC v. Kovzan, No. 2:11-cv-02017 (D. Kan. Filed Jan. 12, 2011), which was another perquisite case alleging trivial violations that lacked supporting evidence and made no sense as a matter of enforcement policy and an allocation of enforcement resources.

The main losers in SEC v. Miller will be “we, the people.”  The taxpayers will pay for this exercise in overcharged macho enforcement, and, of course, the shareholders of Polycom will pay dearly as well, in amounts that dwarf the perquisite amounts alleged in the complaint.  One way or another, through indemnity obligations or increased D&O insurance rates, Polycom will foot a mid-seven figure bill for defending claims that should never have been brought.  The SEC will manage to make those seats to Les Miserables and Jersey Boys a lot more expensive than anyone could have imagined.

Straight Arrow

April 1, 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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SEC Gets Reasonable Relief in Life Partners Case — but only 2.5% of $2 Billion Request

On August 22, 2014, we discussed the SEC’s outrageous request for a $2 billion award of disgorgement and penalties in SEC v. Life Partners Holdings, even after getting no fraud judgment.  See SEC Again Runs Amok, Seeking $2 Billion in Texas Case.  The final judgment is now in, and Judge James Nowlin gave a thoughtful and well-reasoned package of relief of just below $50 million, only $1,950,000,000 less than the SEC argued was the proper result.  So the SEC can be 2.5% right and still cause a lot of pain.  You can read the court’s Final Judgment here: Judgment in SEC v Life Partners Holdings.

Fraud violations of section 17(a)(1) of the Securities Act of 1933 were found by the jury, but the judge set aside that portion of the verdict because the SEC’s only evidence of securities fraud involved a time period not charged in the complaint.  Judgment was issued only on the jury’s findings of reporting violations of section 13(a) of the Securities Exchange Act of 1934 and SEC Rules thereunder, but it was plain from the opinion that the judge found serious culpability at least for the individual who controlled and guided the company’s conduct.

Brian D. Pardo

R. Scott Peden


Individual defendants Brian Pardo and R. Scott Peden




Judge Nowlin gave short shrift to the testimony of the SEC’s putative “expert,” Larry Rubin, who testified that there should be a “disgorgement” remedy of $500 million, on the theory that “retail investors would have paid $500 million less than they actually did” if Life Partners used accurate life expectancy information in its disclosures.  (Life Partners is in the “life settlement” business, acquiring and reselling life insurance policies that generate payments when the insured person dies; longer life expectancies result in delays in revenue or lower resale values.)  The court wrote that it “is not satisfied that Larry Rubin’s testimony supports the SECs proposition that $500 million is a reasonable estimate of [Life Partners’] illicit gains….  [T]he task of discerning the good money from the bad — as the law requires — is exceptionally complicated in this case, and the SEC offers a meat cleaver when a scalpel is required.  Such an approach is not a reasonable means of calculating how much [Life Partners] should have to pay back.”  Slip op. at 9-10.

Judge Nowlin was forced to resort to his own analysis in an effort to do rough justice where the SEC failed to even attempt to do so.  He excoriated the defendants’ bad faith in issuing a series of false disclosures, and made an effort to distinguish between gains obtained as a result of misleading Life Partners investors, which was the subject matter of the allegations, and benefits derived from overpricing resales of policies by Life Partners, which were not securities violations.  That analysis showed that an order to disgorge $500 million would be “neither justified nor just.”  Id. at 11.

Without the benefit of any useful expert analysis, the judge came up with a disgorgement number he felt comfortable with — $15 million.  He found this was “sufficiently large — it is more than half the current market capitalization of [Life Partners] — to deter future wrongdoers,” yet he was “confident that it does not overstate the ext[e]nt of [Life Partners’ ill gotten gains.”  Id. n.5.

The judge also went through a reasonable analysis of the other forms of relief awarded.  He granted the SEC’s request for an injunction against future violations — which the SEC seeks in every case — but not before explaining in detail why injunctive relief was warranted.  Here, he explained, the key defendant who controlled the company was a recidivist with a previous injunction against him, who presided over a company that made no efforts to remedy past violations and operated with an ill-informed and inactive Board of Directors.  The judge dwelled on how grossly uninformed one the directors was.  This was not an example of rote issuance of an injunction merely because a violation was found.  See slip op. at 3-7.

The judge also made a reasonable effort to calculate civil penalties, choosing an amount below the maximum ($2 million) for a defendant with lower culpability, and hitting the repeat offender who made the company’s decisions with penalties several times higher ($6 million).  Penalties against the company were assessed at $23.7 million.  Given the size and economic wherewithal of the company, this is a huge award.  The judge justified it based on his review of the evidence showing blatant violations of law that were at least reckless, even though the violations adjudicated against the defendants were non-fraud reporting violations of Section 13(a).

In the end, the SEC obtained major relief against the defendants, but showed truly bad form in doing so.  It’s proposed disgorgement and penalties were a joke, and hence were not taken seriously by the judge.  Another judge might have reacted more harshly to this combination of puerile gamesmanship and spectacularly poor judgment.  But Judge Nowlin did his job notwithstanding the SEC’s overreaching, and it looks like rough justice was done.

Straight Arrow

December 3, 2104

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Judge Rakoff Slams SEC for Increased Use of Administrative Proceedings

We have previously discussed the controversial decision of the SEC’s Division of Enforcement to move enforcement actions cases from the federal district courts to the SEC’s administrative court process.  This is particularly troubling as to civil prosecutions involving large potential “civil” penalties and ancillary relief like lifetime bars that can be debilitating to individual and corporate respondents.  Serious due process and separation of powers constitutional issues have been raised about this approach.  See our previous posts here, here, and here.

On November 5, 2014, U.S. District Court Judge Jed Rakoff, a constant thorn in the side of the SEC, told a gathering of SEC enforcement lawyers he was troubled by this policy as well.  A copy of Judge Rakoff’s speech is available here: Judge Rakoff PLI Speech.

Judge Rakoff did not venture into the merits of the legal challenges to these proceedings now proliferating in the courts.  Instead, he addressed the wisdom — or lack of wisdom — of the policy decision.  He first placed the SEC’s enforcement powers in historical context, noting that “When the SEC was first created in the 1930’s, its enforcement powers were largely limited to seeking injunctions in federal district courts to enjoin violations of the securities laws, and the only express provision for administrative hearings was to suspend or expel members or officers of national securities exchanges.”  In the next 50 years, expansions of the SEC’s enforcement powers were “tied to the agency’s oversight of regulated entities or those representing those entities before the Commission, and even then was largely ancillary to the broader remedies and sanctions it could obtain only by going to federal court.”  The power to seek monetary relief in these proceedings, in the form of so-called “disgorgement,” was not added until 1990.  And it was not until the Sarbanes-Oxley Act in 2002 that the SEC was accorded the extraordinary “power to employ administrative proceedings to bar any person who had violated the securities laws from serving as an officer or director of a public company.”  Finally, the 2010 Dodd-Frank Act gave the SEC “the power through internal administrative proceedings to impose substantial monetary penalties against any person or entity whatsoever if that person or entity has violated the federal securities laws, even if the violation was unintentional.”

Almost all of these accretions in SEC enforcement power, Judge Rakoff noted, came about “at the request of the SEC, usually by tacking the provisions authorizing such expansion onto one or another statute enacted in the wake of a financial scandal,” based on “a claim greater efficiency.”  Judge Rakoff’s acerbic nature is reflected in his reaction to this: “While a claim to greater efficiency by any federal bureaucracy suggests a certain chutzpah, it is hard to find a better example of what is sometimes disparagingly called ‘administrative creep’ than this expansion of the SEC’s internal enforcement power.”  This “efficiency,” he noted, is achieved by depriving the targets of enforcement actions of key procedural protections.  “Superficial” “streamlining” comes about “for the simple reason that SEC administrative proceedings involve much more limited discovery than federal actions, with no provision whatsoever for either depositions or interrogatories.  Similarly, at the hearing itself, the Federal Rules of Evidence do not apply and the SEC is free to introduce hearsay.  Further still, there is no jury, and the matter is decided by an administrative law judge appointed and paid by the SEC.”  As a result: “It is hardly surprising in these circumstances that the SEC won 100% of its internal administrative hearings in the fiscal year ending September 30, 2014, whereas it won only 61% of its trials in federal court during the same period.”

Beyond this concern, Judge Rakoff identifies another serious policy concern: moving cases from the federal courts to the SEC’s captive administrative court “hinders the balanced development of the securities laws.”  He notes that SEC enforcement actions often involve charges of fraud, which is a concept with little statutory or administrative, as opposed to judicial, development.  “Indeed, the SEC has often resisted any attempt to replace these provisions with something more specific, on the theory that such broad statutory provisions provide the flexibility needed to deal with the new schemes that fraudsters are constantly devising.”

His prime example is the area of insider trading, where the SEC “has repeatedly resisted any effort by Congress to statutorily define insider trading, preferring to leave the concept sufficiently flexible as to be able to adjust to new developments.”  “Fair notice” of what does, and does not, constitute insider trading fraud comes from “federal courts, where the law of insider trading has been developed and elaborated in much-publicized cases.”  Judge Rakoff noted that in two recent insider trading cases, SEC v. Cuban and SEC v. Obus, the SEC suffered “stinging defeats.”  As a result, “the SEC might well be tempted in the future to bring such cases as administrative enforcement actions, and thereby likely avoid the sting of well-publicized defeats.  But the result would be that the law in such cases would effectively be made, not by neutral federal courts, but by SEC administrative judges.”  And the availability of judicial review of these decisions, after they are reviewed by the SEC itself, is extremely limited because the SEC’s decision must be “presumed correct unless unreasonable” under the required appellate review standard.

Here is Judge Rakoff’s devastating conclusion:

In short, what you have here are broad anti-fraud provisions, critical to the transparency of the securities markets, that have historically been construed and elaborated by the federal courts but that, under Dodd-Frank, could increasingly be construed and interpreted by the SEC’s administrative law judges if the SEC chose to bring its more significant cases in that forum.  Whatever one might say about the SEC’s quasi-judicial functions, this is unlikely, I submit, to lead to as balanced, careful, and impartial interpretations as would result from having those cases brought in federal court.

In the short-run, this would be unfair to the litigants.  In the longer-run, it might not be good for the SEC itself, which has its own reputation for fairness to consider.  But, most of all, in the both the short-run and the long-run, it would not be good for the impartial development of the law in an area of immense practical importance. . . .

I see no good reason to displace [the Article III judicial process] with administrative fiat, and I would urge the SEC to consider that it is neither in its own long-term interest, nor in the interest of the securities markets, nor in the interest of the public as a whole, for the SEC to become, in effect, a law onto itself.

Hear, hear!

The plot thickens on the SEC’s enforcement power grab.  Judge Rakoff, who had considerable prosecutorial experience in the securities area before he was appointed to the bench, has an extensive following on the issues of securities law enforcement.  The new Republican Congress is not likely to be enamored of an enforcement process that enhances administrative powers at the expense of individual rights.  SEC Chair Mary Jo White should get prepared for a bumpy ride.

Update on SEC response:

In a panel discussion the next day at the same PLI conference, Andrew Ceresney gave 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.  An extended analysis of his arguments can be found here.  In sum, he’s wrong, and badly so.  You can see a description of his comments here.  Cereseny needs to do some homework before he makes comments that show he simply doesn’t understand the issues.

Straight Arrow

November 6, 2014 (updated November 10, 2014)

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SEC Scores Huge Appellate Victory on “Neither Admit Nor Deny” Settlements

On June 4, 2014, in SEC v. Citigroup Global Markets, Inc., No. 11-5227, the U.S. Court of Appeals for the Second Circuit shot down District Judge Jed Rakoff’s effort to make judicial approval of the substance of SEC settlements part of the process of approving SEC consent decrees with enforcement action defendants.  It also soundly rejected the notion that a reasonable settlement between the SEC and enforcement defendants in the public interest requires some admission of facts or liability by the defendants.  You can see a copy of the decision here.

For many years, the vast majority of SEC enforcement actions have been resolved by consent injunctions, together with other ancillary relief, such as “disgorgement” and civil penalties, agreed upon by the parties.  The parties negotiate the violations of law to be alleged, and the injunctions almost uniformly order that the defendants not violate those provisions of law in the future.  For years, it was a generally accepted practice that such settlements and consent decrees be entered into without the defendants either admitting or denying the violations alleged.  The huge costs of litigation and trial, as well as the risks of failure, are avoided by both parties, and the actual merits of the claims – whether the allegations are supported by sufficient evidence to prove them – would remain unresolved by agreement.

Judge Rakoff was not happy with just such a settlement in this case.  The case involved allegations that Citigroup Global Markets, Inc. (CGMI) misrepresented the nature of its participation in the structuring and marketing to investors of a $1 billion portfolio of collateralized debt obligations by failing to disclose that Citigroup played a role in selecting 50% of the portfolio, and pre-arranged to short those securities  Complaints were filed against CGMI and one of its mid-level employees, Brian Stoker.  The SEC and CGMI agreed to a settlement in which negligence-based violations of sections 17(a)(2) and (3) of the Securities Act of 1933 would be alleged, a consent injunction would be issued by the district court barring future violations of those provisions, CGMI would pay $160 million in “disgorgement” of alleged profits as well as $30 million in prejudgment interest, and CGMI would pay a civil penalty of an additional $95 million.  CGMI agreed to the settlement “without admitting or denying” any of the allegations.

Stoker would not agree to a settlement and went to trial, probably because the SEC insisted that any settlement include an order barring him from future employment in the securities business.  The two week jury trial was a disaster for the SEC.  Stoker was found not liable on all of the SEC allegations.

Before his appointment to the Bench, Judge Rakoff spent some time as a federal prosecutor in the office of the U.S. Attorney for the Southern District of New York, including two years as Chief of the Business and Securities Fraud Prosecutions Unit.  He apparently was not pleased with the SEC’s settlement decision.  The issuance of a consent injunction is a judicial act, and Judge Rakoff concluded he should not do so until he was satisfied that the court was “not being used as a tool to enforce an agreement that is unfair, unreasonable, inadequate, or in contravention of the public interest.”  SEC v. CGMI, 827 F.Supp. 2d 328, 332 (S.D.N.Y. 2011).  He forced the SEC and CGMI to answer specific questions about the justifications for various aspects of the settlement, and pointedly challenged the decision to allow CGMI to settle “without admitting or denying” liability.  By doing so, he placed at issue the SEC’s discretion to use the settlement framework that had been used in SEC enforcement cases for decades.

Judge Rakoff’s insistence that he not serve as  “a potted plant” in the review and approval of the settlement and proposed consent injunction struck a chord with other judges.  Following his decision, several other judges in the Southern District and around the country began to question whether SEC “neither admit nor deny” settlements were appropriate.  It also struck a chord with the public and the Congress.  All of a sudden, the SEC was bombarded with suggestions that its willingness to accept “neither admit nor deny” settlements was inconsistent with its oversight of the public securities markets.  Not the least of these were the private plaintiffs’ bar, which now saw the possibility that SEC settlements could provide them with evidence of wrongdoing, which in turn would increase the settlement value of follow-on private securities actions against the defendants.

Although top SEC enforcement officials defended the pragmatic need for “neither admit nor deny” settlements, in a response not likely to win a “Profiles in Courage” award, the SEC blinked and SEC Chair Mary Jo White announced on June 18, 2013 an increased focus on obtaining admissions in settlements, even though “neither admit nor deny” settlements would remain the norm.  She said the SEC would require admissions “in certain cases where heightened accountability or acceptance of responsibility through the defendant’s admission of misconduct may be appropriate.”  That led to much discussion about the likelihood of increased litigation with the SEC because defendants would be loathe to admit facts or liability that could be used in ensuing private damage actions against them.

The Second Circuit’s decision may, and should, quell these rumblings.  The appellate court soundly rejected Judge Rakoff’s notion that courts should sit in judgment of the wisdom of the SEC’s settlement choices, noting that “federal judges – who have no constituency – have a duty to respect legitimate policy choices made by those who do.”  “What the district court may not do is find the public interest disserved based on its disagreement with the S.E.C.’s decisions on discretionary matters of policy, such as deciding to settle without requiring an admission of liability.”

The court also clearly rejected Judge Rakoff’s notion that SEC settlements are inadequate if  they fail to establish facts about the allegations: “It is an abuse of discretion to require, as the district court did here, that the S.E.C. establish the ‘truth’ of the allegations against a settling party as a condition for approving the consent decrees.”  “It is not within the district court’s purview to demand ‘cold, hard, solid facts, established either by admissions or trials’ … as to the truth of the allegations in the complaint as a condition for approving a consent decree.”  In reaching this result, the court noted that SEC settlements are supposed to be compromise resolutions of disputes: “Consent decrees are primarily about pragmatism….  Consent decrees provide parties with a means to manage risk.”   

This was a “bet the company” case for the SEC, and plainly is the right result.  Although the SEC faced a severe challenge to its enforcement program, it weathered the storm.  “Neither admit nor deny” settlements are a practical necessity; the agency simply cannot litigate a large portion of its cases.  It would be a terrible burden to have to do so, and, frankly, its increasing difficulty in getting verdicts of liability in tried cases would likely be exacerbated.  Now we must wait to see whether the Division of Enforcement has the wisdom (and self-knowledge) to realize that its new policy of requiring admissions in settlements is best left as a the rare exception that proves a much more sensible rule.

Straight Arrow

June 4, 2014

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SEC’s Single-Minded Focus on Fraud Theory Results in Loss on Appeal

On May 19, 2014, in SEC v. O’Meally, No. 13-1116, the United States Court of Appeals for the Second Circuit overturned a jury verdict in a “market timing” case finding violations of sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933.  The case is noteworthy as an example of a common flaw in SEC enforcement actions: overreaching in its charges because of a failure to recognize that not all cases involve fraud.  A copy of the O’Meally opinion can be found here.

The case involved so-called “market timing,” which was a common practice in the late 90s and early 2000s in which investors would arbitrage price differentials between mutual fund valuations and stock market prices.  Because the net asset value of a mutual fund is determined based on the stock prices of its portfolio investments at the close of daily market trading on the U.S. East Coast, but market information continues to flow in after that time, investors could have an opportunity for short-term mutual fund investments based on stale prices.  Many mutual funds barred such trading, especially after the practice became well-known and a target of law enforcement and private litigation, but also sometimes made exceptions to their rules.  It was argued that this kind of short-term trading activity hurts long-term mutual fund investors, for example by increasing overall costs and requiring that funds maintain larger reserves for redemptions.  But there was nothing inherently unlawful about market timing trades – they were merely a form of trading arbitrage.  However, the trades could be unlawful if they were accomplished through misrepresentations, which sometimes occurred to avoid fund rules barring such trades.

In 2006, Prudential Securities paid $600 million to a number of government agencies or regulators – the Department of Justice, the SEC, the New York Stock Exchange, the NASD, the New York state attorney general, and several state securities agencies – to settle potential claims based on market timing, as reflected here.

Frederick O’Meally was a broker at Prudential Securities who made money for his customers in market timing trades (and became one of Prudential’s top traders).  The SEC sued four such brokers based on market timing activities, and three others settled.  O’Meally went to trial.  The SEC’s theory at trial was that O’Meally engaged in fraud because he knew about the fund rules he was violating, and used methods to disguise that his trading activity was market timing.  The evidence at trial showed that mutual funds applied their restrictions on market timing trades inconsistently, sometimes permitting trades based on negotiations with Prudential or based on the large amount of business Prudential did with them.  Other people at Prudential knew about O’Meally’s trading activity, including his supervisors, the compliance department, and the legal department.  In fact, “Prudential’s legal and compliance departments approved O’Meally’s trading practices on more than one occasion….”

It appears that the evidence was decidedly mixed.  O’Meally contended he acted “in good faith” because he received these internal approvals, noted that mutual funds often permitted market timing trades, and had valid customer-based rationales for the trading methods the SEC argued were intended to deceive the funds.  The testimony from Prudential witnesses, and even the mutual funds involved, lent some support to this contention.

The SEC charged both fraud and non-fraud violations.  The non-fraud violations required only proof  of negligence, not scienter (knowing fraud or reckless misconduct).  But instead of hedging its bets and introducing evidence that O’Meally at a minimum acted negligently, it went “all in” on its fraud charges, presenting essentially no evidence on negligence.  To prove negligence, the SEC would have had to show that O’Meally breached an accepted “standard of care” with regard to these trades, but it never even tried to do so.  As the court noted: “The only evidence adduced was of deliberate acts that were carefully executed, profitable and legal.  The SEC did not propose how O’Meally’s conduct might have been sloppy or ill-calculated.  Negligence was not referenced in the opening or closing arguments.”

The jury rejected the claims of fraud (either by deliberate or reckless conduct) as to trades with all of the 60 mutual funds involved, apparently accepting O’Meally’s good faith defense.  But it went on to find that as to six of those funds, O’Meally violated two provisions, sections 17(a)(2) and 17(a)(3) of the 1933 Act, by acting negligently.

The Second Circuit reversed the judgment as to sections 17(a)(2) and (a)(3) because the SEC presented no evidence to support a negligence finding.  Given the standard that would apply to overturn a jury verdict – that even with all inferences drawn in the SEC’s favor there was no evidence upon which a reasonable juror could find negligence – the result reflects poor tactical judgments by the SEC.  The SEC chose not to introduce any evidence of a standard of care that governed O’Meally’s conduct under which he should have known that repeatedly violating fund rules was not permitted.  That normally would be done through an expert witness who would give his or her opinion that the conduct was at least negligent, and the SEC has plenty of access to experts who could provide that type of testimony.  But it failed to do so.

If this were just a “one off” failing, it would hardly be worthy of mention.  Lawyers make tactical mistakes all the time.  But it was not.  The SEC habitually obsesses on fraud charges in its enforcement actions, and often neglects to present evidence or argument on charges that require a lesser state of mind.  That is because the SEC enforcement staff views fraud as the charge with the most firepower and media impact.  Especially after having “convinced” other defendants to give up and accept a settlement that charged (but did not prove) fraud, the enforcement lawyers are loathe to accepting a jury verdict showing a lesser degree of culpability.  But the cases that go to trial are often the  ones that present the most difficult facts, and therefore are often the ones in which the ability to prove fraud is seriously in doubt.  Instead of pursuing an approach that might succeed at proving lesser violations, the SEC’s lawyers often go “all in” on the fraud theory, even where, as here, there is substantial contrary evidence.  The result here is that after years of litigation (the alleged violations occurred in 2000-2003), the SEC left all of its chips on the table.

Straight Arrow

May 19, 2014

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