WHAT’S NEW AND NOTEWORTHY
SUPREME COURT DEALS ANOTHER BLOW TO THE SEC’S AUTHORITY TO HOLD WRONGDOERS ACCOUNTABLE IN AGENCY ENFORCEMENT PROCEEDINGS – Axon Enterprise, Inc. v. FTC and SEC v. Cochran, Nos. 21-86 & 21-1239 (Apr. 14, 2023) – A unanimous Court holds that respondents can side-track administrative enforcement actions in district court instead of following the review process that Congress chose.
The Issue. The Supreme Court has sided in favor of another attack on the administrative tribunals that hear hundreds of agency enforcement actions every year. In these two companion cases, the issue before the Court was a procedural or jurisdictional one, not the merits of the constitutional claims lodged against the administrative enforcement mechanism. As to Cochran, the securities laws plainly provide that challenges to the outcome of an administrative enforcement proceeding must be brought only after the proceeding has ended and only in a federal appellate court, not a federal district court. In this case, however, a respondent who was alleged to have committed serious violations of the securities laws sought to block the administrative enforcement action against her by jumping into district court before the case had run its course. She succeeded, as the Supreme Court held that district courts do have jurisdiction to hear constitutional challenges to the ALJ enforcement process, notwithstanding the different mechanism that Congress chose. Thus, those charged with violating the securities laws will be able to short-circuit the law, delay the process, and ultimately impede effective and efficient enforcement by the SEC.
The Decision. In Cochran, the respondent before the Court, Michelle Cochran, was fined over $20,000, suspended for five years, and ordered to cease and desist from future violations of federal accounting standards in an SEC administrative enforcement action. After the Supreme Court ruled in Lucia v. SEC, 138 S. Ct. 2044 (2018). that the SEC’s corps of ALJs had been appointed in violation of the Constitution, the SEC sent Cochran’s case back for rehearing before a properly appointed ALJ. However, in a defensive gambit, Cochran challenged the enforcement action on yet additional constitutional grounds, asserting that the restrictions on the removal of ALJs violate Article II of the constitution (a separation of powers argument). Rather than contesting the case on the merits and then challenging any adverse outcome in the appellate court, as prescribed by law, Cochran promptly asked a federal district court to block the case.
The district court appropriately held that the Exchange Act requires all challenges to the SEC’s adjudications to be brought only after they are final and only in the courts of appeals. It further held that the Act’s review framework encompasses even the types of constitutional claims that Cochran had raised. However, in an en banc opinion, the Fifth Circuit reversed in part, holding that the district court did have jurisdiction over Cochran’s removal claim.
In their brief to the Supreme Court on the merits, the Solicitor General and the SEC argued persuasively that Cochran’s bid to short circuit the enforcement case was remature and literally misplaced—in the wrong court. They pointed out that the Exchange Act includes detailed provisions for judicial review of orders issued by the Commission during administrative adjudications. They authorize review only at the end of the administrative proceedings, after the Commission issues its final order, and only in courts of appeals, not in district courts. Moreover, they argued, Cochran’s attempt to seek review violates the Administrative Procedure Act, as the APA generally authorizes judicial review only of “final agency action.” 5 U.S.C. § 704. And neither the Exchange Act nor the APA contains any exceptions for constitutional claims, Article II claims, or removal-power claims. To the contrary, the APA explicitly “encompasses suits alleging that an agency has acted ‘contrary to constitutional right, power, privilege, or immunity.’” Brief for the Federal Parties at 11, SEC v. Cochran, Nos. 21-86, 21-1239 (Aug. 8, 2022) (quoting 5 U.S.C. § 706(2)(B)) (emphasis added) (“Government’s Brief). On each point, the agency cited ample precedent to the effect that the Congressionally chosen review process need not and should not be second-guessed.
However, in a unanimous decision written by Justice Kagan, the court held that while the statutory review process generally divests district courts of their ordinary jurisdiction, some cases, including challenges to the constitutionality of an agency’s structure or function, may be heard in a district court and before the administrative process has run its course. The Court applied the three-part test established in a case known as Thunder Basin Coal Co. v. Reich, 510 U.S. 200 (1994), and concluded that 1) Cochran’s removal power claim would not receive meaningful judicial review in a court of appeals; 2) that the constitutional claim was wholly collateral to the enforcement action review process; and 3) that the claim lay outside the SEC’s expertise.
Why It Matters. First, the Court’s holding will allow premature challenges to administrative enforcement proceedings, thus disrupting the enforcement of the securities laws against those who commit fraud, manipulation, and a myriad of other violations. The ruling will undoubtedly encourage other respondents to file district court cases seeking to derail administrative enforcement actions against them, at least where they launch constitutionally-based challenges to the proceedings. That, in turn, will further disrupt the agency’s administrative enforcement mechanism on which it heavily relies to police fraud and bad actors in the securities markets. The administrative enforcement mechanism has stood the test of time and serves as a pillar of the SEC’s enforcement program.
Second, the ruling will have disruptive legal and judicial consequences. It “turns constitutional avoidance upside down,” accelerating judicial consideration of weighty constitutional claims that federal courts generally avoid if possible while deferring consideration of non-constitutional claims. Government’s Brief at 11. It also promises to generate judicial inefficiency, producing “parallel litigation by bifurcating judicial review, with a district court and a court of appeals (perhaps in another circuit) reviewing different claims arising out of the same agency proceeding.” Id. In addition, Cochran’s theory will likely prove difficult to administer consistently, as judges in the circuit courts will disagree about which constitutional claims can be heard immediately in the district courts.
Finally, the decision represents another step in a lamentable judicial trend in which judges and Justices increasingly siding with those who attack the work that administrative agencies seek to do. Indeed, Justices Thomas and Gorsuch seized the opportunity to write separate opinions arguing for even greater judicial oversight and intervention as to agency processes. Of course, this hostility starkly conflicts with the unquestionably successful and longstanding role that the regulatory agencies have played in implementing and enforcing federal statutes and rules to protect the public from a wide range of threats to their health, safety, and financial well-being.
OTHER COURTS AND CASES WE CONTINUE TO WATCH
THE SUPREME COURT
The Supreme Court is now well into its October 2022 term. Along with cases involving high-profile social policy questions, the Court will be addressing important issues in the realm of financial regulation and economics, which have a profound impact on the financial well-being of virtually all Americans. In late September 2022, we issued our review of the Supreme Court’s recent decisions on those issues, and we looked ahead to the slate of similar cases the Court will soon be resolving. Thus far, the Court has issued only a handful of decisions this term, the most relevant of which is the Bittner opinion discussed above. But as the term unfolds and the Court renders its judgments in more cases, we will be highlighting the outcomes and what it means for the wallets of the American people.
Over the last few years, we’ve issued a number of reports highlighting the Court’s critically important economic and financial decisions, including reports found here and here. In our reports, we also sometimes focus on the Justices appointed to serve on the Court, examining how their judicial philosophy is likely to affect the Court’s approach to financial regulation and administrative law. We’ve profiled three Justices so far, including Justices Kavanaugh (here), Barrett (here), and Jackson (here). And we’ve examined some of the institutional concerns surrounding the Court, including its shadow docket.
The overarching message is clear: The Court has a profound impact on the economic well-being of every American who is working, saving, and investing for a better standard of living and a decent retirement. The bottom line is that anyone who uses a financial product or service—a checking account, credit card, mortgage, student loan, car loan, retirement plan, college savings fund, or brokerage account—should care about the Supreme Court’s decisions.
Here are two of the most important cases either pending in the Supreme Court or likely to be reviewed by the Court that we are watching:
- CFPB FUNDING UNDER THE APPROPRIATIONS CLAUSE – CFPB v. Community Financial Services Association of America, No. 22-448. In a shocking decision, the Fifth Circuit held that the CFPB’s basic funding mechanism—drawing on a portion of the Federal Reserve budget—violated the Appropriations Clause of the Constitution. The CFPB petitioned for review, and the Supreme Court granted that petition on Feb. 27, 2023. The merits briefing is scheduled to begin in early May and run through into July.
- SEC ALJS AND ADMINISTRATIVE ENFORCEMENT – Jarkesy v. SEC, No. 22-859. A three-judge panel of the Fifth Circuit ruled that imposition of civil penalties by SEC Administrative Law Judges (ALJs) violates the Seventh Amendment right to a jury trial and the constitutional non-delegation doctrine; the panel also ruled that SEC ALJs are unconstitutionally protected from removal by the President. The full Fifth Circuit denied a petition for rehearing en banc. The SEC filed its petition for a writ of certiorari on March 8, 2023, and the brief in response is due in May.
OTHER FEDERAL COURTS, DISTRICT AND CIRCUIT
CRYPTOCURRENCY ENFORCEMENT – SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y., filed Dec. 22, 2020) – The SEC deploys investment contract theory to protect investors from crypto abuses.
The Issue. Cryptocurrency offerings are grabbing huge attention, as their prices fluctuate wildly, investors take a beating in the latest crypto market plunge, and policymakers wrestle with how to regulate them. The SEC’s position is that most crypto offerings are securities in the form of investment contracts, and an enforcement action filed in December of 2020 illustrates the 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 is seeking an injunction, disgorgement, and civil monetary penalties.
The complaint explains 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 reasonably expects 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 also highlights 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.”
Why it matters. The case is being hotly contested on the merits and also in the discovery stage, and it’s worth watching as one test of the SEC’s application of the investment contract theory to cryptocurrency offerings. To its credit, the SEC has not hesitated to apply the securities laws to any issuers or promoters of crypto offerings that constitute securities. A ruling against the SEC in this case would strike a blow against the agency’s ability to police the crypto markets, which are inflicting huge damage on investors.
BEGINNING (FINALLY) TO ENFORCE REGULATION “BEST INTEREST” – SEC v. Western International Securities, Inc., No. 2:22-cv-04119 (C.D. Cal.) – 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 two 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.
SEEKING TRANSPARENCY ABOUT DIVERSITY ON CORPORATE BOARDS – Alliance for Fair Board Recruitment v. SEC, No. 21-60626 (5th Cir.) – Opponents challenge the SEC’s approval of a new rule issued by the NASDAQ that would help advance the cause of racial justice.
The Issue. The NASDAQ, a major national stock exchange that lists over 3,000 company stocks, took a major step forward on the racial injustice 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 is arguing 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.
Why It Matters. A victory in the case by the Alliance will invalidate an important measure that provides key insights into the composition of thousands of boards of directors, information that would undoubtedly and ultimately lead to greater diversity in America’s board rooms and progress toward bringing minorities into the economic mainstream. The court heard oral argument on August 29, 2022, but it has yet to issue an opinion.
SEEKING TO HOLD MARKET MANIPULATORS ACCOUNTABLE – In re: Overstock Securities, et al., No. 21-4126 (10th Cir.) – 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.
ATTEMPTING TO FORCE ARBITRATION ON SHAREHOLDERS – The Doris Behr Irrevocable Trust v. Johnson & Johnson, No. 22-1657 (3d Cir.) – Pro-arbitration advocates attempt to force public company shareholders into mandatory arbitration, a biased, secretive, and anti-consumer forum.
The Issue. In this case, a federal court is being asked to decide if a public company can be forced to impose mandatory arbitration not just on its customers but also on any shareholders with claims against the company for fraud, mismanagement, or other breaches of duty. The stakes are high. If the court gets this wrong and allows this dramatic—and dramatically bad—legal development, then the toxic effects of mandatory arbitration will be further broadened, incentivizing corporate lawbreaking by limiting the legal rights of shareholders to enjoin it and hold those responsible accountable. Given that shareholders are the owners of public companies, who rely on legal actions as one important way to protect their investments and police management, such a decision could have a significant and adverse impact on capital formation and allocation.
Why It Matters. Mandatory or forced arbitration takes away the rights of consumers and investors to seek relief in open court before unbiased judges when they have been ripped off by banks and corporations. These often fine-print clauses force defrauded investors and other victims into secret, unfair, and biased arbitrations. Those proceedings are generally run by an industry self-regulatory organization that consistently favors the industry. Investors and consumers rarely obtain meaningful recovery.
In a positive development, the district court once again granted defendant Johnson & Johnson’s motion to dismiss. The court ruled that there’s no real “case or controversy” between the parties because the Trust’s claims are either moot (already resolved) or unripe (not yet ready for resolution). Obviously disappointed by the court’s ruling, the plaintiffs have appealed to the U.S. Court of Appeals for the Third Circuit. The case was fully briefed in December 2022 and the Court has indicated that it will decide the case on the briefs without oral argument.
WILL BANKS BE GRANTED 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.) – A bank asserts 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 is 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, and we await that Court’s decision in light of the Supreme Court’s instructions.
Why It Matters. By arguing that it should not be liable for its false statements about key subjects like its conflicts of interest because, it claims, they were too generic, Goldman is effectively asking the courts to give them a license to lie. 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. In fact, they were hardly “little” misrepresentations in this case. As we have argued, if the courts buy Goldman’s argument, then they should at least require banks to color-code their deceptive statements so that everyone knows which ones are supposedly “general” or “little” and which ones are major.
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 February 2, 2022) and American Securities Ass’n v. DOL, No. 8:22-cv-00330 (M.D. Fla. filed February 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 tells a client they should 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 February 2023, the Florida court rejected some of the claims but also vacated the DOL’s FAQ 7 addressing when rollover advice may be considered advice on a “regular basis.” Notices of appeal were filed by both sides in April. The Texas court has yet to rule on the pending cross motions for summary judgment.
