SUPREME COURT DETERMINES THAT SEC ALJS MUST BE APPOINTED BY THE COMMISSIONER

On June 21, the Supreme Court issued its opinion in Lucia v. S.E.C., reversing sanctions ordered by an Administrative Law Judge (“ALJ”) appointed by SEC staff and not the SEC Commissioner. ALJs are tasked with presiding over SEC enforcement proceedings, and the Court held that they must be appointed by the Commissioner and not staff because ALJs are “Officers of the United States” within the meaning of the Article II, Section 2, Clause 2 of the United States Constitution (“Appointments Clause”).

The SEC is authorized by statute to institute administrative proceedings against alleged wrongdoers, and the Commission itself is permitted to preside over the proceedings. 17 CFR § 201.110 (2017). The Commission is also authorized by statute to delegate administrative proceedings to ALJs and has done so. See 15 U.S.C. § 78d-1(a). ALJs possess significant powers over discovery, motion practice, the admissibility of evidence and testimony, and generally regulating the course of proceedings, including the ability to impose sanctions. 17 CFR §§ 201.111, 201.180, 200.14(a), 201.230. At the conclusion of administrative proceedings, ALJs issue an “initial decision,” setting out “findings and conclusions” about all “material issues of fact [and] law,” including an “appropriate order, sanction, relief, or denial thereof.” Id. at §§ 201.360(a)(1), 201.360(b), 201.360(d)(1). After the “initial decision,” the SEC can either review and modify the decision or, without review, “issue an order that the [ALJ’s] decision has become final.” Id. at § 201.360(d)(2).

In Lucia, the SEC initiated an administrative proceeding against Raymond Lucia, charging Lucia and his investment company with violating the Investment Advisers Act for misleading clients into investing an a retirement saving strategy called “Buckets of Money.” The SEC assigned the case to ALJ Cameron Elliot, who determined Lucia should be sanctioned, charged $300,000 in civil penalties, and banned from the investment industry for life.

The Appointments Clause states that all “Officers of the United States, whose Appointments are not herein otherwise provided for . . . [may be appointed by] the President alone, [by] the Courts of Law, or [by] the Heads of Departments.” Central to the Court’s decision was the characterization of ALJs as “officers” rather than mere “employees.” Lucia argued that Judge Elliot was an “Officer of the United States” and was not duly appointed by a “Head of Department,” namely, the SEC Commissioner. After the D.C. Circuit rejected his argument, he appealed to the Supreme Court to resolve the emerging circuit split. See Bandimere v. SEC, 844 F.3d 1168, 1179 (2016).

Justice Kagan spoke for the Court, penning an opinion that largely tracked the Court’s Appointments Clause jurisprudence. The Court commented that its opinion in Freytag v. Commissioner, 501 U.S. 868, 873 (1991), “says everything necessary to decide this case.” Freytag held that “special trial judges” (STJs) of the United States Tax Court were “Officers of the United States” after applying the “significant authority” test articulated in Buckley v. Valeo, 424 U.S. 1 (1976). See also United States v. Germaine, 99 U.S. 508 (1879).

Reviewing the facts, the Court determined that ALJs exercise “significant discretion” when carrying out “important functions” including “all of the authority needed to ensure fair and orderly adversarial hearings—indeed, nearly all the tools of federal trial judges.” The Court reversed the judgement of the Court of Appeals, ordered a new hearing before a “properly appointed” official, and determined that Judge Elliot could not hear the case because he could not be expected to consider the matter as though he had not adjudicated it before.

Interestingly, in footnote 6, the Court commented that while the present case was moving through the courts, the SEC issued an order “ratifying] the prior appointments of its ALJs.” The Court found “no reason to address that issue” because “[t]he SEC may decide to conduct Lucia’s rehearing itself” or “it may assign the hearing to an ALJ who has received a constitutional appointment independent of the ratification.” This leaves open the question of whether the SEC’s ratification was effective to retroactively protect rulings from constitutional attack or whether the ratification simply authorized ALJ proceedings moving forward.

THE TRUMP TRANSITION: CONSEQUENCES FOR SECURITIES AND FINANCIAL REGULATION

Federal—A Change in Course for Financial Regulation and the SEC?

President-elect Trump gave few specifics on how he would handle financial regulation and the SEC during his campaign. His comments regarding Dodd-Frank, including his promise to “dismantle” it, imply a new era of reduced regulation. But he also repeatedly criticized his opponent for being “owned” by big banks, and his website called for a “21st Century Glass-Steagall,” referring to the law that required separation between investment and commercial banking until its repeal in 1999. Trump’s choices during the transition, however, have now clarified his approach.

To lead the transition team’s efforts on financial regulation, Trump chose former SEC commissioner Paul Atkins. Atkins is a staunch libertarian, according to reporting by The Wall Street Journal, and he has long been critical of aggressive financial regulation.  Atkins’s role signals that the SEC will not likely follow the Labor Department’s footsteps in promulgating a tougher fiduciary duty rule. Atkins criticized the Labor Department rule, stating in a 2015 congressional hearing that the Labor Department “should go back to the drawing board.” Speculation is rampant about other potential changes, including scaling back corporate auditing requirements, shifting SEC focus from large corporate penalties to holding individuals accountable, and requiring whistleblowers to first report to their companies (for which Atkins advocated in 2011).

Answering those questions during his confirmation hearing is Trump’s selection to chair the SEC: corporate attorney Jay Clayton. Clayton is a partner with Sullivan & Cromwell in New York focusing on M&A and capital raising, along with representing clients in regulatory and enforcement actions. Commentators view this pick as signaling a shift in focus away from enforcement to other SEC goals. Critics note Clayton has spent years as a “Wall Street insider,” but outgoing Chair Mary Jo Wright praised Clayton as “very smart, very thoughtful, very knowledgeable of the markets and the securities laws and I think a terrific person.” Regardless, the general trend appears to be friendlier to Wall Street. Anthony Scaramucci, a hedge fund manager advising the transition team, said the new head of the SEC needed to “get back to reffing the game properly and end the demonization of Wall Street.”

Finally, the Director of the Consumer Financial Protection Bureau (created by Dodd-Frank), Richard Cordray, may be forced to step down under Trump, despite language in Dodd-Frank preventing the CFPB director’s removal except for cause. The statute creating the CFPB prohibits removal of the director of the agency except for cause during his five-year term, which would insulate the director from political change. In October, however, the D.C. Circuit Court of Appeals held that structure unconstitutional because it gave too much power and autonomy to the sole director. The Obama administration is appealing that ruling, but some legal scholars believe Trump can simply withdraw the appeal after his inauguration, leaving the D.C. Circuit’s ruling intact and allowing Trump to immediately remove Cordray. Trump certainly seems open to firing Cordray, as he met with Representative Randy Neugebauer from Texas, a strong CFBP critic, about possibly replacing Cordray.

State—Regulators Fear Federal Preemption of Enforcement

Paul Atkins has also allegedly been discussing “ways to ensure that federal securities laws preempt state [Blue Sky] laws” such as the New York Martin Act, as reported by Fox Business. This news, along with Trump’s comments regarding Dodd-Frank, has prompted state regulators to push back and assert their authority. “You need a national regulator; and if they can’t, the states need to do the job and should,” said William Galvin, secretary of the commonwealth of Massachusetts. “It sounds like we’re going to be under the same type of problems there were prior to the Great Recession, with securities and financial services being ‘lightly regulated,’” Galvin explained. “I think that’s a problem.”

Other state regulators have echoed Galvin’s sentiments. Mike Rothman, Minnesota’s commerce commissioner and president of the North American Securities Administrators Association, commented: “Any attempt to weaken the investor protections provided by state ‘Blue Sky’ laws would erode investor confidence and remove a vital first line of defense for all investors working to provide a secure future for themselves and their children.” And New York Attorney General Eric Schneiderman warned that “any attempt to gut these consumer and investor protections would severely undercut state police powers and only embolden those who seek to defraud and exploit everyday Americans.” “At a time of regulatory uncertainty at the federal level, it is essential that we maintain the very laws that have helped state and local law enforcement keep consumers and investors safe for over one hundred years,” he said. Schneiderman’s office recently reached a $25 million settlement agreement in New York’s case against Trump University for violation of state education laws, among other things.

REGISTER AND DISCLOSE: LESSONS FROM SEC COMPLAINT AGAINST TEXAS AG KEN PAXTON

Texas Attorney General Ken Paxton became the object of an SEC civil complaint this past week. While it is early in the process and the facts are far from certain, the complaint against Paxton is a reminder to anyone soliciting investments: being paid a commission means you almost always must be registered as a broker and you must disclose your compensation to potential investors. If the alleged facts are true, Paxton may learn these lessons the hard way.

TIPPING FOR NOTHING: SUPREME COURT TO TACKLE INSIDER TRADING SPLIT OVER TIPPEE LIABILITY

Last week, the Supreme Court agreed to hear United States v. Salman to resolve a split over insider trading liability. Because “[a]ll disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders,” a tipper must receive a “personal benefit” for the tip to violate securities laws. Dirks v. S.E.C., 463 U.S. 646, 661-62 (1983). But what kind of personal benefit, and can it be inferred? Circuit courts are split, and the Supreme Court is about to weigh in.

ONCE INSOLVENT, ALWAYS INSOLVENT? CLARIFYING THE CURIOUS CASE OF DERIVATIVE CREDITORS

Quadrant Structured Prods. Co., LTD. v. Vertin, 115 A.3d 525 (Del. Ch. 2015)

Did you know as an officer or director of a Delaware corporation you may owe fiduciary duties to creditors and not just shareholders? If your company is insolvent, you do. But directly or derivatively? What duties? And what if your company later becomes solvent? The Court of Chancery decision Quadrant Structured Products Company, LTD. v. Vertin from earlier this year went a long way to clarifying this area of the law.

The answer: A creditor has standing to sue officers and directors derivatively for breaches of the duties of loyalty and care to a company insolvent at the time the creditor filed suit, without having to show the company was irretrievably insolvent and regardless of whether a company later returns to solvency. It is thus possible for both creditors and shareholders to simultaneously pursue derivative claims against officers and directors of an insolvent company that later regains solvency.

DON’T TELL ANYONE! (EXCEPT THE SEC)

Lance Currie

Companies should review their employee confidentiality agreements and investigation procedures to avoid running afoul of the SEC’s ever-watchful eye, according to a new enforcement action announced today. The order entered in In re: KBR, Inc. resolved the first case against a company for using a confidentiality agreement to potentially silence whistleblowers in violation of Dodd-Frank. Rule 21F-17, enacted under the Dodd-Frank Act, prohibits actions impeding whistleblowers from communicating with the SEC about potential securities law violations. In internal investigations, Houston-based KBR, Inc. asked interviewed employees to sign a confidentiality statement prohibiting them from discussing the interview with anyone without prior authorization by KBR’s legal department, or face company discipline that could include termination. KBR had used this statement prior to the enactment of Dodd-Frank, but continued using it after Rule 21F-17 was enacted. Continued use of the statement violated Rule 21F-17, according to the SEC, and KBR was required to pay a $130,000 penalty, change its confidentiality statement, and inform prior interviewees that they could contact federal enforcement agencies without company retaliation.

Within the order is the following language that KBR agreed to include, which is useful guidance on how companies should amend similar confidentiality statements and procedures:

Nothing in this Confidentiality Statement prohibits me from reporting possible violations of federal law or regulation to any governmental agency or entity, including but not limited to the Department of Justice, the Securities and Exchange Commission, the Congress, and any agency Inspector General, or making other disclosures that are protected under the whistleblower provisions of federal law or regulation. I do not need the prior authorization of the Law Department to make any such reports or disclosures and I am not required to notify the company that I have made such reports or disclosures.

The order and SEC press release can be found here.

AN UNCERTAIN BASIS: SUPREME COURT CLARIFIES LIABILITY FOR OMITTED BASES OF OPINION IN REGISTRATION STATEMENTS

Lance Currie

It’s not what you say. It’s what you don’t say. At least, according to the Supreme Court’s opinion issued today in Omnicare, Inc. v. Laborers District Council  Construction Industry Pension Fund, 575 U.S. --- (U.S. 2015), which clarifies potential liability under the Securities Act of 1933 for directors’ opinions stated in their companies’ public filings. Directors may be liable under § 11 of the Act for their opinions “if a registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion . . . if those facts conflict with what a reasonable investor would take from the statement itself.” Id. at 12. Said another way, liability for a director’s opinions under § 11 hinges not on whether the director honestly held the opinions but on a whether omitted facts cannot be squared with an reasonable investor’s “fair reading.” See id. at 14. Focusing on a statement from the perspective of its recipient, rather than its speaker, creates an objective measure for liability based on directors’ stated opinions.

The majority opinion in Omnicare, written by Justice Kagan, clarifies what § 11 of the Act means when a purchaser can sue for damages because a document “contain[s] an untrue statement of a material fact” or “omit[s] to state a material fact . . . necessary to make the statements therein not misleading.” Id. at 1 (quoting 15. U.S.C. § 77k(a)). The plaintiff pension fund alleged that the directors’ opinion in Omnicare’s registration statement that they believed the company’s contracts complied with federal and state law was false and misleading after the government later sued Omnicare for violating anti-kickback laws. The majority first noted that under § 11 an investor need not prove that the defendant acted with any intent to deceive or defraud. Id. at 2. Addressing the first provision—“untrue statement[s] of a material fact”—Justice Kagan explained that liability would only follow if the speaker did not hold the belief he professed or if a supporting fact he supplied were untrue. Id. at 9. The plaintiff did not contest that the opinions were honestly held. And because the statements at issue did not include support, they were pure statements of opinion not containing “untrue statement[s] of a material fact.” See id. at 9.

But the majority did find that the opinion on legal compliance could have omitted material facts necessary to make it not misleading. The majority explained that the question of whether a statement is misleading because of omitted facts is objective. The majority explained that “a reasonable investor may, depending on the circumstances, understand an opinion statement to convey facts about how the speaker has formed the opinion—[i.e.,] . . .the speaker’s basis for holding that view.” Id. at 11. If registration statements omit key facts about the issuer’s inquiry into or knowledge prior to an opinion and those facts conflict with what a reasonable investor would take from the stated opinion, then § 11 creates liability. Id. at 12. The majority tried to limit its holding by explaining that investors read statements in the context of surrounding text, disclaimers, industry custom and practice, etc. and that omitted statements only create liability when they cannot be squared with a “fair reading.” Id. at 13.  To meet this new standard, investors must “identify particular (and material) facts going to the basis of 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.” Id. at 18. Conclusory assertions of a lack of basis or failure to include a material fact, without more, are insufficient. Id. Because neither lower court applied the correct standard, the Supreme Court remanded. See id. at 20.

Directors must be careful when stating opinions in registration statements. To avoid liability, directors need to consider explaining the process for arriving at the opinion, outlining the facts supporting the opinion, or clearly articulating the tentativeness of the opinion. It is also unclear how Omnicare will impact claims brought under SEC Rule 10b-5 (based on § 10(b) of the Securities Exchange Act of 1934). Rule 10b-5 makes unlawful the making of “any untrue statement of a material fact” or omission of “a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading”—language identical to § 11 of the Securities Act. But 10b-5 claims require proof of scienter—i.e., intent to “deceive, manipulate, or defraud.” Thus despite the identical language between 10b-5 and § 11, the impact of Omnicare on 10b-5 claims (or other securities law claims) is not yet known.