Important Cases in the Federal Courts

TEXAS DISTRICT COURT UPHOLDS DEPARTMENT OF LABOR (DOL) RULE CLARIFYING ABILITY OF FIDUCIARIES TO CONSIDER ESG FACTORS IN INVESTMENT DECISIONS – State of Utah, et al. v. Walsh, No. 2:23-CV-016-Z (Sept. 21, 2023) (N.D. Tex.) – Federal court appropriately defers to the DOL’s judgment under Chevron and easily dismisses “major questions” doctrine assault on the rule; industry appeals to Fifth Circuit Court of Appeals. 

The Issue. In 2022, the DOL issued what is known as the “2022 Investment Duties Rule” (Rule).  It clarified the duties of fiduciaries when selecting investments for retirement plans under the Employee Retirement Income Security Act (ERISA). Specifically, the new Rule made changes to a prior Trump-era 2020 rule that created confusion and had a chilling effect on the ability of retirement plan fiduciaries to consider environmental, social, and governance (ESG) factors in making their decisions about which investments to select for plans. The Rule made clear that the risk and return factors that plan advisers must always consider may include the ESG factors, depending on the facts and circumstances.

In January 2023, a group of 26 Republican state attorneys general brought a challenge to the Rule, alleging that it violated the statutory requirements of ERISA and was arbitrary and capricious in violation of the Administrative Procedures Act (APA).

The Decision. In a decision issued on September 21, 2023, Trump-appointed Judge Matthew Kacsmaryk rightly rejected the plaintiff’s arguments on both fronts, granting the DOL’s cross-motion for summary judgment and upholding the Rule.

With respect to the plaintiff’s statutory arguments under ERISA, the court applied the two-step analysis of the Chevron doctrine.  It first held that Congress had not directly spoken to the issue presented.  It then held that the DOL’s interpretation of the law embodied in the Rule was reasonable and indeed consistent with the DOL’s long held position. According to Judge Kacsmaryk, “[t]he 2022 Rule changes little in substance from the 2020 Rule and other rulemakings.” He further explained that “[f]or nearly three decades,” DOL has maintained the position that ERISA does not forbid fiduciaries from considering non-financial ESG factors in their investment decisions, so long as “the selection of competing investments . . . serve the plan’s economic interests equally.”  Given this consistent regulatory history, the judge also summarily dispensed with the challengers’ contention, based on the major questions doctrine, that the DOL had asserted an authority of such extraordinary “history and breadth” that more clear Congressional authority was necessary.

Judge Kacsmaryk also rejected a large assortment of arguments that the Rule violated the Administrative Procedure Act.  He began by articulating the governing principles of judicial review:  The scope of the review is narrow, the court is not to substitute its judgment for that of the agency, and agencies have expertise in administering their statutes “that no court can properly ignore.” Based on these principles and others, the Court readily rejected all of the challengers claims about specific flaws in the Rule.  And the judge reflected an appropriately objective application of the law when he wrote that “while the Court is not unsympathetic to plaintiffs’ concerns over ESG investing trends, it need not condone ESG investing generally or ultimately agree with the Rule to reach this conclusion.”

Why It Matters. This case is important for at least three reasons.  First, it upholds an important rule that provides helpful clarity to ERISA fiduciaries facing increasing investor interest in ESG investments.  The Rule removes impediments to the consideration of the ESG factors.  At the same time, it preserves the overriding focus in ERISA on the financial risks and returns that investments offer.  And it clarified the tiebreaker scenario in which fiduciaries may rely on the ESG factors in making a final selection between two options that “equally serve” the financial interests of the plan.

Second, the case is a reminder that litigation outcomes are unpredictable, even in courts such as the Fifth Circuit that many regard—with good reason—as ideologically slanted against regulation.  The upshot is that the agencies must continue to fashion the most effective rules they believe are necessary to fulfill their statutory mandates and protect the public interest, regardless of the litigation threats they face.

Finally, this case illustrates the importance of the principles that guide judicial review of agency rules, particularly the Chevron doctrine.  Here, the Court’s deference to the DOL’s expertise and judgment was an important factor in leading the Court to uphold the Rule, notwithstanding the judge’s own avowed reservations surrounding the ESG investment movement.  That’s why the fate of the Chevron doctrine is so important, as we explain in our recent report on the Supreme Court.

On October 26, 2023, the Republican Attorneys General plaintiffs appealed the district court ruling to the Fifth Circuit Court of Appeals. We will continue to monitor the case as it progresses.

PUNISHING SECURITIES LAWBREAKERS: SUPREME COURT TO REVIEW CONSTITUTIONALITY OF THE SEC’S ADMINISTRATIVE ENFORCEMENT PROCESS – Jarkesy v. SEC, No. 22-991 (June 30, 2023), Jarkesy v. SEC, 34 F.4th 446 (5th Cir., May 18, 2022) – The U.S. Supreme Court agrees to reconsider a split-panel decision resurrecting New Deal-era attacks on administrative enforcement.

The Issue. In 2013, the SEC began pursuing George Jarkesy for misrepresentations to investors in two hedge funds. The agency sought fines and other penalties against him before an Administrative Law Judge, known as an “ALJ.” In his defense, Jarkesy attacked the constitutionality of the ALJ forum, advancing his arguments in a U.S. District Court, at the D.C. Circuit, and even at the SEC itself. All of his challenges were rejected.  His case finally ended with a cease-and-desist order and an order imposing $300,000 in civil penalties, requiring him to disgorge unlawful profits, and barring him from a variety of investment activities. He then pursued one final appeal before a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit.

Unfortunately, two of those judges took up his constitutional assault in a May opinion. The majority held first that ALJ adjudication of securities fraud claims violated the Seventh Amendment right to a jury trial, largely because the SEC sought fines.  Second, it held that Congress, through the Dodd-Frank Act, had unlawfully given the SEC the “legislative” power to choose between seeking civil penalties before an ALJ or in federal court, applying a concept known as the “non-delegation doctrine” widely thought to have died out after the 1930s. And for good measure, the majority found that SEC ALJs had too much protection from presidential removal thanks in part to the Merit Systems Protection Board; in the court’s view, this meant ALJs had too little accountability to the President, supposedly interfering with his ability to carry out the law. The third judge on the panel dissented with each of those holdings.

The SEC’s Petition.  In July, the SEC petitioned for rehearing en banc, asking the full set of Fifth Circuit judges to vacate the majority decision and re-decide the case. The court requested a response to that petition from Jarkesy, a rare step that suggests at least some judges favored rehearing the case. Unfortunately, in a brief order issued on October 19, 2022, the judges denied the petition based on a vote of 10 against rehearing and 6 in favor.  On April 10, 2023, the SEC filed a Petition for a writ of certiorari before the United States Supreme Court, asking the Court to review the Fifth Circuit’s decision. Briefs from both parties were filed in May and the case was distributed for conference in late June. On June 30, 2023, the Supreme Court granted the cert petition and slated the case for review during its upcoming October term.

Why It Matters. It is hard to imagine a more fundamental assault on administrative enforcement, and not just under the federal securities laws. The two-judge majority from the Fifth Circuit departed from precedents holding that when the government seeks to enforce statutory public rights, the Seventh Amendment does not preclude the case from being heard before an administrative tribunal without a jury. Worse still, the majority tried to breathe life into the non-delegation doctrine. Though long-defunct, the doctrine seems to appeal to some members of the Supreme Court, something unlikely to have escaped the attention of the panel. A revival of that doctrine might be used to challenge any number of rules or other agency actions, not just the SEC’s administrative enforcement methods. The third and final holding suggests that basic civil service protections might later be seen in other cases as constitutionally suspect.  We will continue to closely monitor the case.

SUPREME COURT TO DECIDE CONSTITUTIONALITY OF CFPB’S FUNDING STRUCTURE, WITH IMPLICATIONS FOR THE FEDERAL RESERVE AND OTHER SIMILARLY-FUNDED AGENCIES – Consumer Financial Protection Bureau v. Community Financial Services Association of America, No. 22-448 (Nov. 14, 2022) – Latest assault on the CFPB now before the Supreme Court takes aim at the agency’s funding mechanism, which the Fifth Circuit declared unlawful under the Appropriations Clause of the U.S. Constitution.

The Issue. When Congress created the CFPB in the wake of the Great Recession, it knew the importance of ensuring that the agency was free from regulatory capture and undue political influence. By granting the agency an independent funding structure sourced from the Federal Reserve System, Congress sought to insulate the CFPB from potential budgetary constraints or partisan pressures that could compromise its ability to protect consumers. Thus, Congress set forth in the agency’s authorizing statute that the CFPB was to receive a portion of the Federal Reserve’s annual funding, rather than go through the traditional annual congressional appropriations process. With this independent funding structure, the CFPB joined several other banking regulators, including the Federal Reserve, who share similar autonomous funding structures.

Nonetheless, Community Financial Services Association of America argued in CFPB v. CFSA that this funding mechanism violates the U.S. Constitution’s Appropriations clause, which states that “No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law.” However, the CFPB contends that although it does not undergo annual congressional budget process, its funds are unambiguously distributed to the agency “in Consequence of Appropriations made by Law,” namely the Dodd-Frank Act.

The Decision. Although this legal theory has been rejected many times in the courts in the past, the Fifth Circuit ruled in favor of CFSA, erroneously holding that the Bureau’s funding structure violates the Appropriations Clause. Prior to this ruling, never before has any court held that a law passed by Congress to fund a federal agency is not a proper ‘appropriation’ under the Appropriations Clause. The Fifth Circuit’s decision has been widely criticized because the court ignored the plain language of the Constitution, ample precedent, and Congress’s long-established use of similar funding mechanisms for a host of other agencies, including the Fed and other banking regulators.

In November 2022, the CFPB filed a cert petition in the U.S. Supreme Court asking the Court to review and reverse the lower court decision. In February 2023, the Supreme Court granted cert. to review the case in the upcoming term. And in May 2023, Better Markets joined an amicus curiae brief with the Lawyers’ Committee for Civil Rights Under Law and other prominent civil rights organizations urging the Supreme Court to uphold the constitutionality of the CFPB.

Why It Matters. The Fifth Circuit’s radical and unprecedented decision in CFPB v. CFSA, if confirmed, would undermine the critical work carried out by the CFPB in protecting consumers and enforcing regulations against unfair and deceptive practices by banks and other predatory lenders. Sidelining the CFPB entirely or undermining its independence will sharply curtail if not eliminate protections for millions of Americans, harming all consumers but especially communities of color that are targeted by unscrupulous actors.  An adverse ruling would also jeopardize numerous other financial regulators with similar funding structures, including the Federal Reserve, posing a clear risk to the stability of financial markets. The Supreme Court is scheduled to hear oral argument in the case on Tuesday, October 3rd.

NINTH CIRCUIT CLOSES THE COURTHOUSE DOORS TO WRONGED INVESTORS, JEAPORDIZING THE RIGHT OF SHAREHOLDERS TO HOLD COMPANIES ACCOUNTABLE – Lee v. Fisher, No. 21-15923, 2023 WL 3749317 (3:20-cv-06163-SK) (9th Cir., June 1, 2023) (en banc); Lee v. Fisher, 34 F.4th 777 (9th Cir., May 13, 2022) – An en banc panel of the Ninth Circuit green lights the use of corporate bylaws to extinguish securities suits seeking recovery for fraud.

The Issue. Can a company use its bylaws to cancel or nullify federal securities laws, including those designed to hold companies accountable for misconduct that hurts shareholders?  That was the issue decided by an en banc panel of the U.S. Court of Appeals for the Ninth Circuit in the important case of Lee v. Fisher, which issued its opinion on June 1, 2023. The Gap, Inc., a well-known clothing retailer incorporated in Delaware, amended its corporate bylaws to require that certain shareholder lawsuits against the company (known as “derivative” suits) must be brought in a Delaware state court specializing in business litigation—and only in that court.  The plaintiff, Lee, sued Gap for federal securities violations under the Securities Exchange Act. She claimed that The Gap had misrepresented the company’s commitment to diversity in its proxy statements.  Under the Exchange Act, these types of legal claims can only be brought in a federal court, so Lee filed her suit in a federal district court.

The district court dismissed the case based on the view that, under Gap’s bylaws, Lee was required to file her claim in Delaware state court—even though the Delaware court would be bound by the Exchange Act to dismiss her claim for a federal securities law violation.  That left the plaintiff with no forum at all in which to bring her federal securities law claims.  A three-judge panel of the U.S. Court of Appeals for the Ninth Circuit affirmed the district court’s dismissal, and it did so fully acknowledging that another panel from the Seventh Circuit had reached the opposite conclusion.  In late October, a majority of the full roster of Ninth Circuit judges voted to vacate the three-judge decision and rehear the case as an en banc court.

In November 2022, Public Citizen, joined by Better Markets and the Consumer Federation of America, filed an amicus brief in the en banc proceedings. Our brief explained the troubling and growing trend among companies of using their corporate bylaws as a shield to avoid accountability under federal securities law and other federal statutes, and it explained why this outcome is inconsistent with the provisions of the Securities Exchange Act.  Our brief also highlighted the importance of these uniquely important shareholder “derivative” suits, in which shareholders sue on behalf of companies that have been harmed by mismanagement.

The Decision. Unfortunately, however, in yet another example of courts shutting the courthouse doors to wronged investors, the Ninth Circuit upheld the enforceability of the forum-selection clause forcing the suit into Delaware state court, despite the fact that such a ruling virtually extinguishes securities claims that must be litigated in federal court. The majority held that the forum selection clause did not violate the “anti-waiver” clause in the Exchange Act because Lee could resort to another litigation process—the direct action—to press her substantive claims.  But the court erred by equating direct and derivative actions.  As the dissent rightly noted, the corporate bylaw provision allows “a litigation to nowhere, depriving shareholders of any forum in which to pursue derivative claims.” The decision in Lee thus creates a circuit split with the 7th Circuit, which increases the likelihood that the Supreme Court will  grant review if Lee decides to seek it via a petition for cert. Fortunately, on June 29, Lee filed a petition for another rehearing en banc, this time by all of the judges of the Ninth Circuit.  On July 3, Public Citizen, Better Markets, and the Consumer Federation of America once again weighed in with an amicus brief supporting this petition. Unfortunately, however, the Ninth Circuit denied the petition for rehearing en banc on August 1, 2023.

Why It Matters. This decision validates the clear trend among companies that increasingly seek to use their corporate bylaws to extinguish certain federal claims and insulate themselves from liability. If left to stand, the Ninth Circuit’s decision will thwart private enforcement by making it harder — if not impossible — to assert certain federal claims against corporations, such as securities claims, antitrust claims, and others. While the SEC is the first line of defense against securities violations, private actions are, as the Supreme Court has repeatedly said, an important and necessary complement to SEC enforcement, and shareholder derivative suits are one way to fill the inevitable gaps in the SEC’s enforcement program.  More broadly, the damaging impact of the decision won’t be limited to securities law—many other types of federal remedies are threatened with extinction by companies adding corporate by-laws that in effect nullify the right of investors and consumers to seek relief under a variety of federal statutes.

CHAMBER OF COMMERCE CHALLENGES SEC STOCK BUYBACK RULE IN FIFTH CIRCUIT COURT OF APPEALS – Chamber of Commerce v. SEC, No. 23-60255 (5th Cir., May 12, 2023) – Chamber of Commerce challenges SEC’s newly approved share repurchase disclosure rule.

In May this year, the SEC issued a rule requiring companies to provide more detailed information about their share repurchases.  As we explained in our comment letter, it was designed to help investors understand whether the buybacks were in the best interest of the company and its shareholders or instead a maneuver intended to increase executive compensation.  The Chamber of Commerce and its allies promptly challenged the rule in the Fifth Circuit.  On October 31, 2023, the Court issued its decision with mixed results.  The Court rightly rejected claims that the rule violated the First Amendment limits on compelled disclosure, as we urged in our amicus brief.  It also correctly held that the SEC had offered a sufficient public comment period.  It nevertheless found that the rule was “arbitrary and capricious” in violation of the Administrative Procedure Act (APA) because the SEC had failed to respond to issues raised by commenters and had thereby failed to conduct a proper cost-benefit analysis.

However, in a positive turn, the Court concluded there was “at least a serious possibility” that the Commission could cure the defects that the Court identified. Therefore, instead of immediately wiping the rule off the books (“vacating” it), it remanded the rule to the SEC for 30 days to address the problems.  Unfortunately, however, the SEC was unable to meet this unrealistic timeline within 30 days, and the Fifth Circuit therefore officially vacated the stock buyback rule on December 19, 2023.

FEDERAL COURT REJECTS CHAMBER OF COMMERCE’S CHALLENGE TO SEC’s PROXY ADVICE RULE – Chamber of Commerce v. SEC, No. 23-5409 (6th Cir., May 04, 2023); Chamber of Commerce v. SEC, No. 3:22-cv-00561 (M.D. Tenn., Apr. 04, 2023) – Chamber of Commerce appeals to Sixth Circuit after Middle District of Tennessee sides with SEC and investors in rejecting industry’s predictable attacks on proxy advice rule.

The Issue. The right to vote on corporate leadership and policy choices is one of the most fundamental shareholder rights. Meaningful exercise of corporate suffrage can help ensure that boards and management are accountable to shareholders and other stakeholders. And the right to vote not only on the selection of board members but also on the adoption of major corporate policies can help ensure that shareholders have a voice in corporate strategies affecting the company itself, the communities in which they operate, and even the world at large.

To that end, advisory services for shareholder proxy voting are a central feature of modern corporate governance and capital markets. These services help shareholders decide how to vote on extremely important issues, from board members and executive compensation to fundamental corporate policy affecting workers and communities, all matters of increasingly intense interest to shareholders in the era of ESG investing. The SEC has traditionally exempted the providers of these services from compliance with its proxy solicitation rules.  Yet, in 2020, the SEC issued a new rule to narrow this exemption.   In part, the 2020 rule conditioned the exemption on notice of the proxy advice to the company holding the vote and an opportunity for that company to respond in writing prior to the voting. These reforms were staunchly opposed by shareholders but heavily favored by company managers seeking to minimize interference with their control over company votes. In 2022, the Commission assessed the market response to the 2020 rule and decided to rescind the notice-and-response condition for reliance on the exemption.  The SEC reasoned that this condition had proved too costly and threatened the ability of the proxy advisory firms to provide timely and independent advice to their clients. However, like clockwork, the Chamber of Commerce challenged this rule in federal court, arguing that the SEC violated the Administrative Procedures Act (APA) in issuing the rule.

The Decision. In late April, the U.S. District Court in the Middle District of Tennessee rejected the industry’s now-typical laundry list of baseless attacks on SEC rulemakings, and it upheld the SEC’s rule protecting the right of investors to receive independent and timely advice about upcoming proxy votes. The court methodically considered and rejected numerous challenges to the SEC’s decision to revise the Trump-era rule that unduly burdened proxy advisory firms, undermined the public interest, and was met with staunch opposition from all but corporate management and their allies. Despite the industry’s long list of familiar claims to the contrary, the court found that the SEC’s rule squarely complied with the APA’s requirements. For example, the court found that the official 30-day comment period (which in reality was considerably longer) complied with the law, that the SEC’s qualitative economic analysis of its rule was sufficient, and that the SEC adequately explained the rule, including the decision to revisit and modify the misguided 2020 rule adopted under the Trump Administration.

Why It Matters. The court’s ruling in the Middle District of Tennessee will remove a cloud hanging over an important rule that investors need to ensure their access to independent, timely, and affordable advice regarding how their proxies should be voted.  Put differently, investor protection triumphed over corporate management’s attempt to burden and constrain proxy advisers. Unfortunately, the industry has continued its assault in the courts by appealing this decision to the Sixth Circuit Court of Appeals, hoping to find a panel of judges that will accept their claims. We’ll track the case as it is litigated in federal court, but we hope and expect the Sixth Circuit will affirm the lower court ruling and side with investors over corporate management.

SECOND CIRCUIT EFFECTIVELY GRANTS BANKS A LICENSE TO LIE, AS LONG AS THEIR FALSEHOODS ARE SUFFICIENTLY “GENERIC” – Arkansas Teacher Retirement System v. Goldman Sachs Group, Inc. (In re Goldman Sachs Group, Inc.), No. 22-484 (2d Cir., Aug. 10, 2023) – The Second Circuit accepts a defense to fraud claims that in effect allows deception.

The Issue.  In the years before the 2008 financial crisis exploded and began dismantling our economy, Goldman Sachs organized, promoted, and sold mortgage-backed securities that, unbeknownst to investors, were essentially designed to fail. Goldman had become convinced that the residential mortgage market was headed for collapse, and it saw a rich profit opportunity. So it bet against the investments even as it foisted them onto countless unsuspecting investors who were persuaded to take the “long side” of the deal. The bank thus had a huge and undisclosed conflict of interest. And in addition to misleading investors, Goldman also misled the public—including its own shareholders—by falsely proclaiming that it had “extensive procedures and controls in place” to manage such conflicts of interest and by reassuring everyone that clients “always come first.” When the truth came out, the bank’s stock price fell, and shareholders suffered losses.

Many of those shareholders, including pension funds, have been struggling for years in the courts to hold the bank accountable for its misrepresentations. The threshold issue now is whether the case can be brought as a class action. And to beat back the shareholder claims, Goldman is advancing the strained argument that its deceptive assurances, which concealed profound conflicts of interest, were too immaterial, typical for the industry, or “exceedingly generic” to have any impact on the bank’s stock price by artificially propping it up.

The Supreme Court’s Decision. The case went to the Supreme Court, which held that the general nature of a misrepresentation is a factor a trial court should consider as it decides whether a misrepresentation about a company could have affected the market price of the company’s stock.  141 S. Ct. 1951 (decided June 21, 2021). However, the Court also decided to send the case back to the lower court, since it wasn’t convinced the lower court took the generic nature of Goldman’s misrepresentations properly into account when it allowed the case to go forward. We filed an amicus brief in the Supreme Court supporting the shareholders, detailing Goldman’s history of mishandling its conflicts of interest, and showing why it was clearly important for Goldman’s shareholders to have truthful disclosures about the way the bank managed—or mismanaged—its conflicts.

Following remand and another class certification in the district court, the case was once more before the Second Circuit, and in July 2022, we once again filed an amicus brief similarly urging the court to consider the context and the history of Goldman’s conflicts of interest, something every investor would care about regardless of how “generic” the false representations may have been.  Oral argument was held before the Second Circuit on September 21, 2022.

On August 10, 2023, the Second Circuit reversed the certification of the class of Goldman Sachs shareholders who sought to hold the bank accountable for misrepresentations concerning its sale of mortgage-backed securities.  In a long and convoluted opinion, the court held that given the generic nature of the alleged misrepresentations, the “mismatches in specificity” between the alleged misstatements and the subsequent corrective disclosures, and the special challenges surrounding allegations of deception by failure to disclose, the bank had shown by a preponderance of the evidence that the misrepresentations did not impact Goldman’s stock price, thus rebutting the normal presumption of reliance and precluding class certification.  

Why It Matters. By arguing that it should not be liable for its false statements because they were too generic, Goldman effectively asked the court to give it a license to lie.  Unfortunately, the Second Circuit has in effect granted that request with its decision. While Goldman may insist that it only wants to avoid legal accountability for its supposedly little or generic lies, those falsehoods still deceive investors and others, particularly when considered in the context of Goldman’s history regarding its handling of conflicts of interest.  The holding will undermine investor protection by raising the already challenging hurdles for class certification, here with respect to the presumption of investor reliance necessary for a securities fraud class action to proceed.

On November 22, 2023, after years of litigation, the plaintiffs voluntarily dismissed their claim against Goldman Sachs.

SEEKING TO HOLD MARKET MANIPULATORS ACCOUNTABLE – In re: Overstock Securities, et al., No. 21-4126 (10th Cir., Oct. 19, 2021) – Investors seek to recover damages for a brazen market manipulation scheme allegedly perpetrated by Overstock’s CEO, Patrick Byrne, and others.

The Issue. The plaintiffs have alleged, among other frauds, that Byrne artificially inflated the stock price of Overstock by orchestrating what’s known as a “short squeeze,” a series of actions that forced short sellers to buy stock to cover their positions, thus driving up the price of the stock. They allege that Byrne succeeded; cashed in his own shares at inflated prices, reaping tens of millions of dollars; and essentially admitted the manipulation. The district court in Utah rejected the claims as a matter of law, relying in part on the argument that an essential element of market manipulation is deception, something the court deemed was absent in this case given the overt nature of the defendants’ conduct.

What We Did. On February 2, 2022, Better Markets, joined by the Consumer Federal of America, filed an amicus brief explaining not only the legal errors in the district court’s decision but also the more far-reaching harm that the decision threatens unless it is reversed.  In our brief, we showed that the securities laws and rules were written broadly to cover fraud and manipulation as two separate forms of illegal conduct, driving home the point that manipulation schemes distort share prices and inflict harm on investors regardless of whether they were carried out using lies or traditional forms of deceit. We also highlight the damaging impact that the district court’s decision will have unless it is reversed. The plaintiffs will almost certainly be left without any remedy for their losses, and over the long-term, market manipulators will be able to fashion schemes that skirt the law but nevertheless wreak havoc in the markets and inflict untold harm among investors.

Why It Matters. Our securities markets are already viewed as unfair and rigged in many ways, and a ruling that immunizes a broad swath of market manipulation schemes is the last thing that investors or the markets really need. That’s why we urged the Tenth Circuit to reverse the district court and allow the claims to be heard.  The court heard oral argument on February 9, 2023, but it has yet to issue a decision.

SEC DEFEATS CHALLENGE TO NASDAQ’S RULE REQUIRING TRANSPARENCY ABOUT DIVERSITY ON CORPORATE BOARDS – Alliance for Fair Board Recruitment v. SEC, No. 21-60626 (5th Cir.) (decided Oct. 18, 2023) – Challengers lose bid to nullify the SEC’s approval of a new rule issued by the NASDAQ that helps investors select companies for investment and also advances the cause of social justice.

The Issue. The NASDAQ is a major national stock exchange that lists over 3,000 company stocks.  It took a major step forward on the social justice front by issuing a new rule that would require each company listed on the exchange to publicly disclose the self-identified gender, racial, and LGBTQ+ status of each member of the company’s board of directors. The rule also requires each listed company to have, or explain why it does not have, at least two members of its board who are diverse, including at least one director who self-identifies as female and at least one director who self-identifies as an underrepresented minority or LGBTQ+.

The SEC approved the rule in August 2021, and the petitioner, the “Alliance for Fair Board Recruitment,” promptly challenged it in the U.S. Court of Appeals for the Fifth Circuit. The Alliance is based in Texas, and its website simply declares that its mission is to “promote the recruitment of corporate board members without regard to race, ethnicity, sex and sexual identity” and further that “The identities of our members are confidential.” The Alliance argued that the rule violates the petitioners’ right to equal protection under the Fifth Amendment to the U.S. Constitution, that it also violates the First Amendment by requiring disclosure of controversial information, and that the SEC lacked authority under the securities laws to approve the rule.

The Court’s Decision.  In a decision issued on October 18, 2023, the Fifth Circuit rejected all of the Alliance’s arguments and upheld the NASDAQ’s rule.  It held that the constitutional arguments did not apply because the NASDAQ is not a state actor; that the SEC had the authority to approve the rule; and that the SEC’s approval was neither arbitrary nor capricious.

• The Court first held that the challengers’ constitutional claims lacked merit because the NADAQ is a private entity, not a state actor subject to the alleged constitutional restraints. Nor the Court held, is the rule attributable to the government, since listing standards are not a traditionally public function, the SEC did not compel the rule, and the SEC did not act jointly or become closely intertwined with the rule.  Mere approval of the rule by the SEC was simply not sufficient to render it government action.
• The Court then held that the SEC acted within its statutory authority when it approved the rule. In support of that conclusion, the Court explained that 1) the SEC appropriately considered subjective evidence of investors’ desire for the information provided by the rule; 2) a rule may require the disclosure of information that doesn’t necessarily constitute “material information” as defined in the context of a fraud action under the securities laws; 3) the rule did not regulate corporate governance, a matter traditionally reserved for the states; and 4) the rule did not violate the “major questions” doctrine.

The Court’s latter ruling was especially important and clear-cut, as the Court flatly rejected the notion that the rule would have enormous political or economic significance.  Instead, the Court said, the rule represented the ordinary exercise of the SEC’s authority, calling it “business as usual” for the agency.  Moreover, it observed, the securities laws gave the SEC clear authority to approve such exchange rules and provided clear standards for the agency to apply in the process.

• Finally, the Court held that the SEC’s approval of the rule was neither arbitrary nor capricious, since 1) it furthered the objectives of the law, including the maintenance of fair and orderly markets; 2) it did not discriminate unfairly against foreign issuers; 3) the SEC satisfied its limited duty under the law to conduct an economic analysis of the rule; 4) the SEC independently analyzed the data in the record; and 5) it considered the necessary factors in deciding to approve the rule.

Why It Matters.  This is a major win for investors, for the cause of social justice, and for the SEC and NASDAQ, which showed commendable leadership by issuing the rule.

As recounted in the opinion, a broad array of investors have demanded more disclosure about the composition of corporate boards, as those investors navigate the markets and analyze the many investment opportunities available. Disclosure of that information also promises real progress on the social justice front, as it can be expected over time to produce greater diversity in America’s corporate board rooms.  Ultimately, that means progress in bringing minorities into the economic mainstream and centers of corporate power.

Finally, the result in this case is a significant win for the SEC.  Its rules are subject to a constant barrage of attacks in court, based on a wide range of often weak arguments.  Here, the outcome in favor of investors and greater diversity demonstrates that the shameless pattern of forum shopping in the Fifth Circuit doesn’t guarantee success:  The three-judge panel took an objective look at the law and the facts and unhesitatingly reached the right result in favor of the rule and against the challengers.

BEGINNING (FINALLY) TO ENFORCE REGULATION “BEST INTEREST” – SEC v. Western International Securities, Inc., No. 2:22-cv-04119 (C.D. Cal., June 15, 2022) – The SEC files its first enforcement action alleging violations of its rule aimed at protecting investors from conflicted investment advice.

The Issue. For decades, financial advisers have been allowed to recommend investments that line their own pockets with huge fees and commissions but saddle their clients with low returns and high risks. Those recommendations, heavily influenced by incentives that promote the adviser’s self-interest, have siphoned away billions of dollars in Americans’ hard-earned money every year.  In 2019, the SEC issued a rule, titled “Regulation Best Interest” or “Reg BI,” which it claimed would require advisers always to act in the best interest of their retail clients when recommending securities investments. In reality, the rule is weak, vague, and confusing. Nevertheless, it became effective in mid-2020 and even investor advocates believed it could help protect investors from adviser conflicts of interest if it was aggressively enforced by the SEC.

Although it took the SEC two years to act, the agency has now taken a step in the right direction and filed the first case alleging violations of the rule. The SEC’s complaint alleges that the defendants, including a broker-dealer and five individual registered representatives, sold over $13 million in high-risk, unrated, and illiquid bonds to retirees and other investors who had only moderate risk tolerances. It specifically claims that the defendants recommended the bonds without having a reasonable basis to believe the bonds were in their customers’ best interest, in violation of the explicit requirements in Reg BI.  It also claims the defendants violated their compliance obligations under Reg BI by failing to establish and enforce written policies and procedures reasonably designed to achieve compliance with the rule. The SEC alleges that the defendant firm and the named individuals collectively reaped hundreds of thousands of dollars in commissions and fees from the sale of the risky bonds.

Why It Matters. Even the best rules can have only limited effect if they are not enforced, and even the weakest rules can do some good if they are aggressively enforced.  This enforcement action is therefore significant because it will at least send a signal to advisers that the SEC expects compliance with Reg BI as written.  That message needs to be sent because the evidence so far—including data gathered by state securities regulators and FINRA, the brokerage industry’s self-regulatory body—indicates that when it comes to managing conflicts of interest, advisers have largely continued with business as usual in the three years since Reg BI was finalized.  Thus, even with its flaws, Reg BI can perhaps begin to curb the conflicts of interest that have continued to contaminate investment advice and harm investors.

We’ll track the case as it is litigated in federal court.  We’ll also be watching to see if the SEC follows up with additional enforcement actions under Reg BI to limit the harm that adviser conflicts of interest are having on countless everyday American investors.  For now, jury trial has been set to begin January 30, 2024, and the parties continue to conduct ongoing discovery in the meantime.

ATTEMPTING TO TEAR DOWN EVEN MODEST PROTECTIONS FOR RETIREMENT SAVERS – Federation of Americans for Consumer Choice v. DOL, No. 3:22-cv-00243 (N.D. Tex., filed Feb. 2, 2022) and American Securities Ass’n v. DOL, No. 8:22-cv-00330 (M.D. Fla., filed Feb. 9, 2022) – Industry associations file two challenges to guidance issued under the Department of Labor’s December 2020 best interest rule.

The Issue. Outdated Department of Labor (DOL) rules have long provided that the law protecting investors from conflicted advice doesn’t apply when an adviser gives a client one-time advice to roll their entire nest egg out of a 401(k) account and into other investments, such as annuities that reward advisers with huge commissions. For over a decade, the DOL has been trying to develop new rules to close those gaps and provide better protections for retirement savers. In 2016, it issued a set of strong new rules, but they were struck down by the U.S. Court of Appeals for the Fifth Circuit—the only court, among half a dozen federal courts to hear challenges to the rules, that accepted industry’s arguments.  Under the Trump Administration, in December 2020, the DOL came up with a watered-down set of protections that left major gaps intact. However, those rules at least indicated that “rollovers” could be covered under the law, potentially requiring an adviser to make such recommendations only if they were in the client’s best interest.

In April 2021, the DOL released a series of “frequently asked questions” in which the agency provided guidance confirming that rollovers, including an initial rollover recommendation to a client, could fall under the rule’s best interest standard. The insurance industry is especially upset at the rule and the guidance because they eat into huge profits from the sale of annuities.  They have challenged the guidance in federal courts in Texas and Florida, arguing that the DOL failed to abide by the notice and comment rulemaking requirements set forth in the Administrative Procedure Act.

Why It Matters. For decades, many financial advisers subject to powerful conflicts of interest have been enriching themselves at the expense of their clients by recommending overpriced, poor-performing, and overly risky investment products. The damage has amounted to tens of billions of dollars a year, a cost that is especially harmful to everyday Americans struggling to save and invest for a decent and dignified retirement.  If even the modest protections in the DOL’s 2020 rule governing rollovers, as informed by the challenged guidance, fail to survive this legal challenge, then retirement savers will be that much more exposed to the predatory advisers who recommend rollovers to line their pockets, not serve the best interests of their clients.

The parties have briefed dispositive motions in both cases.  In the Florida case, Securities Ass’n v. DOL, the court resolved the cross-motions for summary judgment in February 2023. In that ruling, the court rejected some of the plaintiffs’ claims but also vacated the DOL’s FAQ 7 addressing when rollover advice may be considered advice on a “regular basis.” In the Texas case, Federation of Americans for Consumer Choice v. DOL, dispositive motions have yet to be fully resolved. However, on June 30, a United States magistrate judge issued its Findings, Conclusions, and Recommendations regarding the pending Motions for Summary Judgment and Motions to Dismiss. In its ruling, the magistrate judge made the following findings and recommendations: (1) that plaintiffs have standing to bring their challenge and therefore the court should deny the defendants’ motion to dismiss; (2) that the court should grant in part and deny in part plaintiffs’ motion for summary judgment; (3) that the court should grant in part and deny in part the DOL’s cross-motion for summary judgment; and (4) that the court should vacate the portions of PTE 2020-02 that permit consideration of actual or expected Title II investment advice relationships when determining Title I fiduciary status. Despite these recommendations, however, the district court has still yet to issue a ruling on the matter.

CRYPTOCURRENCY ENFORCEMENT – SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y., July 13, 2023) – A federal district court rules that Ripple’s XRP cryptocurrency is both a security and not a security, depending on who purchases the digital asset, thus affording protections to “sophisticated” institutional investors but not to individual retail investors purchasing crypto on a public exchange.  This turns 90 years of securities investor protection priorities upside down.

The Issue.  Cryptocurrency offerings continue to draw huge attention, as a steady stream of enforcement actions and criminal cases against crypto firms and their principals make headlines while the industry swarms Congress in an effort to secure light-touch regulation at the hands of the underfunded, understaffed, and industry-friendly CFTC.  The SEC (under Republican and Democratic leadership) has consistently taken the position that most crypto offerings are securities in the form of investment contracts, and an enforcement action filed in December of 2020 (by Trump’s SEC) illustrates the agency’s approach.  The SEC filed its case in federal district court against Ripple Labs, Inc. and two of its principals, alleging that since 2013, the defendants had been selling digital assets (known as “XRP”) that were unregistered securities under the Howey investment contract test.  The SEC sought an injunction, disgorgement, and civil monetary penalties.

The SEC’s complaint explained that under the Supreme Court’s landmark decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), investment contracts are instruments through which a person invests money in a common enterprise and is led to expect profits or returns derived from the entrepreneurial or managerial efforts of others. The theory advanced in this case is that investors are being asked to speculate on the value of XRP and that its value hinges on the “efforts of others,” i.e., the success of the promoters who are trying to generate demand for XRP as a medium for financial firms to effect money transfers.  In its complaint, the SEC highlighted the risk of harm to investors and the informational vacuum created when promoters fail to register their securities offerings:

Because Ripple never filed a registration statement, it never provided investors with the material information that every year hundreds of other issuers include in such statements when soliciting public investment. Instead, Ripple created an information vacuum such that Ripple and the two insiders with the most control over it—Larsen and Garlinghouse—could sell XRP into a market that possessed only the information Defendants chose to share about Ripple and XRP.

The Decision. Following years of intense litigation dominated by discovery disputes (reportedly costing Ripple hundreds of millions of dollars in attorneys’ fees and costs), the case was ready for a much-anticipated ruling on cross-motions for summary judgment—arguments from each party claiming that based on the undisputed facts and the law, they were entitled to a judgment in their favor. On July 13, Judge Analisa Torres of the U.S. District Court for the Southern District of New York issued a 34-page ruling that is already being heralded as a victory by the crypto industry, even though it produced decidedly mixed results, some clearly in the SEC’s favor.

The court ruled that XRP was a security under the SEC’s jurisdiction when Ripple sold the digital asset specifically to institutional investors.  However, it also ruled that the same investment product was not a security when it was sold on public exchanges to individual retail investors through so-called “programmatic sales.” So, according to this district court, XRP is both a security and not a security, depending on who is purchasing it and how.

The court’s decision ultimately came down to its conviction that institutional investors have more knowledge about XRP and its value in relation to Ripple’s entrepreneurial efforts than retail investors have.  As the court explained, “A reasonable investor, situated in the position of the Institutional Buyers, would have been aware of Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts.” In other words, these institutional investors purchased the asset with the expectation that they would derive profits from Ripple’s efforts. As a result, under the standard set forth in the Howey case, these transactions constituted the purchase of a security. Conversely, reasoned Judge Torres, individual retail investors are “generally less sophisticated” and should thus not be expected to have “similar ‘understandings and expectations’” of Ripple and XRP. Thus, for these “less sophisticated” investors, who purchased XRP on digital asset exchanges, the purchase of XRP “did not constitute the offer and sale of investment contracts” with the expectation of profits derived from the efforts of others.

The court was certainly correct in holding that XRP offerings were investment contracts from the standpoint of the institutional investors.  However, the court erred in finding that XRP tokens were not securities as to the retail investors who acquired XRP via exchange trading. On this issue, the court’s analysis was internally contradictory, based on erroneous assumptions about retail investors, and at odds with the remedial purposes that underlie the Howey test and the securities laws.

First, while generally insisting that retail investors did not understand to whom or for what they were investing their money, the court conceded that at least some of those investors may have purchased XRP “with the expectation of profits to be derived from Ripple’s efforts” to support and develop its token.  Yet the court held fast to its view that none of the “programmatic” investors purchased securities.

In addition, the court relied on assumptions about the supposedly limited knowledge of retail investors regarding Ripple and XRP that were inconsistent with the record.  It claimed that the Howey test involves an objective assessment of the promises and offers made to investors, not a search for subjective motives.  But the court’s “objective assessment” was wrong based on the extensive evidence.  The court itself recounted “Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts,” which appeared through a variety of social media platforms and news sites over several years.  Based on this “objective” evidence, it is far more reasonable to conclude that even the programmatic retail investors trading via the exchange had a good grip on what Ripple was up to and in fact were counting on returns derived from Ripple’s efforts.  In short, the court failed to persuasively explain how XRP could be a security in one context but lose its fundamental character simply because it was traded in a secondary market—which is a common feature in today’s securities markets.

Finally, the decision is equally troubling from a policy standpoint, as it turns the remedial purposes of the securities laws on their head.  Under the court’s holding, those who need protection the least — like the “sophisticated” hedge funds who purchased XRP — are afforded the many protections provided by the securities laws, while those who need protection the most — the retail investors who buy cryptocurrency on a public exchange — are denied those very same protections.  And here too the court was inconsistent.  It recited with approval the familiar attributes of the Howey test, pointing out it was intended to be a flexible, not static principle, capable of adapting to the countless schemes devised by those seeking investors’ money.  It further noted that the Howey test was intended to effectuate the statutory policy of broad investor protection, a goal not to be “thwarted by unrealistic and irrelevant formulae.”  Yet the court arrived at a decision that at least in part conflicted with these principles.

There was certainly some comfort in the court’s decision, not only as to the status of XRP as a security with respect to the institutional investors but also as to a number of other issues presented in the case.  For example, the court acknowledged that a wide variety of ordinary assets—including crypto tokens—can be packaged and sold as investment contracts, depending on the circumstances.  It also rejected Ripple’s attempt to graft an elaborate assortment of new requirements onto the investment contract test, including a requirement that there be a contract conferring specific rights and obligations.  And it firmly rejected the defendants’ due process arguments, holding that they had ample notice of the Howey test based on the Supreme Court’s decision and subsequent cases.  Finally, as to whether the individual defendants aided and abetted Ripple’s violations, the court held there were genuine issues of material fact surrounding those claims that would have to be resolved at trial.

On August 18, the SEC filed a motion in the district court seeking leave to pursue an interlocutory appeal of that ruling. On October 3, 2023, Judge Analisa Torres denied the SEC’s motion for an interlocutory appeal, holding that it did not meet the relevant legal standard of presenting a “pure question of law” that could “decided quickly and cleanly without having to study the record.”

Why It Matters.  The ultimate impact of the decision will hinge on whether the SEC eventually lodges a successful appeal and has the court’s ruling reversed on the status of the XRP tokens sold via the programmatic trading.  Meanwhile, the crypto industry will not only tout its win but also adapt its offerings and trading platforms to gain maximal protection from the court’s holding that secondary trading by retail investors can strip a digital asset of its character as an investment contract.  That will energize the crypto industry, likely protect at least some of their offerings from securities regulation, and spawn new platforms, all adding to the already massive harm inflicted on investors by this lawless and predatory industry.