Tag Archives: Securities Act of 1933

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

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SEC ALJ Jason Patil Stings Enforcement Division with Dismissal in Ruggieri Case

SEC Administrative Law Judge Jason Patil’s September 14, 2105 Initial Decision in In the Matter of Bolan and Ruggieri, File No. 3-16178, represents a milestone is SEC administrative jurisprudence in several respects.  The decision is available here: Initial Decision in In the Matter of Bolan and Ruggieri.

First, coming as it did in the midst of controversy over questionable fairness, and allegations of bias, in the SEC’s administrative enforcement process, ALJ Patil’s opinion, which rules against the SEC Division of Enforcement in a publicized insider trading case, shows that SEC ALJs are capable of giving serious scrutiny to the Division’s often overblown charges and questionable evidentiary support in support them.  ALJ Patil, a recent arrival at the SEC, has already shown a judicial temperament and backbone that is needed to assure a more level playing field in these cases.  We previously noted some high quality work by Mr. Patil.  See Some SEC Administrative Law Judges Are Thoughtful and Even Judicious.

Second, ALJ Patil’s decision itself was solid and thoughtful.  His analysis was mostly independent and well-reasoned.  The main exception was a not-very-thoughtful rejection of several constitutional challenges, which was presented in brief paragraphs that showed little of the painstaking analysis he gave to the evidence and the law in the remainder of his opinion.  He devoted fewer than two pages to dismiss five distinct constitutional arguments.  See Initial Decision at 2-4.  I chalk this up to a recognition that the constitutional issues were pretty much beyond his pay-grade, a point he even used in response to one of them (“I do not have authority to adjudicate this claim” (referring to a delegation doctrine argument)).  Id. at 3.  The treatment of the Appointments Clause issue now before several courts completely deferred to the SEC’s decision in In the Matter of Raymond J. Lucia Cos. (id.), and on the related issue of the double layer of ALJ tenure protection, he speciously argued that the Supreme Court footnote in its decision regarding the PCAOB in Free Enterprise Fund v. PCAOB meant that it “did not support” applying the same analysis to SEC ALJs.  Id.  That, of course, evades the argument, it does not address to it.  And the one sentence on the Seventh Amendment jury trial issue fails to consider the key point – whether a process that allows solely the SEC to require a jury trial (by choosing the forum) but deprives a respondent of any comparable right could be consistent with the Seventh Amendment. Id. at 6.

ALJ Patil was wrong to give these issues scant treatment because they were a side show.  If he didn’t want to take them seriously, he should have declined to address them because they were, as it turned out, unnecessary to consider in light of his decision on the merits.  Knowing his decision on the merits made this discussion superfluous, the correct approach was simply to decline to rule on those constitutional issues.

But in the overall picture, this may be just a quibble.  When it came to doing the hard work of evaluating the evidence and applying the law to the evidence, ALJ Patil did excellent work.  There were some flaws in his description of insider trading law, but he eventually got to the right place.

Third, ALJ Patil took on some key aspects of the implementation of insider trading law pursuant to Dirks v. SEC and United States v. Newman, and showed the fortitude to adopt positions – which I believe to be correct – that conflict with current SEC and Government arguments being made in Newman itself and in other insider trading cases.  That takes some cojones, and ALJ Patil should be commended for taking an independent view.

In particular, ALJ Patil rejected the argument now being made by the Government in the Newman cert. petition that the Newman decision breaks with Supreme Court precedent in Dirks v. SEC: “In its petition for a writ of certiorari, the government contends that Newman conflicts with Dirks and erroneously heightened the burden of proof.  See Pet. Writ Certiorari, United States v. Newman, No. 15-137 (July 30, 2015); 17 C.F.R. § 201.323 (official notice).  I do not, however, read Newman as conflicting with Dirks, but rather as clarifying the standard where proof of a personal benefit is based on a personal relationship or friendship.  See 773 F.3d at 452.”  Initial Decision at 35.  He also rejected the Division’s concerted argument that the “personal benefit” requirement for tipper liability adopted in Dirks, and further developed in Newman, has no place in insider trading violations based on the “misappropriation” theory, rather than a “classical” insider trading violation.  We will discuss his analysis on this point below, but his bottom line was that the personal benefit requirement plays the same important role in misappropriation cases as it does in classical cases.  See id. at 28-32.  Finally, he rejected multiple arguments by the Division that the personal benefit requirement was satisfied by the evidence when it was plain that the evidence did not support any such inference.  See id. at 33-49.

The Facts

Unlike many recent tippee cases, including the Newman/Chiasson case, the facts here are relatively straightforward.  Bolan and Ruggieri both worked for Wells Fargo.  Bolan was a researcher and analyst covering healthcare companies; Ruggieri was a senior trader of healthcare stocks who traded for Wells Fargo clients and also in a Wells Fargo proprietary account.  Unpublished Wells Fargo research and ratings analysis was proprietary and confidential company information.  Wells Fargo mandated that analysts not share ratings changes with traders before they were made public. Ruggieri knew that he was prohibited from trading based on nonpublic information from a forthcoming research report.

The SEC alleged that Bolan tipped Ruggieri to imminent Wells Fargo ratings changes he was about to make for specific stocks, and that Ruggieri took advantage of that knowledge on six occasions to trade in advance of publication and profit when the stock prices moved after the ratings change was announced.

Bolan settled the SEC’s case against him.  Ruggieri did not.  He was charged with violations of section 17(a) of the 1933 Act and section 10(b) of the 1934 Act and Rule 10b-5 thereunder.

The Findings

Much of the opinion addresses the evidence surrounding Ruggieri’s trades involving six stocks.  There apparently was little dispute that Bolan provided Ruggieri advance information about his views on these six companies.  But the evidentiary issues were complicated because Ruggieri argued that his decisions in all of these cases were based on his own knowledge of these companies and the market for their stocks, not on Bolan’s incipient ratings changes.  After all, much of the data available to Bolan was also available to Ruggieri, and in addition to that, Ruggieri had independent sources of information through the institutional investors he serviced for Wells Fargo, who often were the source of information about investor views about these companies.

After reviewing the extensive record, ALJ Patil concluded that the Division did not satisfy its burden of proving that Ruggieri’s trades in two of the six stocks were founded on tips from Bolan, but that he did rely on Bolan’s tips on four of the trades.

ALJ Patil’s Overview of Insider Trading Law Was Not Quite Right

ALJ Patil’s decision includes extensive discussion of his understanding of unlawful insider trading.  His Overview of the law (Initial Decision at 8-9) is mostly correct, but reflects some errors that, while not determinative in this case, suggest a less than complete understanding of the law.

ALJ Patil starts out with a summary statement about the law that is half right and half almost-right: He says that section 17(a) and section 10(b) “do not require equal information among market participants; the mere act of trading on insider information is not fraud. . . .  Rather, insider trading constitutes fraud within the meaning of these provisions when it involves a market participant’s breach of a fiduciary duty owed to a principal for a personal benefit.”  Id. at 8.  The first part is right – the Supreme Court has repeatedly rejected the theory that trading on material nonpublic information is itself unlawful.  The second part is half-right because it omits an important element – insider trading is “fraud within the meaning of these provisions when it involves a market participant’s breach of a fiduciary duty owed to a principal for a personal benefit” if, and only if, that breach of duty is undisclosed.  Trading on information that breaches a fiduciary duty to a principal is not “fraud” under these provisions if it is disclosed.  The importance of the fiduciary duty is that it creates a duty to disclose the breach to the principal, and the failure to do so in the context of a fiduciary relationship constitutes fraud.  That is why it is always said that the trader has the choice to “disclose or abstain from trading” to avoid violating the law.

ALJ Patil goes on to describe that this case involves the “misappropriation” theory of insider trading, since the critical information was not confidential information owned by the issuer of the traded stock, but confidential analytic information about various issuers owned by Wells Fargo: “The Division alleges that Bolan tipped Ruggieri with confidential information . . . in breach of a duty to Wells Fargo for a personal benefit and Ruggieri traded based on such tips.”  Id.  In such cases, the duty is owed to the owner of the information – here, Wells Fargo – and a fraud occurs if “[a] fiduciary who pretends loyalty to the principal while secretly converting the principal’s information for personal gain.”  United States v. O’Hagan, 521 U.S. 642, 653-54 (1997) (emphasis added).  As discussed above, what makes this conduct fraudulent is the failure to disclose the misuse of information stolen from the principal (“secretly converting”).

ALJ Patil notes that under Dirks, Ruggieri’s liability as a tippee “is derivative of Bolan’s alleged breach.”  Initial Decision at 8.  He states: “To establish Ruggieri’s liability, the Division must therefore show that: 1) Bolan tipped material non-public information to Ruggieri in breach of a fiduciary duty owed to Wells Fargo for a personal benefit to himself; 2) Ruggieri knew or had reason to know of Bolan’s breach, that is, he knew the information was confidential and divulged for a personal benefit; and 3) Ruggieri still used that information by trading or by tipping for his own benefit.”  Id. Actually, as discussed above, there is a fourth requirement, which is that Ruggieri knew that the breach of duty remained undisclosed to the principal at the time he traded.

ALJ Patil’s discussion of “materiality” is also not quite right, although his error seems of no consequence here.  He says there is no dispute that Bolan’s ratings were material because “ratings changes typically moved stock prices,” and Bolan’s ratings changes “had a statistically significant impact on the stock prices of the securities being rated.”  Id. at 9.  That would be correct if the disclosure duty at issue here were a duty to company shareholders, as in a case based on the classical insider trading theory.  But, as discussed above, the fraud in a misappropriation case is on the owner of the information, not any investor.  The correct materiality analysis must look for materiality to the owner – not investors.  If the owner of the information could care less whether the information was used or not – i.e., did not treat the confidentiality of the information as important – then even if it were highly material to certain investors there would be no fraud by the employee’s failure to disclose the use of it for his own benefit.  In this case, the information Bolan gave to Ruggieri was material because Wells Fargo made it plain in its internal policies that it was important to keep this information confidential from investors and from other employees outside of the research department.  That would be true even if it was not clear whether disclosing the information would or wouldn’t impact the stock price of the companies researched.  Because the secret ratings information was material to Wells Fargo, ALJ Patil’s finding of materiality was correct, albeit for the wrong reason.

Fortunately, these analytic shortcomings in ALJ Patil’s overall statement of the law did not prevent him from getting to the right decision based on the theory pursued by the Division and the evidence placed before him.

ALJ Patil’s Analysis of Dirks and Newman Was Spot On

ALJ Patil’s best work in this opinion is his discussion of the Dirks “personal benefit” requirement, as further developed by the Second Circuit in Newman.  In pages 28 to 32, he explains why the personal benefit requirement must apply to a misappropriation case, and in pages 33 to 50, he rejects every Division argument that the evidence presented adequately showed that Bolan obtained a personal benefit as part of his communication of impending ratings changes to Ruggieri.  Because there was no such benefit proved, Bolan’s tip was not fraudulent and Ruggieri could not have tippee liability derived from a fraud by Bolan.

ALJ Patil first addressed whether the Division was required to prove a personal benefit. Dirks “rejected the premise that all disclosures of confidential information are inconsistent with the fiduciary duty that insiders owe to shareholders.”  Initial Decision at 29.  He noted that the key element of a violation is “manipulation or deception”: “As Dirks instructs, mere disclosure of or trading based on confidential information is insufficient to constitute a breach of duty for insider trading liability.  Not every breach of duty, and not every trade based on confidential information, violates the antifraud provisions of the federal securities laws.  Rather, such conduct must involve manipulation, deception, or fraud against the principal such as shareholders or source of the information.”  He quoted both O’Hagan (521 U.S. at 655) (section 10(b) “is not an all-purpose breach of fiduciary duty ban; rather, it trains on conduct involving manipulation or deception”) and Dirks (463 U.S. at 654) (“Not all breaches of fiduciary duty in connection with a securities transaction, however, come within the ambit of Rule 10b-5.  There must also be manipulation or deception.”).  Id.  This led to the conclusion: “the Court identified the personal benefit element as crucial to the determination whether there has been a fraudulent breach.”  Id. at 30.  This is how Dirks separated communications not designed to deceive shareholders from those with an element of deception.  Otherwise, “If courts were to impose liability merely because confidential information was disclosed to a non-principal, this would potentially expose a person to insider trading liability ‘where not even the slightest intent to trade on securities existed when he disclosed the information.’”  Id. (quoting SEC v. Yun, 327 F.3d 1263, 1278 (11th Cir. 2003).

He then expressly rejected the Division’s contention that the Dirks personal benefit requirement did not carry over to misappropriation cases by pointing out that O’Hagan, which first accepted the misappropriation theory, equally focused on the need for deceptive conduct:

Contrary to the Division’s position, the alleged breach committed by a misappropriator is not any more “inherent” than the alleged breach committed by an insider in a classical case.  In both scenarios, confidential information was leaked and/or used to trade in securities.  The harm to the principal—the source of the information in a misappropriation case or the shareholders in a classical case—is the same, if “not more . . . egregious” in a classical case. Yun, 327 F.3d at 1277.  “[I]t . . . makes ‘scant sense’ to impose liability more readily on a tipping outsider who breaches a duty to a source of information than on a tipping insider who breaches a duty to corporate shareholders.”  Id.

It is true that Dirks was decided in the context where an insider leaked confidential information to expose corporate fraud, which put the Court in the unenviable position of either finding insider trading liability when there was no objective evidence of an ill-conceived purpose, or crafting a standard to ensure that the securities laws were of no greater reach than intended.  The Division contends that Dirks required a benefit in classical cases to differentiate between an insider’s improper and proper use of confidential information.  The Division asserts that “use of confidential information to benefit the corporation (or for some other benevolent purpose consistent with the employee’s duties to his employer) cannot logically breach a fiduciary duty to the corporation’s shareholders.”  Div. Opp. to Motion for Summary Disposition at 21.  But the same rationale applies in an alleged misappropriation case.  An outsider might just as well divulge information for purposes that he believes might be in the best interest of the source to which a fiduciary duty is owed.

Courts cannot simply assume that a breach is for personal benefit.  See Newman, 773 F.3d at 454 (“[T]he Supreme Court affirmatively rejected the premise that a tipper who discloses confidential information necessarily does so to receive a personal benefit.”).  And the breach in a misappropriation case has not been defined by the Supreme Court as inherent, but as connected to personal benefit.  The misappropriation theory “holds that a person commits fraud ‘in connection with’ a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”  O’Hagan, 521 U.S. at 652.  “Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.”  Id. (emphasis added).  In contrast to a classical case premised “on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.”  Id.

It is with this view that the Supreme Court “agree[d] with the Government that misappropriation, as just defined, satisfies § 10(b)’s requirement that chargeable conduct involve a ‘deceptive device or contrivance’ used ‘in connection with’ the purchase or sale of securities.”  O’Hagan, 521 U.S. at 653.  The Court “observe[d] . . . that misappropriators, as the Government describes them, deal in deception.  A fiduciary who pretends loyalty to the principal while secretly converting the principal’s information for personal gain . . . dupes or defrauds the principal.” Id. at 653-54 (emphasis added). . . .  The Court analogized misappropriation to the scenario where “an employee’s undertaking not to reveal his employer’s confidential information ‘became a sham’ when the employee provided the information to his co-conspirators in a scheme to obtain trading profits,” which constituted “fraud akin to embezzlement—‘the fraudulent appropriation to one’s own use of the money or goods entrusted to one’s care by another.’” Id. at 654. . . .  Thus, the O’Hagan Court accepted the government’s misappropriation theory on the premise that the breach was committed secretly for self-gain, not on the assumption that this element is inherent.

Initial Decision at 30-31 (footnotes and some cites omitted).

ALJ Patil then rejected the Division’s reliance on other cases in support of its argument, finding that though they may have used loose language, they did not need or intend to address the personal benefit issue in this context.  He concluded:

Neither the Supreme Court nor any federal court of appeals has drawn the curtain between classical and misappropriation cases that the Division urges.  Rather, courts have emphasized that the two theories are complementary, not mutually exclusive. . . .  In fact, “nearly all violations under the classical theory of insider trading can be alternatively characterized as misappropriations.”  Yun, 327 F.3d at 1279; see id. at 1276 n.27.  By requiring personal benefit to be proved in a misappropriation case, respondents are judged under similar standards.  Liability should not vary according to the theory under which the case is prosecuted.

At bottom, the Division’s position here, as the one advanced in Dirks, would have “no limiting principle.”. . .  The proposition that an alleged misappropriator violates his duty to a source, in violation of the antifraud provisions, by the mere disclosure of confidential information would improperly revive the notion that the antifraud provisions require equal information in the market, which has been rejected by the Supreme Court. . . .  [Dirks, 463] at 666 n.27 (rejecting similar arguments that “would achieve the same result as the SEC’s theory below, i.e., mere possession of inside information while trading would be viewed as a Rule 10b-5 violation” and reemphasizing that “there is no general duty to forgo market transactions based on material, nonpublic information.” . . .  I therefore adhere to my ruling that the Division must prove personal benefit.

Id. at 31-32.

ALJ Patil then turned to examining the evidence of the alleged personal benefits Bolan received from his tips.  I will not go through the details of the analysis of this evidence, which goes on for 14 pages.  The Division presented multiple claims of “personal benfit,” but the evidence showed that all of them were not in fact benefits related to providing tips but the internal operations of Wells Fargo in the normal course.  Purported “personal benefits” from the tips included “career mentorship” (found to be the norm at Wells Fargo); “positive feedback” (found to be no different for Bolan and others except as his performance justified); “friendship” with Ruggieri (found not be especially strong); a good “working relationship” (again found to be consistent with the Wells Fargo norm); and an intended gift by Bolan (found unproved – the Division did not even call Bolan as a witness).  As a nail in the coffin, ALJ Patil found that the evidence suggested Bolan simply accorded little weight to Wells Fargo’s policies, as reflected in recidivist violations of Wells Fargo confidentiality rules with others as well as Ruggieri (for which he was fired by Wells Fargo).

Why Did the Division of Enforcement Try Ruggieri as a Tippee?

This review of the facts and law of the case leaves a strange question.  What was the point of charging Ruggieri as a tippee rather than for his direct misappropriation of confidential Wells Fargo information?  He received Bolan’s information as a Wells Fargo employee and was obligated to keep that information confidential.  If he knowingly used that information improperly (in violation of his duties to Wells Fargo), in order to gain a benefit for himself (the Division contended the successful trades increased his compensation), and failed to disclose this to Wells Fargo, he violated section 10(b) regardless of whether Bolan did as well.  The Division would not have been stymied by a personal benefit requirement because the lack of a benefit to Bolan wouldn’t matter – the alleged increased compensation to Ruggieri would be sufficient to support a fraud claim.

I’m guessing the Division voluntarily made its case against Ruggieri harder because it wanted to stick it to both Bolan and Ruggieri.  Bolan, who agreed to a settlement (and had already been fired by Wells Fargo), could not be charged with fraud if he were not alleged to be a tipper, and the SEC staff always wants to charge fraud.  So, the ultimate irony of the case may be that in a case centered on greed, it may have been the Division’s own greed for multiple fraud judgments that pushed it to charge a case it lacked sufficient evidence to prove.  It would not be the first time the Division lost a case because, like Johnny Rocco (Edward G. Robinson) in Key Largo, it was motivated simply by wanting “more.”

Johnny Rocco

Johnny Rocco (Key Largo)

(“There’s only one Johnny Rocco.”

“How do you account for it?”

“He knows what he wants.  Don’t you, Rocco?”


“What’s that?”

“Tell him, Rocco.”

“Well, I want uh …”

“He wants more, don’t you, Rocco?”

“Yeah. That’s it. More. That’s right! I want more!”

“Will you ever get enough?”

“Will you, Rocco?”

“Well, I never have. No, I guess I won’t.”)

Like Johnny Rocco, the SEC staff almost always wants “more.”

Straight Arrow

September 15, 2015

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Chamber of Commerce Report Details Concerns with SEC Enforcement and Proposed Reforms

On July 15, 2016, the U.S. Chamber of Commerce released a lengthy and detailed report discussing a range of shortcomings in the SEC’s law enforcement investigative and adjudicative processes.  Little of what was said is new, in the sense that it raises issues or presents ideas not previously discussed by parties or commentators.  But it may be the most comprehensive discussion of SEC enforcement issues in recent years.  It discusses how and why the scope and nature of SEC law enforcement has changed over the years, and, importantly, dwells on why rules, procedures, policies, and practices developed or adopted in the past have become obsolete in light of the changed scope and nature of both the SEC’s enforcement actions and the vastly changed information-storage environment which now dominates all forms of litigation.

The report makes 28 wide-ranging recommendations for revised SEC practices, policies, and oversight of the enforcement process.  Many of these focus upon and address the increased scope and use of administrative courts to pursue SEC enforcement actions, but they also address issues of fairness, efficiency and cost of the Division of Enforcement’s investigative process, the development and presentation of enforcement recommendations to the Commission, the standards to be used by the Commission in making enforcement prosecutorial decisions, the management and oversight of the enforcement activities of the Division of Enforcement, and the coordination of SEC enforcement with that of other law enforcement agencies.  The full report can be read here: Examining U.S. Securities and Exchange Commission Enforcement: Recommendations on Current Processes and Practices.

There is a lot of material here in wide-ranging areas.  But by all appearances, the driving force behind the publication of the report is the festering issue of the untethered use of administrative proceedings to pursue SEC enforcement actions of all types, and the increasingly obsolete and unfair tilt of those proceedings in ways that plainly favor the Enforcement Division and impair the ability of respondents to defend themselves.

The tone of the report is measured, and its points are made with context and analysis. The in-depth discussion of fairness issues in SEC administrative proceedings, in light of the antiquated set of rules and procedures governing those proceedings, stands in contrast with the conclusory, and ill-supported, claims of the SEC’s Director of Enforcement that the SEC administrative process gives respondents an equal shot at prevailing over the Division.  It also spotlights the particular unfairness of a set of policies and procedures that grants the Division the right to pursue its actions before a jury if it wishes to do so, while respondents are powerless to do so, even though the Supreme Court has made it clear that in many such cases brought in federal court, there is a constitutional right to trial by jury.  The discussion also takes the Division of Enforcement to task for the analysis and explanation of its newly-adopted pseudo-policy for determining whether cases should be brought administratively or in court, noting that all of the factors weighed in that document are limited to the vantage point of the Enforcement Division; none of the considerations of fairness, efficiency, and public interest take into account impacts on the persons accused of law violations in these cases.

The report is also useful in reminding us that where we stand now is the artifact of the Gerry-built history of SEC law enforcement powers.  As a result, it is not surprising, but to be expected, that there is an ill fit between the peculiarities of the SEC’s administrative court proceedings and the design of a fair and efficient law enforcement process.

Hopefully, the report can serve as a catalyst for the SEC to get past the current no holds barred effort to beat back litigation efforts to balance the litigation playing field and turn to serious, genuine, adult consideration and resolution of the underlying fairness issues.  If not, perhaps the report can get lawmakers to do that if the SEC commissioners continue to turn a blind eye to the problem.

Some aspects of the report may assist in turning what has been a vacuum of policy discussion into a productive effort to make things better.  First, is the report’s emphasis on the difference between the SEC’s role as the steward of our securities and capital markets and capital, which differs significantly from the prosecutorial role of the Division of Enforcement — and least since that prosecutorial arm moved in recent years from a focus on the public interest to one of wielding crippling punitive sanctions.  Second, is the report’s reminder of how the SEC’s enforcement process got to where it is today, and how the development of steroid-like bulking up of SEC enforcement powers outstripped the quaint procedural concepts that of the SEC’s administrative courts, as well as the managerial means of guiding and controlling the army of enforcement lawyers seeking to flex those new muscles.

The report reminds us that the SEC needs to keep in mind that its goal is broader and more complex than just to win enforcement actions.

The report rightly starts out with a discussion of what the SEC should be trying to accomplish as it considers its enforcement program generally, and the specific aspects of that program that are causing controversy.:

The Division of Enforcement, as the prosecutor, should consider the different aspects and implications of the two forums in making its recommendation to the Commission.  However, the Commissioners acting as a decisional body should not view their role in the same way as a prosecutor.  The Commission has a responsibility to consider the broader statutory questions of what is “necessary and appropriate in the public interest for the protection of investors.”  More broadly, it must also adhere to its multiple statutory mandates to protect investors, promote capital formation, and ensure fair and orderly markets.  Accordingly, the Commission should predicate its forum selection decisions solely upon a clear determination that its choices uphold and further its responsibility as a government agency to promote the public interest and the protection of investors, while respecting the important rights of those whose conduct the SEC chooses to scrutinize.

Report at 3 (footnotes omitted).

This gets to the heart of the Commission’s failure over the last year to show that it is willing to confront and discuss, in a serious, adult, way, how its enforcement policies may be undercutting, rather than achieving, important broader goals, including respect for its decisiion making process.

The report makes it clear that the history of the growth of SEC enforcement powers shows the current model is founded on happenstance, not design.

The report provides a history lesson about how the SEC got to where it is now.  That history shows repeated efforts to enhance and expand SEC enforcement powers and flexibility, but no effort whatsoever to build an managerial and procedural infrastructure necessary to assure that these new-founded powers are used in ways that achieve the SEC’s broader mission.  Here is some of that discussion:

Since the SEC’s creation, it has had the authority to bring administrative proceedings to address violations of the securities laws.  The scope of its authority to bring an administrative proceeding and the sanctions that can be ordered in an administrative proceeding have grown dramatically over time.

Early in the history of the SEC, the administrative proceeding was limited to proceedings to halt an offering of securities to the public, a so-called stop order, under section 8 of the Securities Act, and proceedings to reject an application for or revoke the registration of a broker-dealer or investment adviser.  Administrative proceedings were adjuncts of the Commission’s authority to register securities and register broker-dealers, investment advisers, and investment companies.  When the occasion arose to deny a registration or to revoke one, the administrative proceeding was the vehicle to provide the affected entity with a right to hearing prior to Commission action.

In 1964, Congress amended the Exchange Act and provided the Commission with the authority to institute administrative proceedings to censure, place limitations on the activities of, suspend for a period up to 12 months, or bar associated persons of broker-dealers.  The grounds for denying or revoking a broker-dealer registration or other disciplinary sanction were also expanded.  These new bases included willful violations of the Investment Company Act or the Investment Advisers Act, willful aiding or abetting violations, and importantly, a broker-dealer’s failure reasonably to supervise a person who commits a violation. In 1970, Congress amended similarly the Investment Advisers Act. Comparable authority is also contained in the Investment Company Act.  This authority has become a staple of the SEC Enforcement Program.

In 1990, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the Remedies Act).  The Remedies Act dramatically expanded the nature of SEC administrative proceedings.  For the first time, the Commission could proceed administratively against persons and entities not directly registered with the Commission and, also for the first time, it could impose monetary penalties on registered entities and associated persons.  It authorized the Commission to enter a cease and desist order against any person who is violating, has violated, or is about to violate any provision of the securities laws or any rule or regulation thereunder.  In a cease and desist proceeding, the Commission can order a party to take steps to comply with its rules, to provide an accounting, and to disgorge profits gained or losses avoided.  This Act also created a proceeding to enable the SEC to issue a temporary cease and desist order.  While the Commission has used its cease and desist authority extensively, it has brought only one proceeding under its temporary cease and desist authority.

The Remedies Act also expanded the remedies that the SEC can order in an administrative proceeding against broker-dealers, investment advisers, investment companies, and persons associated with these registered entities.  The SEC can order disgorgement and civil penalties comparable to those available in an injunctive action.  The Sarbanes-Oxley Act (SOX) expanded the remedies available in a cease and desist proceeding by authorizing the SEC to bar an individual from serving as an officer or director of a public company if they violated the antifraud provisions of the Securities Act or Exchange Act. Section 602 of SOX added section 4C to the Exchange Act and provided explicit statutory authority for administrative proceedings against an attorney, an accountant, or other professional such as an engineer or geologist, engaging in improper professional conduct. This codified Commission rule 102(e).

Section 925 of the Dodd-Frank Act (Dodd-Frank) further expanded the Commission’s sanctioning power to include a “collateral” bar from association under all of the securities laws.  It also provided the authority to impose money penalties against persons or entities not registered with the Commission.  In effect, the Commission could, in an administrative proceeding, impose substantially the same penalties available in a civil injunctive action. The substantial expansion in administrative proceeding authority, both in the scope of who may be charged in an administrative proceeding (AP) and in the penalties available in an AP, has coincided with a dramatic increase in the total number of administrative proceedings brought by the SEC.  While the controversy over this shift in policy has been largely focused on the period following Dodd-Frank, and in particular the past two years, the increased reliance on administrative proceedings has been growing steadily for more than two decades.

Report at 11-12 (footnotes omitted).

At a later point, the report discusses some of the current procedural rules governing the administrative proceedings, and makes the telling point that these rules were adopted long before the Commission (or anyone else) had any conception that this process would be used to try to adjudicate complex enforcement cases that went well beyond the areas subject to SEC regulation:

Commission rule 360 provides that “Under the 300-day timeline, the hearing officer shall issue an order providing that there shall be approximately 4 months from the order instituting the proceeding to the hearing, approximately 2 months for the parties to obtain the transcript and submit briefs, and approximately 4 months after briefing for the hearing officer to issue an initial decision.”  At the time they were adopted, the Division was not bringing complex matters administratively, and there was little experience with the explosion of electronic documents that is commonplace today.  As such the time periods in Rule 360 never considered the possibility that litigants in some matters would be forced to review in four months literally millions of pages of documents turned over by the staff.  Of course in 1994, when the Commission last completed a material update of its Rules of Practice, it also did not consider the possibility of complex litigation in an AP.  This explains why the rules provide only the most limited forms of discovery and depositions for respondents.  The lack of adequate discovery opportunities and sufficient time to prepare for trials are serious disadvantages that raise fundamental issues as to the efficacy of bringing complex litigation under the existing Rules of Practice.

Report at 16-17 (footnotes omitted).

And later:

The most significant difference between an administrative proceeding and a civil action is in the area of pre-trial discovery.  Through its investigation and the use of investigative subpoenas, the Commission’s staff will have developed an extensive investigative record over a significant period of time, before instituting an enforcement action.  The Division of Enforcement effectively has had extensive discovery.  While the current Rules of Practice
create a possibility for issuance of subpoenas by an ALJ, the rigorous deadlines for completion of a proceeding often result in ALJ reluctance to delay a hearing by approving the issuance of subpoenas.  The disparity in discovery rules between Commission administrative proceedings and federal litigation is a sore point with SEC defense counsel.

The Commission’s Rules of Practice have not been significantly amended since 1993.  The comprehensive review at that time reflected the substantial changes in authority and sanctions contained in the Remedies Act.  Since the new authority was in its infancy, there was limited experience to provide a benchmark.  It was also not possible to anticipate the additional expansions affected by SOX and Dodd-Frank.  As such the project was an
effort to anticipate what would be needed to ensure that administrative proceedings would be conducted and adjudicated in a timely, fair, and impartial manner. It is fair to conclude that no member of the Task Force working on that project envisioned what the norm is more than 20 years later.  For this reason, the Commission should update and review its Rules of Practice.  This should not be a controversial recommendation, given that the current
general counsel of the SEC has publicly suggested that it is time for a review.

Report at 20-21 (footnotes omitted).

The report puts to rest the bona fides of the ill-conceived response from the Enforcement Director arguing that the rules and procedures governing administrative actions do not favor the Division as prosecutor, and the memorandum from the Division of Enforcement purporting to rationalize the Division’s forum-choice decisions.

When the Director of Enforcement acknowledged a new policy of using the administrative forum more frequently to pursue enforcement cases even in complex actions involving unregulated persons, there was an outcry that this was an effort to stack the deck unfairly in the Enforcement Division’s favor (is there a way to stack a deck fairly?).  See, for example, SEC Enforcement Director Announces Future Plans To Avoid Jury Trials, and Former SEC Enforcement Leaders Urge SEC To Reform Administrative Enforcement Process.   Instead of acknowledging a problem that needed to be discussed and resolved, Enforcement Director Andrew Ceresney gave a premeditated, yet ludicrous, response that respondents were not harmed at all by being forced into the administrative forum.  See Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions.

When this plainly incorrect response failed to quell the sense of outrage, the Division of Enforcement published a memorandum purportedly explaining how it decided, and would decide, which forum to use in a prosecution, presumably in an effort to show that those decisions were not arbitrary.  See SEC Attempts To Stick a Thumb in the Dike with New Guidelines for Use of Administrative Court, and Upon Further Review, SEC Memo on Use of Administrative Courts Was Indeed a Fumble.

The report lays waste to each of these efforts to avoid the key substantive fairness issues raised by the increased use of the administrative forum in its current form.  It hopefully puts to rest any serious contention that respondents are significantly disadvantaged when the Commission chooses to file a complex case administratively at the same time it dissects the Division of Enforcement memorandum to show it is written without adequately considering impacts of this policy outside of the Division itself, and often relies on false premises:

In early May 2015, the Division of Enforcement posted on its page on the SEC website a document titled Division of Enforcement Approach to Forum Selection in Contested Actions.  As the title indicates, the document provides an explanation of the factors that the Division will consider when making a forum recommendation to the Commission. . . .

Four factors are identified and discussed:

• The availability of the desired claims, legal theories, and forms of relief in each forum (factor 1);
• Whether any charged party is a registered entity or an individual associated with a registered entity (factor 2);
• The cost-, resource-, and time-effectiveness of litigation for the Commission in each forum (factor 3); and
• Fair, consistent, and effective resolution of securities law issues and matters (factor 4).

Factor one acknowledges that certain causes of action are unique to each forum. . . .

Factor two restates the long-standing use of the AP process for actions against registered entities and associated persons. . . .

Factor three describes additional time and resource benefits that the staff derive from each type of forum, under certain circumstances.  These time and resource considerations
highlight the benefits exclusive to the Division.  No recognition or consideration is given to the impact of the forum decision on the parties charged.  In this respect, the policy is most troubling.  While the apparent efficiency of an administrative proceeding may be a benefit to the Division, it may be a serious and inequitable impediment to the person charged.  As a factual matter, the claimed rapidity of an administrative proceeding over a federal court action may also be incorrect.

The speed of the AP process is largely a byproduct of two factors.  One factor is the limited availability of pre-hearing discovery.  The second factor is the time limits imposed by Commission rule on the length of the process.

The lack of pre-hearing discovery adversely affects the respondent rather than the SEC staff. This is because the staff has been able to compile its evidentiary record, including sworn depositions, through its investigation process.  In effect, the staff is able to conduct its prehearing discovery before beginning the proceeding.  The respondents in an administrative proceeding have no comparable opportunity.  While they may be provided with the staff’s investigative record, this does not provide them with an opportunity to ask their own questions of witnesses  or seek documentation to support their position.  More important, they may have only a very short amount of time in which to review an investigative file, compiled over years of investigation and encompassing literally millions of pages of material.  The unequal impact of this limitation is discussed further below, under the discussion of factor three.

The second factor, specific time deadlines, may not result in the level of efficiency that the Division suggests. . . .  Factoring in the extended time period for completion of the Commission’s review suggests that the overall period for completion of an administrative proceeding is likely slower than the time required to complete a trial in district court.

Factor three also refers to the costs and benefits arising from the “additional time and types of pre-trial discovery available in federal court.”  While the current AP rules may provide benefits to the staff in terms of resources, they affirmatively disadvantage the respondents in these proceedings. . . .   At the time [these rules] were adopted, the Division was not
bringing complex matters administratively, and there was little experience with the explosion of electronic documents that is commonplace today. . . .  The lack of adequate discovery opportunities and sufficient time to prepare for trials are serious disadvantages that raise fundamental issues as to the efficacy of bringing complex litigation under the existing Rules of Practice. . . .

The fourth factor broadly raises these fundamental considerations of fairness and efficacy.  The only aspects of it that are discussed in the Division’s statements are the traditional statement concerning the superior expertise and experience of ALJs and the Commission, and the benefits that may come from having these experts be the first to examine and interpret the law, subject to appellate review.

Notably absent from this factor is the issue of the right to a jury trial.  One of the core constitutional protections is the right of persons to demand a jury trial.  The Supreme Court
has held that a defendant is entitled to a jury every time the government demands a civil penalty. . . .   Ironically, under the new forum choice process, instead of the defendant controlling the right to request a jury, through the choice of forum the government will have complete control over the right to a jury.  If the Division believes a jury would be advantageous, then it can file in district court.  If the Division prefers not to have a jury hear a case, then it can file an administrative proceeding.  Of all the consequences of the choice of forum controversy, it is likely that most objective persons would view this usurpation of a defendant’s right to request a jury as the most objectionable consequence.

Other fairness issues are also worthy of examination.  As previously explained, the lack of time and lack of discovery options also raise serious fairness issues.  In addition, one should be careful not to overstate the superior expertise that resides with the Commission’s adjudicators. Under the procedure governing the appointment of ALJs, direct substantive expertise in the applicable law is a minor consideration.  The dominating factor in the selection process is experience as an ALJ in the federal government.  During the past 30 years, the SEC has not hired a single ALJ who had directly relevant experience or expertise related to the federal securities laws.  While one may reasonably assume that each ALJ will, over time, acquire this expertise, currently only two of the six SEC ALJs have been at the Commission for more than two years.

This lack of substantive experience is particularly relevant when one considers the different standard for appellate review of SEC opinions compared to federal district court decisions….  This limited standard of review applies even in matters in which the Commission interprets the law differently from judicial interpretation. . . .

Report at 14-17 (footnotes omitted).

The report makes many recommendations for action by the Commission.  Many are fairly obvious for laying a foundation of fairness in this process.  Others may ask too much.  But each is a serious proposal meriting thought, analysis, and discussion, beyond the scope of this article.  The point to be made first is that the report leaves little doubt that it is time for the SEC commissioners to join in a “conversation” about how best to reform the SEC’s enforcement and administrative process, rather than mutely filing briefs in the administrative and federal courts that do their best to try to prevent anyone from causing meaningful reform.

Straight Arrow

July 16, 2015


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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Reactions to Supreme Court Omnicare Decision Vary

Reactions to the Supreme Court in Omnicare Inc. v. Laborers District Council Construction Industry Pensions Fund, No. 13-435, have been predictably varied.  Most note that there are pluses and minuses for both plaintiffs and defendants in federal securities cases under section 11 of the Securities Act of 1933.  Dealmakers express relief that they can devise disclosures to protect against liability for opinions stated in registration statements that are part of public company mergers.  Plaintiffs’ lawyers say they now have a Supreme Court imprimatur for causes of action challenging undisclosed feeble support for company or management opinions in public offering materials.  More developments are inevitable as commentators and the courts focus on the scope and application of Justice Kagan’s concept of what I call “incomplete opinions.”  Our post on the Omnicare opinion is available here: Omnicare: Supreme Court Shoots Down 6th Circuit, but Adopts Amorphous Standard for Section 11 Opinion Liability.

Some amusing reactions discuss Justice Kagan’s unusual chatty style of writing: Minor Wordfoolery in Today’s Supreme Court Opinion (Lowering the Bar) (commenting on pronoun sniping between Kagan and Scalia); “Way overstates,” in a Supreme Court opinion (Washington Post) (commenting on a lapse into Valley girl speak by Kagan); and “Yeah, Well, That’s Just, Like, Your Opinion”:  Supreme Court Limits Securities Liability for Opinions in Omnicare (JDSupra) (in which the only stylistic comment is in the title, but it makes the point).

See for yourself.  We provide below links to commentary about the Omnicare decision.  These links will be updated in the future to include thoughts published after today (March 25, 2015):

We include at the bottom the descriptions and analyses published by various law firms.  For your convenience, if you prefer not to go through the many primary sources provided, we provide at the outset of that section a sampling of quotes from these materials with “takeaways” laid out by several firms.


Omnicare: Supreme Court Shoots Down 6th Circuit, but Adopts Amorphous Standard for Section 11 Opinion Liability (Straight Arrow Mar. 24, 2015 Blog Post)

Supreme Court’s Omnicare Decision Muddies Section 11 Opinion Liability Standards (K&L Gates)

In Omnicare the Supreme Court Provides Evidence for Opinions in Registration Statements (Wolf Haldenstein)

Deals World Rests Easy In Wake Of Omnicare Ruling (Law 360)

Lawyers Weigh In On High Court’s Omnicare Decision (Law 360)

IMHO Omnicare Doesn’t Materially Change Opinion Disclosure (The Venture Alley)

Context Is King in Supreme Court’s Omnicare Ruling (Law.com)

Omnicare: Section 11 Liability and Opinions (SEC Actions)

Facts, Opinions, Omissions, and Context: The U.S. Supreme Court Issues Omnicare Opinion (D&O Diary)

“Yeah, Well, That’s Just, Like, Your Opinion”:  Supreme Court Limits Securities Liability for Opinions in Omnicare (JDSupra)

Supreme Court’s “Omnicare” Decision Follows Middle Path (Washington Legal Foundation)

Supreme Court Sets High Bar For Challenging Exec Opinions (Law 360)

Justices stick to middle of the road in Omnicare securities opinion (Reuters)

A company’s opinion isn’t always a lie (Bloomberg)

Supreme Court Protects ‘Opinions’ From Suit — Unless They’re Contradicted By The Facts (Forbes)

High Court gives Omnicare another shot at stopping investor suit (Wall Street Journal)

Law Firm Advisories

Summary of “takeaways”:

Morrison Foerster:

The Omnicare decision will affect whether and how opinions are communicated in registration statements. It may also shape, to some extent, how courts approach liability even for statements alleged to be misleading where a material fact is omitted from other investor communications. That is because the statutory language at issue in Omnicare is similar to more than a dozen other federal securities laws provisions. One key difference, however, is that civil liability under other statutes like Section 10(b) of the Securities Exchange Act of 1934—the federal securities statute most frequently invoked by private plaintiffs—requires proof of scienter, unlike Section 11. That means that, with respect to opinion statements made outside of registration statements, plaintiffs must show not only a material misstatement or omission, but also that a defendant did not believe his or her opinion and intended to deceive investors, a high hurdle for plaintiffs to overcome.

Going forward, public companies, their speakers, and the gatekeepers who advise them (including in -house and external counsel) should give special consideration to expressions of opinion that are communicated to the investing public. A prudent approach would be to accompany statements of opinion with the actual basis for the belief, the reasons for that belief, and qualifications of the opinion, including caveats or statements of tentativeness. In addition, documents supporting the basis for every statement of opinion should be verified, preserved, and readily accessible if litigation is filed. Indeed, doing so can significantly help bolster the defense of claims relating to all types of public statements, not just statements of opinion.

Sullivan Cromwell:

Yesterday’s decision provides important guidance on how Section 11 applies to statements of opinions.  The Court’s guidance is significant in light of the critical role of pleading standards and motions to dismiss in securities litigation.  The Court’s decision confirms that Section 11 does not authorize lawsuits based on honestly held opinions in registration statements that subsequently turn out to be wrong….  [W]hen opinion statements contain embedded factual assertions—i.e., when an issuer says that it holds a particular opinion because of some fact—issuers should be careful that they have taken measures to verify the factual assertions underlying those opinions.The decision may encourage plaintiffs’ lawyers to bring litigation over whether issuers have adequately accompanied their opinions with statements about how they formed those opinions—i.e., “facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have.”  But the Supreme Court made clear that, “to avoid exposure for omissions under [Section] 11, an issuer need only divulge an opinion’s basis, or else make clear the real tentativeness of its belief.”

….  To guard against the possibility of omissions liability, issuers should consider setting forth the bases for opinion statements in disclosure documents where necessary to prevent any potential confusion.  Issuers also should consider whether there are any material assumptions underlying their opinion statements that would not be apparent from the context of the opinion and may be material to a reasonable investor….  [I]ssuers should consider accompanying their opinion statements with language making clear the opinions’ uncertainty or limited nature or scope. Although the Supreme Court’s decision rested on the language of Section 11, plaintiffs’ lawyers may seek to extend the Court’s rationale to claims under other provisions of the securities laws, such as Section 12 of the Securities Act and Sections 10(b) and 14(a) of the Securities Exchange Act of 1934, including with respect to oral or written statements of opinion not crafted with the care and forethought applied to registration statements.  The Supreme Court was clear, however, that plaintiffs have substantially less room to claim to have been misled by opinions outside the context of carefully drafted registration statements and similar documents….  Defendants may wish to resist any attempt to extend yesterday’s decision beyond litigation under Section 11 in the context of registration statements.

Fenwick West:

Notably, Section 11 cases are typically subject to a stay of discovery during the pendency of a motion to dismiss under the Private Securities Litigation Reform Act of 1995 (PSLRA), and thus plaintiffs will likely have to plead such facts without the benefit of any discovery.

It bears noting, however, that plaintiffs are increasingly filing their Section 11 cases in state court—as there is a split among district courts as to whether Section 11 cases are removable to federal court—and in so doing are arguing that the PSLRA stay of discovery does not apply.  The Omnicare decision may create further incentive for plaintiffs to file in state court to attempt to obtain discovery in order to properly plead a Section 11 claim under the Omnicare standard.

Paul Weiss:

….  The opinion [] strongly suggests that the presence of words like “I believe” may indicate a statement of opinion, rather than one of fact….  As a result, issuers may be more likely — and well advised to use such “opinion” language in their registration statements and other disclosures going forward.  The Court’s ruling, however, also leaves considerable room for lower courts to develop more precise rules about what types of statements do and do not constitute opinions….

[T]he Supreme Court’s ruling that a statement of opinion may be actionable under Section 11 under an omissions theory is likely open to a new avenue of litigation.  Plaintiffs who cannot allege that an opinion was not honestly held may instead allege that it was based on inadequate inquiry or that there was contrary information available to the speaker.  The extent to which such allegations are sufficient to avoid a motion to dismiss will require further judicial development….  [I]t will be up to lower courts to develop case law distinguishing actionable amissions from non-actionable ones, and those distinctions may depend on industry practice and other factors that the Supreme Court’s opinion references but does not conclusively determine.

….  [T]he Supreme Court’s opinion does not address the application of the standards it sets forth to claims based on statements of opinion that are asserted under provisions of the federal securities laws other than Section 11.  The Second Circuit Court of Appeals, for example, has held that the same standards for pleading an actionable misstatement of opinion that apply under Section 11—including subjective falsity—also apply to claims asserted under Section 10(b)….  The Supreme Court’s opinion in Omnicare appears to leave such lower court decisions intact —at least insofar as they concern alleged misstatements.  But, to the extent that lower courts have not drawn the same distinction as the Supreme Court did between affirmative misstatements of opinion and statements of opinion that omit material facts, the decision also raises certain unanswered questions. These include, for example, whether plaintiffs alleging that a statement of opinion is materially misleading under Section 10(b) because the defendant omits that he failed to conduct an investigation supporting his opinion would be entitled to a presumption of reliance under Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972), or whether such plaintiffs would be required to demonstrate reliance through one of the means applicable to a claim of alleged misrepresentation.


….  [T]he Court’s decision places some important restrictions on investors’ ability to challenge statements of opinion under § 11.  First, an issuer need not disclose all facts supporting or undercutting its expressed opinion. Normal principles of materiality still apply….  Second, and relatedly, an issuer can reduce the risk of § 11 liability by “including hedges, disclaimers, and apparently conflicting information.”  For example, an issuer wishing to express its belief in its compliance with law can note the existence of any private or governmental litigation – and any conflicting legal decisions – on the matter at issue and can include cautionary language warning that courts or regulators could view the factual and legal issues differently than does the issuer…. Third, issuers can take some comfort from the Court’s unwillingness to countenance generalized, conclusory assertions about alleged omissions and lack of reasonable basis for opinions expressed.  While the Court cited the general notice-pleading standard articulated in Ashcroft v. Iqbal, the Omnicare decision applies specifically in the § 11 context, so issuers will undoubtedly focus on this language if they believe that plaintiffs have not pled “particular (and material) facts going to the basis for the issuer’s opinion.”

Subsequent cases will explore whether and to what extent Omnicare applies to claims under § 10(b) of the Securities Exchange Act, which – unlike § 11 – requires plaintiffs to prove the defendants’ knowledge (or at least recklessness) as to falsity. If Omnicare allows § 11 liability where an issuer omits material information about the basis for its opinions, must a § 10(b) plaintiff prove that the issuer acted with the requisite scienter in omitting that information?

Moreover, if Omnicare applies to § 10(b) cases involving opinions, investors will presumably need to satisfy the heightened pleading standards of Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act of 1995 (the “PSLRA”) in specifying the “facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have – whose omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.” The pleading standard that Omnicare cited should not suffice in a PSLRA case.

Gibson Dunn:

….  As with most such decisions, the proof is in the pudding: Omnicare’s impact on Section 11 litigation will be borne out in the coming months and years as lower courts grapple with the decision.  And while Omnicare’s relevance beyond Section 11 will no doubt be debated, the opinion’s reach, particularly to federal securities law claims that require scienter, is questionable.  A more subjective standard, such as that set forth in Justice Scalia’s concurrence, likely remains more fitting for scienter-based claims….  But regardless of how the omission standard is applied to federal securities law claims requiring scienter, plaintiffs still face a high pleading burden in such cases.

Latham Watkins:

….  [T]he Court did not directly address important issues regarding how the Omnicare analysis will be applied.

The Court’s opinion provides relatively little guidance as to when an omission may give rise to Section 11 liability.  The Court stated that “to avoid exposure for omissions under [Section] 11, an issuer need only divulge an opinion’s basis, or else make clear the real tentativeness of its belief” – but left it to the lower courts to determine the extent to which the basis of an opinion should be disclosed to accord with a reasonable investor’s expectations, and what more an issuer should say about the “tentativeness” of the belief beyond the inherent uncertainty conveyed by stating the view in the form of an opinion.

The Court also did not address whether and how its analysis applies outside of Sechtion 11. Much of the Omnicare decision has the potential to be equally applicable to other statutes requiring false or misleading misrepresentations or omissions.

Haynes Boone:

As for omissions and opinions under Section 11, because Omnicare’s inquiry focuses on the speaker’s “basis for offering the opinion,” the “foundation” a reasonable investor “would expect an issuer to have,” and “reading the statement fairly and in context,” there will be considerable room for future disagreement between the defense and shareholder plaintiffs’ bars.  Nevertheless, the confirmation that these alleged omissions must be pled with specificity and must be material to a reasonable investor is helpful to issuers.

After Omnicare, it seems likely that future Section 11 complaints involving opinions will be pled strategically under an omissions theory, not as direct misstatements (absent a “smoking gun”).  Companies preparing for an offering should pay close attention to any statement that may qualify as an opinion and carefully review the “hedges, disclaimers or qualifications” directly tied to that opinion in the registration statement.  The Supreme Court instructed that this “context” is critical to determining whether an omission is material and misleading.

Moreover, in instances where an issuer is faced with an internal diversity of views about an opinion, the crafting of the disclosure language is not the only critical step for the company and its counsel. How those diverse views are resolved and memorialized may be critical, should a Section 11 suit concerning that opinion reach the discovery phase.

Arnold & Porter:

While Omnicare involved filings made under the Securities Act of 1933 (registration statements),its reasoning may be instructive for other types of filings – whether statements are materially misleading or omit material facts is a common element of many other claims under the federal securities laws, including those that govern periodic filings.  As the Court wrote, “These principles are not unique to § 11: They inhere, too, in much common law respecting the tort of misrepresentation.

”An issuer’s statement of opinion will not result in liability solely on the basis that the opinion turned out to be incorrect.  Nor, however, are issuers immunized from potential liability because statements are couched as opinions rather than facts. As the Court indicated, there are no “magic words” such as “we believe” or “we think” that will foreclose liability in all circumstances.

The Court emphasized that the evaluation of particular disclosures “always depends on context.”   Accordingly, predicting how lower courts will apply the Court’s standard to particular disclosures may be difficult.  This may be especially true with respect to statements of opinion of the type at issue in Omnicare – i.e., opinions regarding legal compliance – made by companies that could face allegations under anti-kickback laws (such as pharmaceutical or medical device companies) or other laws that are ambiguous as to the lines between lawful and unlawful conduct (such as the Foreign Corrupt Practices Act).  It remains to be seen how lower courts will apply Omnicare, especially in the context of statements of opinion about compliance with complex regulatory statutory schemes where the lines are blurred.

Shearman & Sterling:

From the defense perspective, while the Court’s repudiation of the Sixth Circuit’s “objective falsity” standard for Section 11 material misstatement claims is an important victory, the Court’s omissions analysis could invite more Securities Act claims attacking statements of opinion. Issuers frequently offer statements of opinion concerning “inherently subjective and uncertain assessments,” including, for example, with respect to matters required by GAAP (such as goodwill calculations, reserves or loss contingencies). In the wake of Omnicare, an issuer cannot be confident that Section 11 challenges to such opinions will be subject to dismissal simply because the plaintiff is unable to adequately allege subjective falsity. Accordingly, issuers may need to consider, among other things, whether or the extent to which statements of opinion can or should be coupled with appropriate caveats (beyond those that inhere in the very nature of an opinion) or with an elucidation of the rationale or basis underlying the opinion. And with relatively little guidance from the Supreme Court on how to apply a context-specific standard, the outcomes in Section 11 cases challenging statements of opinion on an omission theory can be expected to vary depending upon the judge. Having said that, the Supreme Court’s admonition that going the omissions route will be “no small task for investors, ”and its seeming requirement of a tight and specifically pleaded nexus between the opinion and a truly important omitted fact regarding its basis, bear emphasis. Properly construed, we believe the Court’s decision should allow potential opinion liability based on omissions in a relatively narrow set of cases rather than open the floodgates to opinion-focused claims.

Lowenstein Sandler:

This week the United States Supreme Court issued a landmark opinion under the federal securities laws in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, ruling that investors can in some cases recover damages for losses even for statements couched as “opinions.”  The Court found that an issuer’s opinions in a registration statement filed in connection with a public offering can be rendered misleading by the issuer’s failure to disclose certain material facts.  The Supreme Court’s opinion effectively overrules the more narrow existing standard established by federal courts in New York, which have held that an issuer’s opinions in a registration statement are actionable only if the investor can prove that those opinions were both objectively false and the issuer did not believe them at the time they were expressed.

Fried Frank:

The Omnicare decision, while on its face a victory for the issuer and protective of opinion statements, will nonetheless open up new avenues for future litigation concerning the contours of omissions liability arising from statements of opinion. In the event that, in hindsight, an opinion turns out to have been untrue, plaintiffs’ lawyers will likely challenge whether the basis of the opinion was adequately disclosed.  Although Omnicare rests on the language of Section 11, plaintiffs may seek to apply Omnicare to claims arising under other provisions of the securities laws, including statements of opinion expressed in places other than registration statements.

Kink & Spaulding:

Omnicare leaves the door open to litigation about the omissions clause of Section 11, much of which will take place at the motion-to-dismiss stage.  The Court stressed that satisfying the applicable pleading burden will be “no small task” for plaintiffs, who cannot skate by with “conclusory assertions” or allegations “that the issuer failed to reveal [the] basis” for its opinion.  Instead, “[t]he investor must identify particular (and material) facts going to the basis for the issuer’s opinion—facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have—whose omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.”

Lower courts can expect to spend long hours applying this new standard to the prolix complaints that are regularly filed when stock prices drop in the wake of bad news.  Public companies hoping to avoid getting caught up in that process might heed Omnicare’s advice that, “to avoid exposure for omissions under § 11, an issuer need only divulge an opinion’s basis, or else make clear the real tentativeness of its belief.”  Alternatively, they might “control what they have to disclose . . . by controlling what they say to the market,” in recognition of the fact that “[s]ilence, absent a duty to disclose, is not misleading.”  Such reluctance to opine could contribute to a deepened circuit split over whether a violation of Item 303 can form the basis of a claim under the federal securities laws.

Hogan Lovells:

Claims premised on an asserted untrue statement of fact. The Omnicare decision likely will have little impact on the volume of Section 11 claims premised on an opinion that allegedly was not honestly believed. Although not an issue addressed by the Supreme Court, circuit courts consistently have held that, because such claims sound in fraud, the heightened pleading requirements of Rule 9(b) of the Federal Rules of Civil Procedure apply to the claims. Accordingly, the trend in the plaintiffs’ bar, as illustrated by the pleading in the Omnicare case itself, is to disclaim any suggestion that the Section 11 claim is premised on a knowingly false statement. Because the Omnicare decision explicitly requires, for pleading a false statement of opinion, that the plaintiff allege a knowingly disbelieved opinion, which would have to meet the stringent pleading requirements for a fraud claim, we expect the plaintiffs’ bar to avoid making such claims absent exceptional circumstances.

Claims premised on an allegedly misleading opinion. The Omnicare decision is likely to result in more Section 11 claims premised on supposedly misleading opinion statements, and potentially in a greater number of Section 11 claims that survive at least an initial motion to dismiss.

The Omnicare decision dramatically alters the standards for reviewing Section 11 claims premised on opinions in those federal circuits, such as the Second Circuit and the Ninth Circuit, that had required plaintiffs to allege both that a statement of opinion was not only “objectively” false but also “subjectively” false in that it was disbelieved by the speaker. In those circuits, plaintiffs had to allege facts raising an inference of dishonesty, which often proved an insurmountable hurdle. That bulwark against Section 11 claims directed at opinions is now no longer available. Moreover, the question of what facts a “reasonable” investor might infer from an opinion – like the issue of what facts a “reasonable” investor might consider material – may prove notoriously fact-specific and not amenable to ready resolution on a motion to dismiss or for summary judgment. The Supreme Court suggested that its ruling would not likely open the floodgates to litigation because a plaintiff must still satisfy the “facial plausibility” pleading standard of Rule 8(a) of the Federal Rules of Civil Procedure and thus “identify particular (and material) facts going to the basis for the issuer’s opinion – facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have – whose omission makes the opinion statement” misleading to a reasonable investor “reading the statement fairly and in context.”

We anticipate that, in many cases, distilling those factual inferences that a reasonable investor might draw from an opinion and assessing whether such inferences are negated or otherwise limited by the “broader frame” of other disclosures will lead to an extended exchange of motions before disposition of a claim. In addition, we expect that courts, assessing plaintiffs’ claims only for facial plausibility (the pleading standard under Rule 8(a)), will find the factual issues too intractable to resolve at an early stage.

Implications for preparing disclosure. The Supreme Court emphasized the importance of evaluating factual inferences that reasonable investors may draw from an opinion statement in the “broader frame.” This emphasis illustrates the importance of drafting registration statements to include, in the words of the Securities Act safe harbor for forward-looking statements, “meaningful cautionary statements identifying important facts that could cause actual results to differ materially from those” in an opinion. Disclosures that meaningfully “bespeak caution” to investors are likely to substantially thwart claims that an opinion was rendered materially misleading by the omission of facts concerning the basis for the issuer’s statement. Some issuers may choose to respond to Omnicare by adding disclosures about the bases for opinions. Doing so may create a new set of risks, so issuers should exercise care and use cautionary language to limit the chances that those disclosures themselves will become grounds for an omissions claim. Because many issuers incorporate by reference their periodic reports and other Exchange Act filings into their registration statements, we advise similar care in drafting those filings. We also recommend alerting disclosure committees and other persons who are involved in preparing SEC disclosures on the need for enhanced care in disclosing expressions of opinion in light of the standard of liability articulated by the Supreme Court in Omnicare.

Here are links to those and other law firm advisories or memos on the Omnicare decision:

Litigation Alert: The Supreme Court’s Omnicare Decision Clarifies When an Opinion Stated in a Registration Statement Can Give Rise to Section 11 Liability (Fenwick)
Supreme Court Clarifies Liability for Statements of Opinion in Registration Statements (Proskauer)
The Supreme Court rules on securities issuers’ liability for misleading statements of opinion (Robins Geller)
Supreme Court Decides When A Statement Of Opinion Can Trigger Section 11 Liability (Latham Watkins)
Supreme Court Limits, But Does Not Reject, Securities Liability for Statements of Opinion in Registration Statements (Linklaters)
Context, Reasons, Hedges, and Disclaimers: The Supreme Court’s Ruling in Omnicare May Shape Whether and How Companies Express Opinions (Morrison Foerster)
United States Supreme Court Limits Investor Suits for Misleading Statements of Opinion (Paul Weiss)
Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund: Liability for Opinions in Registration Statements (Sullivan Cromwell)
Supreme Court Decides Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund (Faegre Baker Daniels)
U.S. Supreme Court Issues Long-Awaited Decision in Omnicare (Gibson Dunn)
Omnicare: Supreme Court Sets Liability Tests for Issuers’ Statements of Opinion in Public Offerings (Haynes Boone)
Legal Alert: Omnicare Opinion Expands Liability for Expressions of Opinion Under Section 11 (Sutherland Asbill)
U.S. Supreme Court Clarifies When Opinions Can Be Actionable Under Federal Securities Laws (Clifford Chance)
Supreme Court Clarifies Liability for Statements of Opinion Under Section 11 of the Securities Act (Arnold & Porter)
Supreme Court Opines on Opinions v. Facts in the Sale of Securities (Michael Best & Friedrich)
We’ll hold you to that: U.S. Supreme Court in Omnicare rules that even pure opinions can create strict Securities Act liability for some omissions (Nixon Peabody)
Supreme Court Sets Standard for Section 11 Opinion Statement Liability in Omnicare Ruling (Shearman & Sterling)
High Court Opens Courthouse Doors to New York Investors Harmed by False Statements Couched as Opinions in Registration Statements (Lowenstein Sandler)
High Court Announces New Standard for Opinion Statements (Akin Gump)
Everyone Has An Opinion: Supreme Court Clarifies When Opinions Create Securities Law Liability (Fried Frank)
U.S. Supreme Court’s Omnicare Decision Leaves Open Narrowed Theory Of Liability For Statements Of Opinion Under Federal Securities Laws (King & Spaulding)
Omnicare: Statements of Opinion, Omissions, and Implication (Sidley Austin)
Supreme Court Limits — But Does Not Foreclose — Section 11 Liability for Statements of Opinion, Leaving Investors With a Steep Climb (Chadbourne)
Supreme Court’s Omnicare Decision Muddies Section 11 Opinion Liability Standards (K&L Gates)
Omnicare and the “Reasonable Investor” Standard for Statements of Opinion (Baker Hostetler)
Supreme Court clarifies liability standard under Securities Act Section 11 for statements of opinion in registration statements (Hogan Lovells)
In Omnicare, Supreme Court Clarifies the Scope of Liability for Statements of Opinion Under Section 11 of the Securities Act of 1933 (Cleary Gottlieb)
Straight Arrow

March 25, 2015

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Omnicare: Supreme Court Shoots Down 6th Circuit, but Adopts Amorphous Standard for Section 11 Opinion Liability

Today, March 24, 2015, in its decision in Omnicare Inc. v. Laborers District Council Construction Industry Pensions Fund, No. 13-435, the Supreme Court gave short shrift to the Sixth Circuit’s expansion of liability under section 11 of the Securities Act of 1933 for statements of opinion in registration statements.  At the same time, the Court approved a dangerously amorphous theory of possible omissions liability for incomplete opinions — the failure to disclose facts related to those opinions — which gives little guidance to lower courts facing future such claims.  A copy of the Supreme Court decision is available here: Supreme Court Decision in Omnicare v. Laborers District Council Construction Industry Pensions Fund.  We previously discussed the flawed Sixth Circuit opinion here: Sixth Circuit Improperly Expanded Section 11 Liability for Non-Factual Statements in Omnicare.

The Sixth Circuit ruled that a section 11 action could be founded on allegations that the defendant’s statement in a registration statement that it believed it’s business activities were in compliance with the law was inaccurate, because aspects of those activities were alleged to be unlawful, even without allegations that company management did not genuinely believe the stated view.  The justices unanimously rejected this ruling, but they disagreed on a different theory: how to treat possible failures to disclose information about the factual underpinning for management’s opinion statements.  Although the lower courts never addressed that issue, Justice Kagan spent most of her opinion discussing the standard for considering such allegations, and remanded the case for consideration of that theory.  Justice Scalia disagreed with Kagan’s analysis of that issue in a concurring opinion.  Justice Thomas thought the issue should not have been addressed by the Court because it was not properly presented for review.

The unanimous Court quickly dealt with the error in the Sixth Circuit’s approach, effectively reiterating the standard in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991), for pleading a claim based on a falsely stated opinion: that an opinion is not a fact, and there is no such claim based on allegations that the stated view was wrong, only on allegations that the opinion was not an accurate statement of the speaker’s actual views.

Justice Kagan described the two statements in the Omnicare registration statement alleged to be inaccurate as follows:

“[T]wo sentences in the registration statement expressed Omnicare’s view of its compliance with legal requirements:

  • ‘We believe our contract arrangements with other healthcare providers, our pharmaceutical suppliers and our pharmacy practices are in compliance with applicable federal and state laws.’
  • ‘We believe that our contracts with pharmaceutical manufacturers are legally and economically valid arrangements that bring value to the healthcare system and the patients that we serve.’”

Slip op. at 2-3.

She then noted that these were not statements of “hard facts,” but of “opinions.”  The Sixth Circuit concluded nonetheless that a claim could be stated based on allegations “that the stated belief was ‘objectively false’; they did not need to contend that anyone at Omnicare ‘disbelieved [the opinion] at the time it was expressed.’”  Slip op. at 4 (quoting 719 F.3d at 506).  In other words, “The Sixth Circuit held, and the Funds now urge, that a statement of opinion that is ultimately found incorrect—even if believed at the time made—may count as an ‘un-true statement of a material fact.’”  Slip op. at 6.  She then exlained that was fundamentally wrong:

But that argument wrongly conflates facts and opinions.  A fact is “a thing done or existing” or “[a]n actual happening.”  Webster’s New International Dictionary 782 (1927).  An opinion is “a belief[,] a view,” or a “sentiment which the mind forms of persons or things.” Id., at 1509.  Most important, a statement of fact (“the coffee is hot”) expresses certainty about a thing, whereas a statement of opinion (“I think the coffee is hot”) does not.  See ibid.  (“An opinion, in ordinary usage . . . does not imply . . . definiteness . . . or certainty”); 7 Oxford English Dictionary 151 (1933) (an opinion “rests[s] on grounds insufficient for complete demonstration”).  Indeed, that difference between the two is so ingrained in our everyday ways of speaking and thinking as to make resort to old dictionaries seem a mite silly.  And Congress effectively incorporated just that distinction in §11’s first part by exposing issuers to liability not for “untrue statement[s]” full stop (which would have included ones of opinion), but only for “untrue statement[s] of . . . fact.”  §77k(a) (emphasis added).

Slip op. at 6.

She explained that section 11’s false-statement provision could still apply to expressions of opinion because “every such statement explicitly affirms one fact: that the speaker actually holds the stated belief.”  But the Omnicare plaintiffs “do not contest that Omnicare’s opinion was honestly held.”  They expressly stated they are not alleging “fraud or deception” (presumably in order to avoid strict pleading requirements for fraud).  Instead, they claim “that Omnicare’s belief turned out to be wrong—that whatever the company thought, it was in fact violating” the laws.  That allegation does not give rise to liability under §11 because “a sincere statement of pure opinion is not an ‘untrue statement of material fact,’ regardless whether an investor can ultimately prove the belief wrong.”  Slip op. at 9.  “In other words, the provision is not . . . an invitation to Monday morning quarterback an issuer’s opinions.” Id.

Having straightforwardly rejected the theory accepted below, Justice Kagan went on to address another potential theory not discussed below – possible liability based on omissions of material facts from the registration statement related to the basis for the statements of opinion that were themselves unactionable: “the Funds also rely on §11’s omissions provision, alleging that Omnicare ‘omitted to state facts necessary’ to make its opinion on legal compliance ‘not misleading’.”  Slip op. at 10.  She rejected Omnicare’s argument that the statement of an opinion could not give rise to liability for omitting facts related to the opinions, “because a reasonable investor may, depending on the circumstances, understand an opinion statement to convey facts about how the speaker has formed the opinion—or, otherwise put, about the speaker’s basis for holding that view.  And if the real facts are otherwise, but not provided, the opinion statement will mislead its audience.”  Slip op. at 11.

She expands on that theory, explaining that a statement of legal opinion could carry with it the implication that there is some underlying legal analysis to support it. If there was no such analysis, or if the statement is made with knowledge of reliable contrary positions taken by the government, a reasonable investor could be misled by the failure to include those facts.  “Thus, if a registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself, then §11’s omissions clause creates liability.”  Slip op. at 12.  Thus, even if a CEO gives a genuine opinion on an issue, if that opinion is held without having considered matters a reasonable investor would expect to be considered, and that fact is not disclosed, there might be liability: “The CEO may still honestly believe in her [opinion].  But under §11’s omissions provision, that subjective belief, in the absence of the expected inquiry or in the face of known contradictory evidence, would not insulate her from liability.”  Slip op. at 12 n.6.

Realizing that she had just crafted a huge hole in the rule that there is no liability for opinion statements, Justice Kagan went on to explain that there have to be really strong allegations to support the contention that important facts about the basis for the opinion were misleadingly omitted:

An opinion statement, however, is not necessarily misleading when an issuer knows, but fails to disclose, some fact cutting the other way.  Reasonable investors understand that opinions sometimes rest on a weighing of competing facts; indeed, the presence of such facts is one reason why an issuer may frame a statement as an opinion, thus conveying uncertainty….  Suppose, for example, that in stating an opinion about legal compliance, the issuer did not disclose that a single junior attorney expressed doubt s about a practice’s legality, when six of his more senior colleagues gave a stamp of approval. That omission would not make the statement of opinion misleading, even if the minority position ultimately proved correct: A reasonable investor does not expect that every fact known to an issuer supports its opinion statement.

Slip op. at 13.

Whether “an omission makes an expression of opinion misleading always depends on context.”  Id. at 14.  For example, in the context of a formal registration statement filed with the SEC, reasonable investors “do not, and are right not to, expect opinions contained in those statements to reflect baseless, off the-cuff judgments, of the kind that an individual might communicate in daily life.  At the same time, an investor reads each statement within such a document, whether of fact or of opinion, in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information.”  Id.

Having just invoked a standard based on amorphous and uncertain assumptions about what a “reasonable investor” would “expect” or “understand” in a particular context (and not explaining in any way how a lower court is supposed to divine such things), the opinion swings back in the other direction, purporting to explain how difficult it would be to meet that standard:

As we have explained, an investor cannot state a claim by alleging only that an opinion was wrong; the complaint must as well call into question the issuer’s basis for offering the opinion….  And to do so, the investor cannot just say that the issuer failed to reveal its basis. Section 11’s omissions clause, after all, is not a general disclosure requirement; it affords a cause of action only when an issuer’s failure to include a material fact has rendered a published statement misleading.  To press such a claim, an investor must allege that kind of omission—and not merely by means of conclusory assertions.… T o be specific: The investor must identify particular (and material) facts going to the basis for the issuer’s opinion—facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have—those omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context….  That is no small task for an investor.

Slip op. at 17-18.

The opinion concludes with unusually explicit instructions on how the lower Omnicare courts should apply the omissions theory in the context of the claim against Omnicare.  That may suffice to provide guidance in this case, but one wonders how it helps courts in other cases faced with inevitable efforts by plaintiffs’ lawyers to plead section 11 cases founded on Justice Kagan’s somewhat inscrutable “incomplete opinions” omissions theory.

Justice Scalia’s concurring opinion explains in some detail why he believes Justice Kagan’s approach misstates and misapplies the law of liability for opinion statements, and is worth reading for that. The Kagan opinion stating liability for what might be called “incomplete opinions” is, however, now the law of the land.

So where does the Kagan opinion leave us in these cases?  It certainly rejects theories of section 11 liability based on allegations that opinion statements were objectively wrong.  But at the same time it opens the door for claims based on “incomplete opinions” — allegations that opinion statements were misleadingly incomplete because they failed to discuss underlying facts that reasonable investors would expect, which might alter how they interpret those opinions.

Despite Justice Kagan’s efforts to explain that the bar for such claims is high enough to make it “no small task for an investor,” lower courts are left largely adrift on how to apply this standard in real future cases.  How are they to decide on motions to dismiss what investors would expect in the particular context alleged?  How demanding should the courts be to have complaints that lay out strong factual grounds supporting the contention that there were undisclosed related facts that seriously limit the value or meaning of stated opinions?  To what extent will liability be created for statements now considered to be unactionable “soft information,” including future predictions, based on allegations that undisclosed facts about the basis for those opinions would alter investor interpretations of those statements?  To what extent will Justice Kagan’s exhortations for “particular (and material) facts going to the basis for the issuer’s opinion—facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have” be treated by lower courts as trumping the normal pleading standards for section 11 claims?

Until these questions are answered in district court and appellate court decisions, issuers and management would be wise to limit opinion statements to the bare minimum, and to have reliable analysis in hand to support the ones that are given.  The scope of potential liability for “incomplete opinions” may remain unclear for some time into the future.

Straight Arrow

March 24, 2015

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