Tag Archives: Supreme Court

Supreme Court Should Take Action To Rehabilitate Brady Rule in Georgiou v. United States

Justice requires that the Supreme Court shore up the foundations of one of its landmark due process cases, Brady v. Maryland, 373 U.S. 83 (1963).  Otherwise, Brady, one of the seminal due process cases of the 20th Century, will be “more honor’d in the breach than the observance.”

In Brady, the Court ruled that prosecutors could not hide material exculpatory evidence from defendants. It is founded on the simple concept that a fair trial requires that a jury be presented with unbiased evidence, and the Government cannot, consistent with due process, prevent important exculpatory evidence from reaching the jury.

Over the years, prosecutors have largely resisted the concept that they share evidence in their possession that could assist the defense.  This reflects a fundamentally flawed approach to the criminal justice process – too many prosecutors view winning a prosecution as the ultimate goal, when in fact achieving justice – win or lose – is the sine qua non of the criminal justice system of which they are part and parcel.

It is well-known that obtaining exculpatory evidence from prosecutors can be like pulling their teeth, and it has been documented that the failure to follow the simple Brady mandate is a common occurrence.  The courts, which are entrusted to assure the Brady rule is followed, have been unduly neglectful of this key oversight role, showing an unseemly willingness to accept Brady violations under a range of rationalizations.

One of the key rationalizations for permitting Brady violations has been the so-called “due diligence” rule adopted by some courts, under which even the intentional failure of the prosecution to share important exculpatory evidence is ignored if the court develops a hindsight theory of how defense counsel could have uncovered similar information through its own investigations.  The “due diligence” concept finds no support in Brady or other Supreme Court decisions, and, as is readily apparent, flies in the face of the very concept of Brady, which is about the State’s duty to assure a fair trial, not the relative diligence or acumen of the defense lawyers.

This issue has now been placed squarely before the Court in a petition for certiorari in Georgiou v. United States, No. 14-1535.  Some time ago we wrote about some ill-conceived decisions by the Third Circuit in United States v. Georgiou, 777 F.3d 125 (3d Cir. 2014).  The 3rd Circuit first misapplied the Supreme Court decision in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), by ruling that transactions that touched the United States in only the most ephemeral way were subject to extraterritorial jurisdiction.  See Third Circuit Adopts “Craven Watchdog” Standard for Extraterriorial Reach of Securities Laws in U.S. v. Georgiou.  Then, the court sunk a spear into the heart of Brady by ruling that the prosecutors’ intentional withholding from the defense of key exculpatory evidence was not a Brady violation because the defense lawyers could have figured out how to gain access to that information themselves.  See U.S. v. Georgiou: 3rd Circuit Panel Decision Makes a “Mockery” of Brady Disclosures and Jencks Act Compliance.  The Third Circuit opinion is available here: US v Georgiou.

It is well-documented that prosecutorial violations of the Brady rule – which is critically important to both actual and apparent fairness in criminal prosecutions – are common.  This is one of the shameful aspects of our current criminal justice system that most courts blithely ignore.  It is bad enough that non-compliance with Brady is rife; it is even worse that our courts not only conjure up reasons to allow prosecutors to get away with this, but also, like the Third Circuit in Georgiou, create new rules to provide non-compliant prosecutors with a safe harbor to avoid the appropriate consequences – reversal and retrial – for deciding not to comply with the core fairness principles Brady endorsed and imposed.

The cert. petition in Georgiou and three supporting amicus briefs show (i) the Brady rule is often circumvented by prosecutors, mostly with no consequences; (ii) that is what happened in the Georgiou prosecution; and (iii) the post-hoc absolution of prosecutorial misconduct by focusing on hypothetical defense failures to cure that violation is contrary to Supreme Court precedent, antithetical to Brady, and fosters a prosecutorial mindset that the risk of such due process violations is worth taking in order “win” a conviction.

The Georgiou cert. petition is available here: Cert. Petition in Georgiou v. US.  The three amicus briefs in support of that petition are available here: Georgiou v. US Amicus Brief of Former Prosecutors; Georgiou v. US Center on Administration of Criminal Law Amicus Brief; and Georgiou v. US Amicus Brief of California Attorneys for Criminal Justice.

The Georgiou cert. petition presents these key facts relating to the Brady issue:

The charges arose out of an alleged scheme to artificially inflate the prices of several stocks on the over-the-counter securities market. . . .  According to the indictment, Georgiou and his co-conspirators caused the stocks’ prices to rise by engaging in manipulative trading. . . .

. . . . The Government’s star witness was Kevin Waltzer, an alleged coconspirator.  Waltzer was the only witness who could provide what the Government described as “an insider[’]s view into this stock ring by one of its participants.” . . .  And during the trial, Waltzer testified directly to Georgiou’s mens rea, telling the jury that Georgiou “basically” admitted to him that Georgiou “kn[ew] that the public is going to get fleeced.” . . .

Following trial, Georgiou obtained critical material from Waltzer’s own criminal proceedings. Waltzer himself had been charged with wire fraud and other federal crimes. . . .  [M]ore than a year before the start of Georgiou’s trial . . . a [bail report] regarding whether Waltzer should be released on bail . . . stated that Waltzer had “been diagnosed in the past with Anxiety Disorder, Panic Disorder and Substance Abuse Disorder.” . . .  And it noted that he had been taking Paxil for the last ten years for his anxiety. . . .  Georgiou obtained a copy of this bail report for the first time after the end of his trial.

Georgiou also obtained, for the first time following his trial, a copy of the transcript of Waltzer’s arraignment and guilty plea hearing.  During that hearing, in the presence of an assistant U.S. attorney, Waltzer acknowledged “see[ing] a psychiatrist, psychologist or mental health provider * * * in connection with depression and anxiety.”

The Government had failed to disclose either the bail report or the plea transcript prior to Georgiou’s trial, even though Georgiou had requested “any and all evidence” that “a government witness or prospective government witness * * * is or was suffering from any mental disability or emotional disturbance.” . . .  Georgiou had also requested any “[i]nformation concerning Mr. Waltzer’s * * * current or past psychiatric treatment or counseling.”

Cert. petition at 4-8.

The petition also describes how the availability of that evidence would have permitted the defendant to learn that this key witness was an admitted drug addict, and that his medication had known side-effects of memory impairment.  Id. at 6-7 & notes 2-3.  The Third Circuit ruled that the prosecutors’ intentional withholding of this evidence about the state of mind of the Government’s star witness was not a Brady violation because with greater diligence, the defense could have obtained those materials themselves.  It also found they were not “material” evidence under Brady.

The Georgiou case struck a nerve among both defense lawyers and prosecutors.  This is reflected in the three amicus briefs filed in support of granting the writ of certiorari and reversing Georgiou. One was filed by the California Attorneys for Criminal Justice, one by the Center on the Administration of Criminal Law, and one by an unusual, large group of former federal prosecutors, Department of Justice, and other Government officials.  Those officials include: a former Attorney General and federal district judge, two former Acting Attorneys General, a former White House Counsel, four former Deputy Attorneys General, five former U.S. Attorneys, and an assortment of other former high-level federal criminal justice officials.

These three amicus briefs agree that the exception to the Brady rule adopted by the Third Circuit is wrong as a matter of law under Supreme Court precedent, and dangerous as a matter of policy because of its harmful effects on due process.  They also agree that the documented trend of prosecutors ignoring Brady will continue and worsen if the Supreme Court fails to step in to make it clear that the rule is not just a heuristic concept with no serious consequences if (actually, when) it is ignored, but is mandated by principles of fundamental fairness, due process, and the administration of justice, and must be enforced vigorously and without exception.

The impressive group of former DOJ leaders, prosecutors, and government officials wrote:

As the Supreme Court recognized in Brady v. Maryland, the failure to disclose favorable evidence “violates due process … irrespective of the good faith or bad faith of the prosecution.” 373 U.S. 83, 87 (1963); see also United States v. Nixon, 418 U.S. 683, 709 (1974) (“The very integrity of the judicial system and public confidence in the system depend on full disclosure of all the facts, within the framework of the rules of evidence.”).  While this affirmative duty is above and beyond the demands of the “pure adversary model,” United States v. Bagley, 473 U.S. 667, 675 n.6 (1985), it is grounded in an understanding of the prosecutor’s “‘special role … in the search for truth in criminal trial,’” Banks v. Dretke, 540 U.S. 668, 696 (2004).  From their years of combined experience, amici appreciate the challenging judgment calls prosecutors face on a daily basis, but they also deeply believe that fundamental fairness and public confidence in our justice system relies on prosecutors taking their disclosure obligations seriously and fulfilling this duty capaciously.

Amici do not believe that Supreme Court precedent recognizes an exception to the Brady rule for lack of diligence by the defense and are concerned that the decisions of several federal circuits, including the Third Circuit, have undermined Brady by shifting focus away from the prosecutor’s affirmative obligation to disclose. We submit this brief to emphasize that the introduction of an antecedent “due diligence” inquiry focused on the defendant is inconsistent not only with Supreme Court precedent but also principles codified in the codes of ethical conduct for prosecutors.

Petitioner George Georgiou’s case presents a straightforward question about the appropriateness of conditioning Brady disclosures on a defendant’s exercise of due diligence.  According to the government, Georgiou and his co-conspirators engaged in a scheme that inflated the prices of four securities through various trading strategies and then fraudulently used those manipulated securities as collateral to obtain large loans. . . .  The prosecution relied on the testimony of Kevin Waltzer, Georgiou’s former business partner and alleged co-conspirator. . . .  Waltzer’s testimony corroborated certain physical evidence collected by the government . . . and undergirded the government’s contention that Georgiou acted “wilfully” and had the “intent to defraud.”. . .

Recognizing the importance of Waltzer’s testimony, Georgiou made a pre-trial request that the government turn over any Brady information that would “reflect upon the credibility, ompetency, bias or motive of government witnesses,” including with respect to any mental health problems or substance abuse issues Waltzer might have had. . . .  The government provided limited information regarding Waltzer’s drug use responsive to this request. . . .

Yet the government had been aware from Waltzer’s own criminal proceedings that he had an extensive history of substance abuse and mental health problems, and possessed two pieces of evidence at issue on appeal that it failed to disclose: A Bail Report provided to the government a year before Georgiou’s trial by pretrial services . . . and the transcript of Waltzer’s arraignment and guilty plea hearing . . . .  Both documents contained specific information about the timeline of Waltzer’s mental health and substance abuse issues, as well as the medication and treatment he was receiving in the period leading up to his testimony.  This information might have informed Georgiou’s defense strategy and advanced his efforts to undermine Waltzer’s credibility. . . .

The Third Circuit affirmed the conviction. The court held that the evidence had not been suppressed because Georgiou failed to exercise “reasonable diligence” in seeking evidence of Waltzer’s mental health history. . . .  In particular, the court reasoned that the Bail Report and the Minutes, as public records, were equally available to Georgiou and the prosecution.  . . .

By adopting this circumscribed view of a prosecutor’s obligations under Brady, the Third Circuit has joined a growing list of courts departing in this way from Supreme Court precedent and the fundamental principles that undergird the Brady doctrine.  Where prosecutors are aware of this sort of information, they should disclose it to the defense, and their obligations to the truth-seeking process and principles of fairness are not discharged on the theory that the defendant could seek it out for himself.  Such an approach contributes to a harmful notion that the criminal justice system is a game, and that victory rather than justice is a prosecutor’s goal.

. . . . The Third Circuit has diminished this constitutional and ethical requirement by introducing a rule that excuses a prosecutor from fulfilling her obligation if the defendant could have but did not find the favorable evidence himself.  Rather than ask whether the prosecution has withheld from the defendant evidence that, “if made available, would tend to exculpate him or reduce the penalty,” Brady, 373 U.S. at 87-88, the Third Circuit asks whether the defendant could have obtained the evidence “from other sources by exercising reasonable diligence,” United States v. Perdomo, 929 F.2d 967, 973 (1991).  Such a rule is tantamount to saying that a “‘prosecutor may hide, defendant must seek,’” which this Court in Banks v. Dretke made clear “is not tenable in a system constitutionally bound to accord defendants due process.”  540 U.S. 668, 696 (2004) . . . .  It is also at odds with standards of prosecutorial conduct.

Brief of Former Prosecutors and Officials at 2-7.

The Center for the Administration of Criminal Law (CACL) provided similar views, and focused on the harmful impact of fashioning rules that allow departures from Brady obligations:

Prosecutors’ duty under Brady to disclose exculpatory evidence to defendants is a core component of prosecutors’ ethical duty to seek justice rather than victory.  Nonetheless, many prosecutors fail to live up to the obligations that Brady imposes on them.  Because of the public perception that prosecutorial misconduct is widespread, public confidence in prosecutors’ integrity and the overall fairness of the criminal justice system is in decline.

The Third Circuit’s recognition of a “due diligence” exception to Brady not only undermines defendants’ constitutional right to due process, but also fosters conditions likely to further erode public confidence in the system.  While a legal doctrine excusing Brady violations might appear to be an attractive option for prosecutors, in fact it harms both prosecutors and defendants.  It muddies an otherwise clear ethical obligation to disclose exculpatory information, which is central to prosecutors’ duty to seek justice.  It burdens prosecutors by requiring speculation about information available to their adversaries through due diligence – a determination that prosecutors are ill-equipped to make for myriad reasons.  By undermining defendants’ confidence in the information they receive from prosecutors, it discourages plea bargaining, which is essential to the efficient functioning of today’s criminal justice system.  By undercutting public confidence in prosecutors generally, it hampers their ability to obtain the cooperation of witnesses and the trust of jurors.  And ultimately, it undermines the public’s interest in ensuring that the guilty are convicted and the innocent exonerated, because those outcomes depend on a robust adversarial system in which both sides have actual knowledge of the material facts.

CACL Brief at 3-4.

The CACL brief also focused on the growing problem of non-compliance with Brady:

Unfortunately, Brady’s promise of full disclosure often has not been realized in practice.  In a recent frank opinion, Chief Judge Alex Kozinski of the U.S. Court of Appeals for the Ninth Circuit observed that “Brady violations have reached epidemic proportions in recent years, and the federal and state reporters bear testament to this unsettling trend.”  United States v. Olsen, 737 F.3d 625, 631 (9th Cir. 2013) (Kozinski, J., dissenting from denial of reh’g en banc) (collecting cases).  Some commentators are even more critical.

Empirical studies confirm that Chief Judge Kozinski’s statement was no exaggeration.  According to a study by the Veritas Initiative, prosecutors withheld or delayed disclosing favorable evidence in roughly one-third of the cases sampled.  [Citation omitted.]  Yet in 2001, “[a] nationwide study of all reported cases involving discipline for prosecutorial misconduct found only twenty-seven instances in which prosecutors were disciplined for unethical behavior that compromised the fairness of a trial.”  [Citations omitted.]  Recognizing a due diligence exception, and thereby increasing uncertainty about Brady’s scope, threatens to exacerbate these problems by suggesting judicial sanction for prosecutors’ noncompliance.

. . . .

Disclosing exculpatory evidence helps to “justify trust in the prosecutor,” and supplies legitimacy enabling the prosecutor to fulfill his or her mandate. . . .  By excusing failures to disclose Brady material that might be discovered through “reasonable diligence” . . ., the exception both weakens prosecutors’ disclosure obligations and reduces transparency.  In short, it undermines trust in prosecutors by minimizing their duty to disclose exculpatory evidence.

Id. at 6-7, 10.

The CACL brief goes on to discuss at length why presenting prosecutors with the option to game the Brady rule by speculating about what defense “due diligence” might reveal – thus negating their own obligation to reveal exculpatory evidence they know exists – undermines the rule, and places even good faith prosecutors in an untenable position to make decisions based on guesses or suppositions that they are ill-fitted to make.  Id. at 13-18.

The California Attorneys for Criminal Justice likewise argue that removing the uncertainty of the products of “due diligence” from the Brady disclosure equation is necessary to achieve Brady’s key fairness goals:

The “due diligence” exception adopted by the Third Circuit in this case, and by other circuits and state courts around the country, should be rejected because it undermines the animating principle of Brady and imposes on prosecutors and courts the unavoidably speculative analysis of whether a particular piece of evidence would be meaningfully “available” to a diligent defendant.  The exception also invites prosecutorial mischief, as complex rules that rest on speculative inquiries are far more vulnerable to mistakes, or abuse, than clear and simple commands.  The exception also imposes onerous and inefficient limitations on counsel to indigent defendants, who often do not have resources to conduct fulsome investigations.

. . . .

As Brady itself recognized, “[s]ociety wins not only when the guilty are convicted but when criminal trials are fair; our system of the administration of justice suffers when any accused is treated unfairly.”  373 U.S. at 87. . . .  The “due diligence” rule applied by the Third Circuit in this case undermines these goals. . . .  The due diligence exception has no place in the Brady analysis, and in fact operates only to undermine the promise of fair trials.  As applied by the Third Circuit and other courts, the exception affects the outcome of the Brady analysis only when the defendant has established the failure to disclose evidence that has a reasonable probability of affecting the outcome of a case.  That is, it preserves a conviction precisely, and only, when there is substantial doubt that the defendant was “convicted on the basis of all the evidence which exposes the truth.”

. . . .

The Third Circuit’s opinion in this case relied on the assumption that the undisclosed evidence “could have been accessed through his exercise of reasonable diligence.” . . .  Even if that assumption were warranted here, in many cases a prosecutor’s determination whether evidence is reasonably accessible to defendants will require speculation regarding both the availability of evidence and the resources available to the defendant and his counsel.  And more importantly, even when a defendant might have access to information via rumors or innuendo, a prosecutor might well have access to reliable, admissible documents with far more persuasive value.  Due Process cannot condone withholding admissible, exculpatory evidence on the grounds that a defendant, through the exercise of due diligence, could have had access to inadmissible hearsay.

. . . .

If speculation as to the fruitfulness of “pre-trial depositions and other discovery” is sufficient to establish the “availability” of evidence in an undisclosed police report, and is therefore sufficient to excuse a Brady violation, the result will be that Brady violations, including intentional suppression of exculpatory evidence, will be excused.  And on a practical level, such a rule invites a prosecutor to engage in the same speculation in seeking to determine whether to disclose plainly exculpatory evidence under Brady.  The question of “availability” of evidence therefore becomes yet another opportunity for subjective analysis by prosecutors creating a corresponding risk of error—or temptation into gamesmanship.

California Attorneys for Criminal Justice Brief at 3-5, 8, 10.

Ironically, the lack of equivalence the California Attorneys point to between actual exculpatory evidence known to prosecutors, and the hypothetical prospect that defense counsel might obtain access to some form of similar information in the exercise of so-called “due diligence,” is one that is often addressed under the securities laws — the same laws under which Mr. Georgiou was convicted.  Under the securities laws, however, the availability of material information through exercise of due diligence by investors does not relieve companies or company officials of duties they may have to disclose that same information.  That rule applies for good reason, because obtaining hard information from a reliable company source with a duty to disclose it is different from ferreting out what may be the same information by means that may lack the same provenance.  It is a bizarre world where the duties of corporate officers to disclose business information could be more onerous and inflexible than the duties of public prosecutors to maintain a fair criminal process.

The Georgiou case gives the Supreme Court an opportunity to stem the growing trend of Brady non-compliance, and the creation of exceptions to the Brady rule that ignore its core message and effectively impede its goals.  The fairness of criminal proceedings is not a discretionary concept to be toyed with by aggressive prosecutors or judges unwilling to put teeth behind core due process requirements.  The Georgiou cert. petition should be granted, and the Supreme Court should send a clear message to the lower courts that some concepts are sacred.

Among those concepts is the admonition in Berger v. United States, 295 U.S. 78, 88 (1935), that the federal prosecutor “is the representative not of an ordinary party to a controversy, but of a sovereignty … whose interest, therefore, in a criminal prosecution is not that it shall win a case, but that justice shall be done.”  The prosecutor’s duty is not to win, but to “ensure that a miscarriage of justice does not occur,” and that includes complying with Brady by disclosing “evidence favorable to the accused that, if suppressed, would deprive the defendant of a fair trial.”  United States v. Bagley, 473 U.S. 667, 675 (1985).  In Brady, the Court made it clear that it is in society’s broader interest “when criminal trials are fair,” and that “our system of the administration of justice suffers when any accused is treated unfairly.”  373 U.S. at 87.  A vague, unverifiable, and poorly-conceived “due diligence” exception to the Brady rule – which excuses even intentional prosecutorial efforts to prevent a fair trial — eviscerates that paramount need and requirement.

Straight Arrow

August 20, 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

July 9, 2015

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Briefing of ALJ Constitutionality Before SEC Leaves Resolution in Doubt

We discuss today the SEC’s pending consideration of a challenge to its administrative law process in In the Matter of Timbervest, LLC et al., File No. 3-15519.

Briefly, the case involved alleged violations of sections 206(1) and 206(2) of the Investment Advisors Act.  Timbervest is an Atlanta company that manages timber-related investments. The SEC alleged that in 2006 and 2007, company officers received unauthorized and undisclosed real estate commissions paid out of the pension plan assets of Timbervest’s largest client.  The SEC further alleges that in 2005-2006, Timbervest made an undisclosed and unauthorized sale of a timberland property from a fund holding that same client’s pension assets to another investment fund the firm managed.

The order instituting proceedings was issued in September 2013.  The administrative proceeding was tried before SEC Administrative Law Judge Cameron Elliot, who issued his Initial Decision in August 2014.  Mr. Elliot found for the Division of Enforcement in all respects except that he concluded two of the individual respondents lacked the scienter required for aiding and abetting the firm’s violations, and that the five-year statute of limitations in 28 U.S.C. § 2462 precluded the associational bars sought against the individuals and the revocation of Timbervest’s adviser’s license.  Both the respondents and the Division of Enforcement petitioned the SEC for review, and both petitions were granted.  In their ensuing filings, the respondents argued, among other things, that the administrative process was unconstitutional because SEC ALJs are executive officers who enjoy “two-tiered tenure protection,” although they dedicated only two paragraphs in their opening brief to this issue, and the Division of Enforcement responded with only one paragraph in its opposition brief.  In response, the Commission asked that the parties file supplemental briefs on that issue.

Those supplemental briefs have now been filed.  The Division of Enforcement’s supplemental brief is here, the respondents’ supplemental brief is here, and a supplemental notice of authority by the respondents is here.  The SEC recently scheduled oral argument on the case for June 8, 2015.  We know, of course, that the SEC is going to uphold the constitutionality of its own ALJs, so the result at this stage is not really in question.  But there will be an appeal to a court of appeals (either the D.C. Circuit or the Eleventh Circuit are possibilities), so it’s useful to see how convincingly the Division of Enforcement argued the constitutionality issue to the Commission.  By my measure, the arguments made are pretty weak, which still leaves to $64,000 Question: will a court of appeals or the Supreme Court really be willing to invalidate the SEC ALJ framework on the basis of this record?

The Division of Enforcement argued that “Commission administrative proceedings do not violate Article II of the Constitution” because “Commission ALJs are not constitutional officers – the only Court of Appeals to have considered the status of an agencys ALJs concluded they are employees, see Landry v. FDIC, 204 F.3d 1125, 1132-34 (D.C. Cir. 2002) – and therefore the removal framework applicable to them does not implicate Article II. And even if Commission ALJs were constitutional officers, the President exercises adequate control to satisfy the Constitution.”  Division Supplemental Br. at 1.

Let’s examine those arguments.

The Argument that “Commission ALJs Are Not Constitutional Officers”

The first argument – that the SEC ALJs are “employees” rather than “inferior officers” from a constitutional standpoint – seems particularly weak.  Perhaps if the SEC were writing on a blank slate this might be sustainable.  But it is not deciding this issue without controlling guidance.  There are a number of Supreme Court decisions out there that must be taken into account.  The Division’s brief does a poor job of addressing these binding precedents.

As we previously wrote (see Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit), the Supreme Court addressed similar issues in decisions in Freytag v. Commissioner, 501 U.S. 868 (1991), Weiss v. United States, 510 U.S. 163 (1994); Ryder v. United States, 515 U.S. 177 (1995); and Edmond v. United States, 520 U.S. 651 (1997).  Freytag ruled that special trial judges for the Tax Court were “inferior Officers” under the constitution, and not “employees” who assisted Tax Court judges in taking evidence and preparing a ruling – even though they lacked authority to render “final decisions” – because they exercised significant discretion in performing tasks like taking testimony, conducting trials, ruling on the admissibility of evidence, and deciding and ordering compliance with discovery orders.  Weiss noted that military judges were Officers of the United States because of their authority and responsibilities, but the issue was not contested by the parties.  Ryder ruled that that judges serving on the Coast Guard Court of Military Review were officers covered by the Appointments Clause, even though they were subject to review by a higher appellate court.  And Edmond explained that intermediate appellate military judges were not “principal officers,” because they were subordinate to a higher ranking officer below the President, were subject to oversight, and could not render final decisions, but plainly considered them to be “inferior officers.”

These cases negate many of the arguments made in the Division’s brief.  It mattered not that these other officials found to be executive officers were involved in a preliminary process; could not render final decisions; were subject to being reversed; served in an adjudicatory, rather than a “core executive” capacity; were subject to supervision by others; and even were “subordinate” to others.  All of the Division’s arguments that ALJs are “employees,” and not “executive officers” for those reasons simply cannot survive contrary Supreme Court precedent.

The invocation of the D.C. Circuit decision in Landry v. FDIC cannot change this.  In Landry, a split D.C. Circuit panel ruled that an FDIC ALJ was not an “inferior officer,” but was instead a mere “employee.”   The opinion questioned the usefulness of the Supreme Court’s guidance in Buckley v. Valeo, 424 U.S. 1, 126 n.162 (1976), that “any appointee exercising significant authority pursuant to the laws of the United States is an ‘Officer of the United States.’”  But the Buckley language was the starting point for the analysis of this issue in Freytag, in which the Court found dispositive the “significance of the duties and discretion that special trial judges possess.”  501 U.S. at 881.  The Landry majority argued that the critical difference between the special trial judges in the Tax Court and the FDIC ALJs was that FDIC ALJs only made “recommendations” to the FDIC, and thus could never issue final decisions.  Not only did that misread Freytag, which focused on the array of “significant” “duties and discretion” of the special trial judges, and not final decision-making powers, but it also ignored the discussions in Weiss, Ryder, and Edmonds, which made it plain that being a final decision-maker was not a decisive factor in determining whether someone is an “inferior officer.”

But even accepting the Landry majority opinion on its face, it provides little assistance to the Division because in some cases SEC ALJs do make “final decisions” like the special trial judges of the Tax Court.  The FDIC was required to review every ALJ “recommendation.”  But the SEC can, and does, decline to review ALJ decisions, and in those cases, it matters little to constitutional analysis that these decisions require a ministerial Commission order to make them formally “final” and appealable.  Moreover, the SEC does not, and cannot realistically, review an ALJ’s management and oversight of the administrative trial itself, during which many “final decisions” are made on important issues that determine the record the SEC can review.  And, of course, the approach taken by a court of appeals panel – and a split one at that – hardly trumps the guidance of the Supreme Court on how to go about determining whether a government official is an “inferior officer.”

The final nail in the coffin of the Division’s argument that the D.C. Circuit decided once and for all in Landry that ALJs are only agency “employees,” and not executive “officers,” is laid out in the Timbervest respondents’ brief.  They point out that the Government itself admitted this is not so.  To avoid a writ of certiorari in Landry, the Government represented to the Supreme Court that the Landry court did not decide that issue.  Here is what the Solicitor General said: “The court of appeals did not purport to establish any categorical rule that administrative law judges are employees rather than ‘inferior Officers.’ . . .” Timbervest Respondents’ Br. at 16 (quoting the U.S. Government brief in opposition to the petition for writ of certiorari).

The Division’s brief presents another argument that carries little water on the “inferior officer” versus “employee” issue: that Congress already decided that ALJs are just employees, not executive officers, by its “placement of the position within the competitive service system,” and the courts must defer to that decision by Congress.  That is wrong in two respects.  First, there is no indication that Congress made any such decision when it placed ALJs within the overall civil service system, and the Division cites no support for that contention.  Second, and far more importantly, it should be wrong that Congress has the power to decide when double-tenure protection can prevent the President from influencing government officials simply by designating those officials to be mere “employees.”  The whole point of the separation of powers doctrine is to assure that Congress may not deprive the President of his constitutional authority to execute the laws; it would be bizarre if Congress could grant executive powers to officials and then insulate them from the President’s influence by exercising Legislative muscle.  The best the Division could muster on this point was language in Justice Souter’s concurring opinion in Weiss suggesting “deference to the principal branches’ judgment is appropriate” (Divison Br. at 8, quoting 510 U.S. at 194), but that is a slim reed that cannot, I believe, be sustained without doing serious harm to the separation of powers concept.

Freytag and the other Supreme Court cases make it crystal clear that whether an executive official is an “inferior officer” depends on the “significance of the duties and discretion” that the official possesses, not a Congressional designation.  The Division simply cannot avoid the obvious similarity – and near congruence – of the “duties and discretion” of SEC ALJs in comparison to the special trial judges at issue in Freytag.  The Court, which was otherwise divided, unanimously viewed the special trial judges as “inferior officers” within the meaning of the Constitution based on their duties, discretion, and overall role in executive department proceedings, which showed that they exercised “significant authority pursuant to the laws of the United States.”  The SEC ALJs have, in reality, at least as great, and almost surely greater, authority and discretion in SEC administrative law enforcement proceedings, and no argument made by the Division in its brief shows otherwise.

The Argument that “Even if Commission ALJs Were Constitutional Officers, the President Exercises Adequate Control To Satisfy the Constitution”

The Division’s argument that the President has adequate control over SEC ALJs faces only one major obstacle: the Supreme Court’s decision in Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010).  There, the Court found that a double layer of “for cause” protection for executive officers from removal by the President was constitutionally unacceptable.  The Division’s task is to identify differences that justify allowing double “for cause” protection for SEC ALJs despite the Free Enterprise Fund decision.  The Division is assisted here by footnote 10 of the opinion, which said: “our holding does not address that subset of independent agency employees who serve as administrative law judges. . . .   And unlike members of the Board, many administrative law judges of course perform adjudicative rather than enforcement or policymaking functions.”  561 U.S. at 507 n.10.

As we saw above, the mere fact that the SEC ALJs “perform adjudicative . . . functions” is not enough under Supreme Court precedent to prevent them from being executive officers performing executive functions.  And on this front, it does not help the Division that the SEC ALJs plainly serve as key players in the SEC’s law enforcement function.

The Division makes the argument, correctly, that the separation of powers doctrine does not create a rigid, formal structure of Branches hermetically-sealed from one another.  The Supreme Court recognizes that there are gray areas, and in such cases it is appropriate to conduct a functional analysis of the extent to which a statutory framework truly impairs a Branch from performing its constitutional duties.  Perhaps the best example of that is the special prosecutor case, Morrison v. Olson, 487 U.S. 654 (1988), which adopted a multifactor test to determine whether the statute that limited Executive control over the special prosecutor was consistent with the separation of powers doctrine.  The Division appropriately quotes Morrison’s statement that interference with removal of the special prosecutor can be acceptable if it does not “interfere with the President’s exercise of the ‘executive power’” or the duty to “take care that the laws be faithfully executed.”  Division Br. at 14 (quoting 487 U.S. at 689-90).

The Division’s brief goes on to draw distinctions between the PCAOB and the SEC’s administrative law judges, mostly by focusing on the PCAOB’s broader role in policymaking, as well as arguing that the PCAOB exercises power more independently than the ALJs.  Whether these are distinctions of constitutional dimension is not apparent, however, since in the realm in which the ALJs function, they have a high degree of independent control over a key law enforcement function, and the constitutional importance of whether they do or do not make policy (as opposed to performing other executive functions) is by no means clear.  But the point is sufficiently made that the analogy between the PCAOB and the ALJs is not so close that it is, in and of itself, compelling (as compared to the analogy of ALJs to the special trial judges in Freytag, which is so close that it is compelling).

Having made a credible showing that the unconstitutionality of the SEC ALJs does not follow inexorably from the Free Enterprise Fund decision, the Division turned to the argument that double insulation of the ALJs from Presidential removal does not significantly impair the President’s executive powers.  The Division makes five arguments.  Four of them are less than compelling; one is downright embarrassing.

First, the Division argues that the Commission decides when the ALJs get to decide cases, and the Commission has only one layer of “for cause” removal protection.  That formalistic argument would seem to carry little weight as part of a functional analysis, however.  From a realistic, functional standpoint, the Commission does – and in reality must – utilize the ALJs to do its enforcement work because it could not handle the workload without them. Put another way, the creation of the ALJs allows the Commission to expand its enforcement activity exponentially, and fueling that expansion with executive officers who cannot be influenced by the President has a real, functional effect on the President’s ability to execute the laws.

Second, the Division argues that “the functions that the Commission has assigned to its ALJs are limited in scope and do not rise to the level of core executive authority.”  Division Br. at 18.  This argument is, in essence, that because ALJs only adjudicate cases, and do not “make policy,” their activities do not significantly impair the President’s execution of the laws.  As the Division says: SEC ALJ adjudications “involve the application of the law to a discrete set of facts in individual cases.”  Id.  I see two problems with this argument. One, it runs headlong into the Supreme Court decisions (discussed above) that either hold, or assume, that officials performing adjudicative roles within an executive function are important facets of the President’s duty to oversee the faithful execution of the laws.  Two, overseeing individual prosecutions, finding facts in those cases, weighing the importance and implications of those facts under the law, and determining whether there are violations, and what remedies should be imposed if there are, are arguably the essence of “core executive authority” because law enforcement prosecutions are a core executive function.

Third, the Division argues that the President can “exercise constitutionally adequate control” over ALJ decisions because “the Commission retains ultimate authority over administrative proceedings” and “exercises sufficient control over SEC ALJs regardless of the limittations placed upon their removal.”  Division Br. at 19.  This is essentially a rehash of earlier points, and runs into the reality, and the buzzsaw of prior Supreme Court decisions, that adjudicators do, in fact, make essentially non-reviewable discretionary decisions that control how a case is presented to the Commission.  They mold the record the Commission gets to review, and that power substantially impacts – or certainly can substantially impact – the Commission’s substantive review powers.

Fourth, the Division argues that the double-tenure protection accorded to SEC ALJs is less extreme than the protection provided to the PCAOB members.  Id.  This is largely a one-paragraph throw-away point, as the Division makes no effort to explain how the difference it argues has a functional impact on Presidential control.

Fifth, “the Executive Branch’s use of tenure-protected ALJs for nearly seventy years establishes a gloss on the Constitution that supports the current removal framework.” Division Br. at 20.  The Division would have been better off leaving this out.  The SEC cannot seriously find that the structure of its administrative enforcement process should be deemed constitutional simply because it has been around for a long time.  The argument is revealing, however, because it reflects what the SEC staff – and probably the SEC itself – really thinks.  They could have written the point more eloquently if they said what they meant (paraphrasing the famous line in Treasure of the Sierra Madre): “Constitutional authority?  We don’t need no stinking constitutional authority.”

[The actual line in the movie is: “Badges?  We ain’t got no badges.  We don’t need no badges.  I don’t have to show you any stinkin’ badges!”  And, as a diversion, enjoy this clip, this one from Blazing Saddles, and this montage.]

Humphrey Bogart in Treasure of the Sierra Madre

Humphrey Bogart in Treasure of the Sierra Madre

Alfonso Bedoya as

Alfonso Bedoya as “Gold Hat” in Treasure of the Sierra Madre — He don’t need no stinkin’ badges.

Seriously, though, the Division’s discussion of why the double-tenure protection of ALJs does not significantly impair the President’s ability to control SEC administrative law enforcement decisions is light on focused analysis of the nature of those law enforcement decisions, the respects in which the Chief Executive may have an interest in influencing those decisions, and the ways in which he can achieve those goals notwithstanding the double-tenure protection.  That is the kind of functional analysis called for by Morrison v. Olson, and the Division brief fails to address those key issues.

Based on reviewing these briefs, this continues to be a close call. The hydraulics are in the Division’s favor – certainly before the Commission, but also before an ultimate court of appeals, which will stretch mightily to avoid undercutting the SEC ALJ framework, and presumably other similar independent agency administrative enforcement frameworks (executive agencies, however, would not present the double-tenure protection issue).

Straight Arrow

May 6, 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.

Articles

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.

Proskauer:

….  [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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Law Professors Argue that Newman Panel Decision Enhances Market Integrity

Professors Stephen Bainbridge (UCLA Law School), M. Todd Henderson (Chicago Law School), and Jonathan Macey (Yale Law School) jointly filed an amicus brief in opposition to the DOJ’s petition for rehearing en banc of the panel decision in United States v. Newman. The sole point of the professors’ submission was to contest the contention of the DOJ and the SEC that the Newman decision threatened the integrity of the United States securities markets.  The professors argued that, to the contrary, the panel’s application of the “personal benefit” standard stated by the Supreme Court in Dirks v. SEC enhanced the integrity of the securities markets by reducing the “chilling effect” on lawful disclosures of a vague rule favoring government flexibility in determining when disclosures are unlawful.  The amicus brief is available here: Amicus Brief of Professors Bainbridge, Henderson and Macey in U.S. v. Newman.

As they summarized at the outset of the brief: “Far from endangering the integrity of the markets, the Newman opinion correctly applies the Supreme Court’s personal benefit test—a test founded in the Supreme Court’s explicit determination that the market must be protected from the chilling effects of standardless liability for insider trading.  The threat to market integrity comes not from Newman’s correct application of the personal benefit test, but from the government’s and the SEC’s campaign to make Dirks’s ‘personal benefit requirement . . . a nullity.’  Newman op. at 22.”  Professors’ Brief at 3.

The professors argued that the Supreme Court’s adoption of the “personal benefit” requirement in Dirks was specifically aimed at finding a way to differentiate between lawful and unlawful disclosures of nonpublic information in order to assure that lawful disclosures, which enhance marketplace efficiency and integrity, are not “chilled” by creating an uncertain prospect of liability for such disclosures under a less than clear standard.  The Dirks Court drew the line with the “personal benefit” standard: “The distinction between fraudulent disclosure, in breach of that duty, and permissible disclosure, turns on the purpose for which disclosure is made.  [Citing Dirks v. SEC, 463 U.S. 646, 662 (1983).]  The ‘personal benefit’ test is the litmus test used to gauge the underlying purpose that motivates the insider to disclose information.  Unless the insider ‘personally benefits’ from the disclosure, there is no breach of duty, and so no derivative liability if the recipient of the information trades.”  Professors’ Brief at 4.

The Dirks standard was founded on precedent and the language of the statute, but also “on an explicit policy determination to protect the market from the threat of prosecutorial over-reaching.”  Id.  The “SEC advocated for a far broader liability rule than the Supreme Court was willing to countenance.”  The Dirks Court rejected the SEC’s broader standard of illegality “on the explicit policy ground that the SEC’s rule would impair ‘the preservation of a healthy market.’”  Id., quoting Dirks, 463 U.S. at 658.  The Dirks court was explicitly protecting the ability of market analysts to “ferret out” information from insiders, which “enables more accurate pricing in capital markets and helps to assure that capital will ultimately be allocated to the highest value users.”  Professors’ Br. at 5-6, citing Dirks, 463 U.S. at 658-59.  Accordingly, “Broad prohibitions against trading based on material, non-public information—such as the SEC’s proposed interpretation of Section 10(b) in Dirks—ultimately damage the overall health of the market, because they limit the incentives of market participants to seek out information on which to trade.”  Id. at 6.

 The Professors note that the “personal benefit” test was the Supreme Court’s means of proving a “limiting principle” for investors and analysts using “objective criteria.”  Id. at 8.  In the professors’ view: “To effectively protect the socially beneficial activities of market participants operating under the eye of the SEC, requires definite and objective limits on the scope of insider trading liability.”  As the Dirks Court said, relying “on the reasonableness of the SEC’s litigation strategy” as the only assurance that activities will not be prosecuted “can be hazardous.”  Id. at 8, quoting Dirks, 463 U.S. at 664 n.24.

The professors argue that the Newman panel drew the right line.  “The Newman panel correctly recognize[ed] that the government would make ‘a nullity’ of the personal benefit rule.”  Professors’ Brief at 12.  “Newman protects the integrity of the market by placing a meaningful and objective limit on the scope of insider trading liability, allowing investors[,] analysts and insiders to function with reasonable certainty and security about whether their conduct violates the law.  In contrast, the government’s version of the personal benefit test fails to supply a standard to which market participants can reasonably conform their conduct.”  Id.

Straight Arrow

Feb. 26, 2015

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

On December 15, 2014, in a far-reaching opinion arguably extending well beyond what was required to decide the case, three of the five Commissioners of the SEC adopted extensive arguments for a broad reading of Rule 10b-5 and section 17(a) in the enforcement proceeding In re Flannery and Hopkins, File No. 3-14081.  A copy of the majority opinion can be read here: In re Flannery Majority Opinion.  Two Commissioners dissented, but no dissenting opinion was published as of December 18.

This is an extraordinary document.  It attempts to preempt judicial development of the scope of several aspects of the securities laws by interceding and applying “agency expertise” to interpret those laws and regulations extremely broadly.  On multiple occasions, these commissioners invoke the purported policy need to maintain as broad and malleable set of governing laws as possible to allow the Commission to address fraudulent conduct in whatever form it may appear.  The policy need to provide certainty to people about what their legal exposures are is not mentioned.

The opinion ranges far and wide in discussing the scope of SEC Rule 10b-5 and section 17(a).  It is difficult to summarize.  But essentially, these commissioners rule that Rule 10b-5(a) prohibits almost any form of participation in deceptive conduct relating to securities as long as a person participates in some form of deceptive act.  Although it does not say so outright, it represents an unveiled attempt to negate the Supreme Court decision in Janus Capital Group v. First Derivative Traders, 131 S. Ct. 2296 (2011).

There is much too much here to cover in a single blog piece.  The opinion will require multiple reads to understand the many ways in which the three commissioners use this relatively minor case to try to revise the law, essentially by fiat.  Some would say that taking such substantial steps to revise and expand the scope of a key regulation, and to interpret a key statutory provision, should occur only after a robust notice and comment process.  Instead, what we have is a questionable act of policy-making by a divided Commission with no public input.

The case had been tried to an administrative law judge, who ruled in the initial decision that Flannery and Hopkins did not violate section 17(a) of the Securities Act of 1933, section 10(b) of the Securities Exchange Act of 1934, or SEC Rule 10b-5.  The Commission majority ruled otherwise, finding both Flannery and Hopkins liable for violations of some provisions, but also rejecting the Division of Enforcement’s appeal in other respects.

The case involved communications by Flannery and Hopkins with investors about the Limited Duration Bond Fund of State Street Bank and Trust Co. (“LDBF”).  LDBF was heavily invested in asset-backed securities, including residential mortgage-backed securities (“RMBS”), and by 2006-2007, its holdings became increasingly concentrated in subprime RMBS.  The claim asserted that in various communications with investors, the respondents provided misleading information about the extent of subprime RMBS holdings and the risk profile of the fund.

The Commission majority used this case as a vehicle to present its position on the proper scope of liability under Rule 10b-5 and section 17(a) following the Supreme Court’s decision in Janus.  In that case, the Court held that SEC Rule 10b-5(b)’s prohibition against “mak[ing] any untrue statement of a material fact” created liability only for persons with “ultimate authority” over the alleged false statement.  People who assist in the preparation of such statements do not “make” them, and therefore are not liable under that language of the Rule.

Since Janus, the courts have hotly debated the scope of liability under other provisions of Rule 10b-5 that do not prohibit only “making” a misrepresentation.  Rule 10b-5(a) prohibits the use  of a “device, scheme, or artifice to defraud,” and Rule 10b-5(c) prohibits an “act, practice, or course of business which operates or would operate as a fraud or deceit,” each in connection with a purchase or sale of securities.  Following Janus, SEC enforcement lawyers often took the position that people not liable under Rule 10b-5(b) under the Janus ruling nevertheless had so-called “scheme liability” under subparts (a) and (c) of Rule 10b-5 because they either used a “device” or “scheme” to pursue a fraud, or used acts that “operated” as a fraud, even if they did not make misrepresentations.  These arguments often were resisted because they tended to “prove too much” by creating “primary” liability under Rule 10b-5 for people who did no more than “assist” fraudulent conduct by others.  That distinction is important because part of the rationale of the Janus Court was that the broad application of Rule 10b-5 to create primary liability for people who were essentially aiders and abettors conflicted with the Supreme Court’s decision in Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164 (1994), which held that Rule 10b–5’s private right of action did not include suits against aiders and abettors.  That case ruled that actions “against entities that contribute ‘substantial assistance’ to the making of a statement but do not actually make it” may be brought by the SEC, but not by private parties.  The Janus opinion noted:If persons or entities without control over the content of a statement could be considered primary violators who ‘made’ the statement, then aiders and abettors would be almost nonexistent.”  The Janus decision was plainly motivated in part by the importance of retaining a distinction between primary and secondary violators because the first are subject to private 10b-5 actions and the second are not under Central Bank.  This is reflected in the following passage in footnote 6: “[F]or Central Bank to have any meaning, there must be some distinction between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits).  We draw a clean line between the two—the maker is the person or entity with ultimate authority over a statement and others are not.”

The Commission majority in Flannery emasculates Janus with the simple view that the Janus Court was expressly addressing only Rule 10b-5(b), which includes the “making” language, but made no determinations about Rule 10b-5(a) or (c), which does not have the same language.  In an extraordinary act of administrative legerdemain, the three commissioners negate Janus by ruling first, that its analysis does not apply outside of Ryle 10b-5(b), and second, that Rule 10b5(a) is so broad that it covers everything covered in Rule 10b5(b) plus other forms of deceptive conduct in connection with the purchase or sale of securities that are excluded from Rule 10b-5(b).  With apologies for the length of the quoted material, here is some of what the three commissioners say about Rule 10b-5:

The Supreme Court’s recent decision in Janus Capital Group v. First Derivative Traders resolved some of the differences among the lower courts, as it clarified—and limited—the scope of liability under Rule 10b-5(b).  The decision was silent, however, as to Rule 10b-5(a) and (c) and Section 17(a), creating confusion in the lower courts as to whether its limitations apply to those provisions, as well.  Moreover, Janus’s narrowing of liability under Rule 10b-5(b) has shifted attention to Rule 10b-5(a) and (c), as well as Section 17(a), making the lower courts’ divergence of views on the scope of those provisions especially evident.  We appreciate the challenges lower courts have faced, and we recognize the ambiguity in Section 10(b), Rule 10b-5, and Section 17(a).  Further, we note that, to date, Commission opinions have provided relatively little interpretive guidance regarding the meaning and interrelationship of these provisions.  By setting out our interpretation of these provisions—which is informed by our experience and expertise in administering the securities laws—we intend to resolve the ambiguities in the meaning of Rule 10b-5 and Section 17(a) that have produced confusion in the courts and inconsistencies across jurisdictions. . . .

In Janus, the Supreme Court interpreted Rule 10b-5(b)’s prohibition against “mak[ing] any untrue statement of a material fact.”  After concluding that liability could extend only to those with “ultimate authority” over an alleged false statement, the Court held that an investment adviser who drafted misstatements that were later included in a separate mutual fund’s prospectus could not be held liable under Rule 10b-5(b).  The adviser could not be said to have “made” the misstatements, the Court reasoned. . . .

Unlike Rule 10b-5(b), Rule 10b-5(a) and (c) do not address only fraudulent misstatements.  Rule 10b-5(a) prohibits the use of “any device, scheme, or artifice to defraud,” while Rule 10b-5(c) prohibits “engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit.”  The very terms of the provisions “provide a broad linguistic frame within which a large number of practices may fit.”  We have explained that Rule 10b-5 is “designed to encompass the infinite variety of devices that are alien to the climate of fair dealing . . . that Congress sought to create and maintain.” . . .

 [W]e conclude that primary liability under Rule 10b-5(a) and (c) extends to one who (with scienter, and in connection with the purchase or sale of securities) employs any manipulative or deceptive device or engages in any manipulative or deceptive act. . . .   In particular, we conclude that primary liability under Rule 10b-5(a) and (c) also encompasses the “making” of a fraudulent misstatement to investors, as well as the drafting or devising of such a misstatement.  Such conduct, in our view, plainly constitutes employment of a deceptive “device” or “act.” . . .  We note that, contrary to what some district courts have suggested, Janus does not require a different result. In Janus, the Court construed only the term “make” in Rule 10b-5(b), which does not appear in subsections (a) and (c); the decision did not even mention, let alone construe, the broader text of those provisions. And the Court never suggested that because the “maker” of a false statement is primarily liable under subsection (b), he cannot also be liable under  subsections (a) and (c).  Nor did the Court indicate that a defendant’s failure to “make” a misstatement for purposes of subsection (b) precludes primary liability under the other provisions. . . .

The [Janus] Court began its analysis with a textual basis for its holding, concluding that one who merely “prepares” a statement necessarily is not its “maker,” just as a mere speechwriter lacks “ultimate authority” over the contents of a speech.  Our approach does not conflict with that logic: Accepting that a drafter is not primarily liable for “making” a misstatement under Rule 10b-5(b), our position is that the drafter would be primarily liable under subsections (a) and (c) for employing a deceptive “device” and engaging in a deceptive “act.”

 Our approach is also consistent with the Court’s second justification for its holding—that a drafter’s conduct is too remote to satisfy the element of reliance in private actions arising under Rule 10b-5.  Investors, the Court explained, cannot be said to have relied on “undisclosed act[s],” such as merely drafting a misstatement, that “preced[e] the decision of an independent entity to make a public statement.”  Again, our analysis fully comports with that logic.  Indeed, we do not suggest that the outcome in Janus itself might have been different if only the plaintiffs’ claims had arisen under Rule 10b-5(a) or (c).  As Janus recognizes, those plaintiffs may not have been able to show reliance on the drafters’ conduct, regardless of the subsection of Rule 10b-5 alleged to have been violated.  Thus, our interpretation would not expand the “narrow scope” the Supreme Court “give[s to] the implied private right of action.”  But to say that a claim will not succeed in every case is not to say that there is no claim at all.  In contrast to private parties, the Commission need not show reliance as an element of its claims.  Thus, even if Janus precludes private actions against those who commit “undisclosed” deceptive acts, it does not preclude Commission enforcement actions under Rule 10b-5(a) and (c) against those same individuals. . . .

Several courts have adopted [an] approach . . . effectively holding that any misstatement-related conduct is exclusively the province of subsection (b).  For multiple reasons, we disagree with those decisions. . . .  [W]e understand their approach to have arisen from a misunderstanding of the Supreme Court’s decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver.  In Central Bank, the Court explained that only defendants who themselves employ a manipulative or deceptive device or make a material misstatement may be primarily liable under Rule 10b-5; others are, at most, secondarily liable as aiders and abettors.  Lower courts appropriately read Central Bank to require that, in cases involving fraudulent misstatements, defendants could not be primarily liable under Rule 10b-5(a) or (c) merely for having “assisted” an alleged scheme to make a fraudulent misstatement.  But they then began to articulate this “more-than-mere-assistance” standard imprecisely, stating that primary liability under Rule 10b-5(a) and (c) must require proof of particular deceptive conduct “beyond” the alleged misstatements.  We cannot agree with this construction of our rule, particularly given how far removed it is from its origins in Central Bank.  And Central Bank itself certainly does not hold that primary liability under Rule 10b-5(a) and (c) turns on whether a defendant’s conduct is “beyond” a misstatement.  Moreover, we note that Janus also does not independently justify such a test.   As discussed, Janus does not address Rule 10b-5(a) or (c), let alone suggest that primary liability under those provisions is limited to deceptive acts “beyond” misstatements.  Indeed, reading Janus to require such an approach would be inconsistent with the decision’s own emphasis on adhering to the text of the rule.

Slip op. at 14-21.

No doubt about it, this is a slap in the face of the Supreme Court — an assertion that the Supreme Court should get its hands off of SEC regulatory matters and let the SEC decide what is and is not unlawful under the securities laws.  To be sure, Rule 10b-5 is an agency rule, not a statute, and the SEC should be able to interpret and apply its rules.  But Rule 10b-5 was adopted by the SEC in 1942 without anything approaching the consideration and parsing done by the three commissioners in Flannery.  It was originally approved without debate or comment, and it is reported that the full extent of consideration was Commissioner Sumner Pike’s comment: “Well, we are against fraud aren’t we?”  The creation of new agency positions on the meaning and scope of this rule without any rulemaking or public comment process, with the specific design to trump the Supreme Court, is risky business indeed.

The regulatory reason for biting off this issue remains less than clear.  Very little about what was said actually alters what the SEC can do in the way of enforcement actions.  That is because, as noted in the Central Bank decision, the SEC already has acknowledged enforcement authority to bring actions for secondary liability against aiders and abettors.  It doesn’t matter whether someone is sued by the SEC as an aider and abettor of a primary violation of Rule 10b-5(b) or a primary violator of Rule 10b5(a) (as the commissioners now hold can be done in many cases).  Either way, the SEC can pursue its enforcement goals.  The only material difference that would be caused by this new view of the scope of Rule 10b-5(a) and (c) is that it creates a new group of persons with primary liability who can be subjected to private securities actions.  Private securities plaintiffs have no cause of action against aiders and abettors, but they can sue primary violators using the implied section 10(b) private cause of action.  That difference was a significant aspect of the Central Bank decision, and was noted in the Janus decision as well.  Why are the SEC commissioners so keen on expanding the scope of liability in private actions?  We don’t know because that consideration wasn’t even mentioned in Flannery.

Much will be written about Flannery.  It certainly will go up on appeal, and if it stands there is a more than fair chance that the Supreme Court will consider it.  A majority of three commissioners is committed to providing the Commission and the Division of Enforcement maximum flexibility in attacking any conduct they choose to categorize as deceptive or fraudulent.  They believe the Nation should put its trust in the ability of SEC commissioners and enforcement lawyers and bureaucrats to decide what may and may not be done in the securities marketplace with as few restrictive parameters as possible.  Count me as dubious.

Straight Arrow

December 19, 2014

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