Important Cases in the Federal Courts

SUPREME COURT GUTS A PILLAR OF THE SEC’S ENFORCEMENT AUTHORITY

SEC v. Jarkesy, No. 22-859 (decided June 27, 2024) (S. Ct.) – Supreme Court rules SEC can only recover civil penalties from lawbreakers through federal court jury trials, not in efficient administrative enforcement proceedings.

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. The case worked its way through the system before reaching the Supreme Court, where the conservative majority ruled against the SEC.

Why It Matters.

It’s a bad ruling for American investors, who depend on the SEC to enforce the law against fraudsters and con artists in the securities markets.  The Court struck down the authority of the SEC to bring enforcement actions before administrative law judges to recover civil penalties, holding that such relief can only be pursued in court before a jury.  based on its view that the Constitution guarantees the right to a jury trial in actions at common law.  But the SEC’s claims are statutory, not common law claims, and they are brought by the government for fraud and other violations of the law.  Thus, they involve the enforcement of ‘public rights,’ a recognized exception to the jury trial requirement.  The decision, which sharply veers away from long-established precedent, upends the SEC’s enforcement program and promises a further drain on its already strained resources.  It also comes at an especially bad time, given the rise in crypto investment schemes that require vigorous enforcement.  And it also casts grave doubt on the ability of other agencies to use administrative law judges as an efficient but fair method of holding lawbreakers accountable through civil penalties.”

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, 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, 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. The case has been briefed on the merits and the court has heard oral argument. We’ll continue to track the case as we await a decision, but we hope and expect the Sixth Circuit will affirm the lower court ruling and side with investors over corporate management.

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, BUT THE FULL FIFTH CIRCUIT AGREES TO RECONSIDER THE CASE– 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.  However, the court agreed to hear the case “en banc.”

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.

The Petition for Rehearing.  Unfortunately, in February, the Fifth took the very unusual step of agreeing to rehear the case.  That means that all the active judges on the court will reconsider the merits of the case and determine if the three-judge panel actually got it right. Better Markets filed an amicus brief in the case.

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

As recounted in the panel’s 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.  But the progress in this case may be lost if the full Fifth Circuit goes the other way and strikes down the SEC’s approval of the rule.

D.C. DISTRICT COURT WILL SOON DECIDE IMPORTANT CASE ON ELECTION GAMBLING –  KALSHIEX, LLC V. CFTC, NO. 1:23CV3257 (D.D.C.). On May 30, the federal district court in D.C. heard oral argument in Kalshi’s bid to offer gambling contracts on the outcome of congressional elections.  It’s difficult to predict outcomes based on oral argument, but clearly the judge is giving the case thorough consideration.  As we argued in our amicus brief filed on March 4, 2024, the CFTC made the right decision in rejecting Kalshi’s application, since if approved, those contracts would undermine the integrity of our federal elections, lead to rampant market manipulation, inflict huge losses on investors, and place the CFTC in the impossible position of policing elections—a responsibility for which the agency has neither the funding nor the expertise.