CLAYTON AND HINMAN GO ON THE RECORD URGING CORPORATE DISCLOSURES RELATED TO COVID-19

In a Public Statement issued by the SEC, Chairman Jay Clayton and Division of Corporate Finance Director William Hinman urged public companies to include corporate disclosures related to the effects of COVID-19 in their “quarterly earnings releases and analyst calls, as well as in subsequent communications to the marketplace.” The SEC requested that corporate disclosures address: “(1) where the company stands today, operationally and financially, (2) how the company’s COVID-19 response, including its efforts to protect the health and well-being of its workforce and its customers, is progressing, and (3) how its operations and financial condition may change as [ ] efforts to fight COVID-19 progress.” Suggested disclosures include, “[d]etailed discussions of current liquidity positions,” “expected financial resource needs,” “efforts to protect worker health and well-being and customer safety,” and “financial assistance received under the CARES Act or other similar COVID-19 related federal and state programs.”

The SEC acknowledged that “providing detailed information regarding future operating conditions and resource needs is challenging . . . but is important on many levels.” For investors, forward-looking COVID-19 disclosures foster more well-reasoned investment decisions. For the market more-generally, such disclosures “enhance valuable communication and coordination across our economy—Including between the public and private sectors." And for the greater fight against COVID-19, such disclosures increase confidence and understanding about particular business and industries which, in turn, “reduces risk aversion and facilitates action.” As an example of this third, “less familiar” policy consideration, the SEC explained, for example, that “if the owner of an industrial laundry business becomes comfortable that the hotel industry is soon to pursue a credible plan for increasing activity, the laundry business may be less likely to furlough (or may plan to rehire) employees.”

The SEC warned that even though “it may be tempting to resort to generic, or boilerplate, disclosures,” such disclosures “do little to inform investors.” Instead, the SEC urged companies to convey “meaningful information” that give investors “a level of insight that allows them to see the key operation and financial considerations and challenges the company faces through the eyes of management” even though such information will be “unavoidably based on a mix of assumptions, including assumptions regarding matters beyond the control of the company.”

Of course, companies are typically cautioned to limit the forward-looking disclosures—they are discouraged from making forward-looking financial estimates. Recognizing this, the SEC stated that companies should still try their best to make forward-looking disclosures related to COVID-19 and to “avail themselves of the safe-harbors” found in Section 27A of the Securities Act and Section 21E of the Exchange Act. In effect, companies should avoid making boilerplate COVID-19 disclosures, but should identify them as “forward-looking statement[s]” and couple them with customary “cautionary statements identifying factors that could cause actual results to differ materially from those in the forward-looking statement.”

The SEC concluded by assuring public companies that “[g]iven the uncertainty in our current business environment, we would not expect to second guess good faith attempts to provide investors and other market participants appropriately framed forward-looking information.” Nevertheless, the SEC continues to closely monitor markets for fraud relating to COVID-19, suspending trading of stock for companies making questionable claims. See, e.g., Predictive Tech. Group, Inc., SEC Order of Suspension of Trading, File No. 500-1 (April 21, 2020) (suspending trading “because of questions regarding . . . statements PRED made about being able to immediately distribute large quantities of serology tests to detect the presence of COVID-19 antibodies”). The best course remains for public companies to follow the SEC’s guidance in order to inform their investors, assure markets, assist in the nation-wide fight against COVID-19, and ultimately protect themselves from enforcement actions and shareholder litigation.

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GOING TO JAIL WITHOUT PASSING GO – SECOND CIRCUIT HOLDS “PERSONAL BENEFIT” NOT REQUIRED TO MAINTAIN TITLE 18 SECURITIES FRAUD CLAIM

On December 30, 2019, the Second Circuit issued its United States v. Blaszczak¹ opinion, eliminating a serious hurdle that might otherwise dissuade federal prosecutors from pursuing a Title 18 fraud claim against an alleged inside trader. The court determined that, unlike Title 15 securities fraud, federal wire fraud and Title 18 securities fraud claims do not require proof that the alleged insider received any personal benefit in exchange for the disclosure of non-public information.

In Blaszczak, federal prosecutors alleged that an employee of the Centers for Medicare & Medicaid Services (CMS) had been illegally disclosing information about reimbursement rate adjustments to a political consultant, who in turn, had been forwarding the information to a group of hedge fund managers, who were trading and profiting on the non-public information.

After the presentation of evidence, the district court instructed the jury that, in order to convict the defendants with Title 15 securities fraud, they would have to find the defendants received a “personal benefit” in exchange for the disclosure of non-public information. However, the court did not include the same “personal benefit” instruction in its Title 18 charge. After many days of deliberation, the jury acquitted each defendant on all counts alleging Title 15 securities fraud, but found the CMS employee guilty on one count of wire fraud, the political consultant guilty on two counts of wire fraud and two counts of Title 18 securities fraud, and the hedge fund managers guilty on one count of wire fraud and one count of Title 18 securities fraud.

On appeal to the Second Circuit, the appellants argued that pursuant to the Supreme Court’s Dirks v. SEC² opinion, the district court erred by not including the “personal benefit” instruction in its Title 18 question. The Second Circuit rejected appellants’ argument, reasoning that Title 15 and Title 18 were enacted for very different purposes. Title 15 (the statute at issue in Dirks) was enacted as part of the Securities and Exchange Act of 1934. While Title 18 was enacted as part of the Sarbanes-Oxley Act of 2002. And, despite both statutes prohibiting schemes to “defraud,” the meaning of the operative term was not shared.

According to the court, Title 15 was enacted for the limited purpose of eliminating insider trading for “personal advantage.” Whereas, Title 18 “was intended to provide prosecutors with a different and broader—enforcement mechanism to address securities fraud than what had been previously provided in the Title 15 fraud provision;” it was purposed to overcome the “technical legal requirements” that other fraud provisions created.

The court determined that because the statutes were enacted for two very different purposes and because the personal benefit test in Dirks was “judge-made doctrine” specifically premised on the limited purpose of Title 15, the personal benefit test should not apply to Title 18 securities fraud claims. Still, the court rejected appellants’ argument that the district court had opened a “backdoor” through which prosecutors could effectively pursue securities fraud claims that would otherwise require proof of a personal benefit. The court rejected this argument, stating that there will always be statutory overlap—where prosecutors can choose between multiple statutory causes of action for the same underlying conduct—but that such overlap is no reason to ignore legislative intent. According to the court, if the legislature believed they had inadvertently created a “backdoor,” it was up to them to intentionally close it.

The takeaway is simple. Whether or not the alleged disclosing party has secured any benefit by sharing non-public information, it could face criminal liability for its actions. Defense attorneys should be cognizant of Title 18’s requirements when assessing the chances of acquittal and make their clients aware of such risk.

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1 18-2811, 2019 WL 7289753 (2nd Cir. Dec. 30, 2019).^↩
2 463 U.S. 646, 662 (1983).^↩

2019 ENFORCEMENT PRIORITIES FOR THE FORT WORTH REGIONAL OFFICE

On February 25, 2019, Eric Werner and Marshall Gandy from the Fort Worth Regional Office of the Securities and Exchange Commission presented to the Dallas Bar Association’s Securities Section on the topic: “2019 Enforcement Priorities for the Fort Worth Regional Office.”

The presentation started and largely centered on the Regional Office’s ability to “do more with less.” Mr. Werner told the audience that in 2018 the Regional Office employed 30 enforcement agents, but currently only employs 20. He remarked that fewer agents will necessarily result in fewer enforcement actions, though the downturn would “not be significant.” Still, Mr. Werner assured the audience that they would not see any notable change in the type of actions pursued by the Commission. And, if any change were observed, it would simply be a function of the type of cases ripe for prosecution, not a realignment of priorities. Perhaps most striking, Mr. Werner suggested resources would need to be reallocated to relitigate cases effected by the Supreme Court’s Lucia decision. His comment hinted at the Commission’s interpretation of the Supreme Court’s stance on relief for respondents with non-pending cases that were previously decided by the Commission’s Administrative Law Judges.

Mr. Gandy commented on the Commission’s examination processes, paying particular attention to the Commission’s desire to engage registrants and empower them to self-police. He told the audience the Office of Compliance Inspections and Examinations does not measure success by how many cases are referred to the Division of Enforcement. He sought to dispel the idea that “if you call [OCIE], you will be examined,” stating, “nothing could be further from the truth.” Mr. Gandy also commented on registrants’ compliance programs and the OCIE’s willingness to help prepare adequate programs.

Both Messrs. Werner and Gandy emphasized the Commission’s focus on Main Street, individual accountability, and the proper allocation of resources. Their tone was cooperative.

SCOTUS POISED TO RESOLVE CIRCUIT SPLIT REGARDING SECTION 14(E) SCIENTER

On January 4, 2019, the U.S. Supreme Court agreed to hear an appeal of the Ninth Circuit Court of Appeal’s controversial decision in Varjabedian v. Emulex Corp., 888 F.3d 399, 401 (9th Cir. 2018), cert granted, 19-459, 2019 WL 98542 (U.S. Jan. 4, 2019). The outcome of the appeal turns on the Court’s interpretation of Section 14(e) of the Securities Exchange Act. The relevant language reads:

It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading.

15 U.S.C. § 78n(e). The Second, Third, Fifth, Six, and Eleventh Circuits have all determined that Section 14(e) requires proof of scienter—the defendant must be shown to have intended to omit or make an untrue statement of material fact to be held liable. The Ninth Circuit decision is the first to break with this trend.

Contrary to its sister courts, the Ninth Circuit determined that Section 14(e) differs from, and therefore should not be read together with, Exchange Act Rule 10b-5. The Ninth Circuit relied on the Supreme Court’s holding in Ernst & Ernst v. Hochfelder to reason that, despite identical language, Section 14(e) and Rule 10b-5 were promulgated at different times and for distinct purposes and therefore require differing proofs of mental culpability. Unlike Section 14(e)—enacted by statute—the Ninth Circuit recognized that Rule 10b-5 is an SEC Rule derived from the Commission’s powers under § 10(b), powers purposed to control “manipulative or deceptive device[s].” 15 U.S.C. § 78j(b). The court found Section 14(e) governing a “broader array of conduct” and therefore requiring less mental culpability. The Ninth Circuit reasoned that in order to interpret “statutes dealing with similar subjects . . . harmoniously,” Section 14(e) of the Exchange Act ought not require proof of scienter, just as the Supreme Court determined to be the case for the nearly identically worded Section 17(a)(2) of the Securities Act of 1933 in Aaron v. SEC. Finally, the Ninth Circuit concluded that Section 14(e) was never purposed to include a scienter requirement because it was passed as part of the Williams Act of 1968 and was accompanied by a Senate Report stating the purpose of the Williams Act was “to insure that public shareholders . . . will not be required to respond without adequate information,” suggesting “[an] emphasis on the quality of information . . . [not] on the state of mind harbored.” All eyes now turn to the Supreme Court to resolve the Circuit Court split.

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.