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October 28, 2022

ACTIONS IN THE FEDERAL COURTS – MONTH IN REVIEW NEWSLETTER – October

The Supreme Court

The Supreme Court began its new term on Monday, October 3, 2022.  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, 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.  As the term unfolds and the Court renders its judgments in those 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.

IMPORTANT RECENT DEVELOPMENTS

A MAJOR WIN FOR THE SEC IN THE D.C. CIRCUIT – Citadel Securities LLC v. SEC, 45 F. 4th 27 (decided July 29, 2022) The industry fails in its bid to overturn the SEC’s approval of a new type of trading order that helps protect investors from predatory trading activity by sophisticated high frequency traders (“HFTs”).

At the end of July, the D.C. Circuit upheld an important new type of trading order approved by the SEC.  While the ins and outs sound technical, the decision will help protect investors from predatory trading activity by sophisticated high frequency trading firms that soak up billions of dollars from everyday retail investors each year.  See our prior newsletters for a rundown of the case and the positive outcome.

A MAJOR DEFEAT FOR THE CFPB, AND CONSUMERS, IN THE FIFTH CIRCUIT Community Financial Services Association of America, Ltd. v. CFPB – The Fifth Circuit concluded that the CFPB’s funding mechanism is unconstitutional, and it therefore nullified an important rule protecting consumers from payday lending practices.

The Issue.  The CFPB was established in 2010 through the Consumer Financial Protection Act (CFPA), a part of Dodd-Frank.  Its mandate was to protect consumers from unfair, deceptive, and abusive financial practices.  The history of financial crises had taught Congress painful lessons about the ability of lending industries to influence regulators, so the authors of the CFPA tried to protect the Bureau from regulatory capture in two ways.  First, the CFPA established a single Director of the Bureau with special restrictions on her removal from the post; second, it funded the CFPB not through recurring appropriations but through the budget of the Federal Reserve.  The Fed, like many other federal agencies, is funded by fees from regulated entities (in its case, banks). The CFPB could request funding up to 12% of the Fed’s operating expenses for its own budget, which made the CFPB self-funded, too.

During the Obama era, the CFPB issued a new rule to regulate payday lending and similar loans that might ensnare borrowers in revolving debt traps.  This rule imposed strong underwriting protections for borrowers likely to fall into such traps, and it also barred lenders from trying to debit a borrower’s account more than twice once notified of insufficient funds.  This latter provision protected borrowers from perpetual overdraft fees triggered by the lender’s endless attempts to withdraw money from borrowers’ accounts.

The Trump-era CFPB repealed the core underwriting protections but left in place the restrictions on unauthorized debiting.  But that wasn’t enough for the payday lending industry, so their trade association sued to overturn those regulations in a Texas federal court.  They claimed that the surviving rule was arbitrary and capricious under the Administrative Procedure Act, was invalid because the Director was unconstitutionally insulated from removal by the President, was invalid because the CFPA was an unlawful delegation of congressional power, and—as a final throw-away argument made in passing—was unconstitutionally funded in violation of the Appropriations Clause of the Constitution.  The district court rejected all of these arguments, and the industry appealed to the U.S. Court of Appeals for the Fifth Circuit.

The Court’s Decision. The Fifth Circuit dismissed industry arguments that the remaining rule was arbitrary or capricious, finding that its regulations were well-grounded in the CFPA’s mandate and supported by clear evidence of injury from payday lending practices.  The court also swept aside the challenge to the CFPA as an unlawful delegation of legislative authority, an argument almost universally rejected since the New Deal.  (But see our note above on Jarkesy.)  As to the Director, the Fifth Circuit noted that the Supreme Court had invalidated the restrictions on the President’s ability to remove her, but it held that this did not mean that individual CFPB regulations were also invalid.  That left the Appropriations Clause claim.

Here, the Fifth Circuit panel of three judges departed from any semblance of well-reasoned and well-supported jurisprudence, ignoring the plain language of the Constitution, Congress’s obvious intent, and an abundance of federal court decisions to the contrary.  In fact, at least seven federal courts, including the D.C. Circuit, had already upheld the CFPB’s self-funding mechanism.  Yet the Fifth Circuit nevertheless insisted that the agency’s funding violated the Appropriations Clause. In the Court’s view—expressed in lofty but irrelevant rhetoric—the CFPB was too insulated from Congress’ control over the federal “purse strings,” thanks to its inclusion in the Fed’s budget and its exclusion from the appropriations process.

The decision suffers from profound flaws.  Perhaps most fundamentally, the Court ignored the plain language of the Appropriations Clause: That provision addresses only how funds may be “drawn from the Treasury,” while the CFPB “draws” nothing from the federal treasury. Its funding thus creates no conflict with the Appropriations Clause.  The Court also sidestepped more than a century of history:  The Federal Reserve and other federal agencies have long been self-funded without any constitutional concerns.  And it was unpersuaded by Congress’s obvious and intentional decision to insulate the CFPB from the politically fraught and potentially corrupting appropriations process—a distinct irony in light of the Court’s professed desire to protect Congress’s interest in controlling government expenditures. Finally, the Court leapt to the dramatic and unwarranted conclusion that the perceived defect in the CFPB’s funding required the Court to vacate the payday lending rule and question the validity of every aspect of the agency’s operations.  What seems clear is that the Court was driven not by the law but by an ideological desire to curb, if not destroy, one of the most effective consumer protection agencies in the history of financial regulation—a judicial activism aimed squarely at the “administrative state.”

Why It Matters.  The decision is seismic on a number of levels.  It nullifies key protections for borrowers forced into the debt traps created by payday lenders, among the most avaricious and predatory players in the credit markets.  It also threatens to open the floodgates for challenges to all sorts of other CFPB actions.  Based on the Court’s reasoning, it is hard to see which CFPB rules, orders, cases, or other actions might not be vulnerable to constitutional challenges, at least within Texas, Louisiana, and Mississippi.  Some cases of that type are already pending in those states.  And it is likely to create chaos in the financial markets under the CFPB’s jurisdiction, as even lenders and other financial institutions rely on the clear guidance, exemptions, and safe harbors provided under the CFPB’s rules.

Given the decision’s attack on the CFPB’s very foundations, the agency may well forego the typical request for rehearing by the Fifth Circuit’s full roster of judges.  That tactic has proven unsuccessful in other recent defeats.  The agency may instead seek a stay directly from the Supreme Court, while it then pursues a full petition for certiorari.  The Supreme Court can be expected to hear the case since the Fifth Circuit’s decision has clearly created a conflict among the federal circuits on an important matter, which is the principal basis on which the Supreme Court agrees to accept a case.  We must also hope that the Fifth Circuit’s extreme and distorted view of the Appropriations Clause is a bridge too far even for the bloc of conservative Justices on the Supreme Court.

THE FIFTH CIRCUIT REFUSES TO RE-THINK ITS ERRONEOUS DECISION THAT THREATENS TO DISABLE THE SEC’S ADMINISTRATIVE ENFORCEMENT MECHANISM – Jarkesy v. SEC, 34 F.4th 446 (5th Cir. three-judge panel decision issued May 18, 2022) – The Court denies the SEC’s petition for rehearing en banc in which the agency asked all of the judges 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 we previously noted. 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; 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 favor 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.  Given the profound implications for the SEC and other agencies, which rely heavily on ALJs to enforce the law, we expect the SEC to file a “petition for certiorari” asking the Supreme Court to take the case and reverse the Fifth Circuit’s decision.

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 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.

OTHER CASES WE CONTINUE TO WATCH

CRYPTOCURRENCY ENFORCEMENT – SEC v. Ripple Labs Inc.No. 1:20cv10832 (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 many 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.

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., (and In re Goldman Sachs Group, Inc.) in the United States Court of Appeals for the Second Circuit, on remand from the Supreme Court – 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.

REAFFIRIMING RETIREMENT PLAN FIDUCIARY DUTIES – Hughes v. Northwestern University, 142 S. Ct. 737 (Jan. 24, 2022) – The Court sides with retirement savers and reaffirms the duty to monitor investment options and cull overpriced offerings, and remands to the Seventh Circuit to re-evaluate the case. 

The Issue.  The Employee Retirement Income Security Act of 1974 (“ERISA”) is the primary law enacted to help ensure that those who administer retirement plans act solely in the interest of the plan participants and beneficiaries.  Among the fiduciary duties it imposes is the duty of prudence, specifically the duty to monitor plan investment options and remove those that do not serve the interests of the participants and beneficiaries.

In this case, the plaintiffs were participants in a defined contribution plan established by Northwestern University, the administrator and fiduciary of the plan.  They alleged breach of the administrator’s fiduciary duty of prudence because the plan included a dizzying array of investment funds—hundreds, in fact—some of which carried excessive recordkeeping and management fees.  The plaintiffs alleged that they suffered losses because their retirement plan administrators offered a confusing array of hundreds of investment options, failed to monitor those offerings, and failed to remove the imprudent ones with excessive investment management and recordkeeping fees.

The district court dismissed the plaintiffs’ lawsuit for failing to state a claim.  The U.S. Court of Appeals for the Seventh Circuit affirmed that ruling, largely on the ground that the plan included at least some prudent selections among its hundreds of options. According to the Seventh Circuit, Northwestern did not breach its fiduciary duty by offering its beneficiaries poorly performing and expensive investment options, because it also offered its beneficiaries investment options that were better on both counts.  Better Markets joined with AARP and other groups in an amicus curiae brief urging the Supreme Court to reverse the lower court’s decision, restore the plaintiffs’ claims, and give them a chance to prove their case at trial.

The Decision.  In a unanimous opinion written by Justice Sotomayor, the Supreme Court sided with retirement savers (and Better Markets).  The Court disagreed with the district court and the Seventh Circuit decisions that absolved plan fiduciaries because they included at least some prudent investment options along with the imprudent ones.   The Supreme Court held that, under a prior decision, Tibble v. Edison International, retirement plan fiduciaries have an ongoing duty to monitor investment options and remove those that are overpriced or otherwise imprudent.  The Court further held that offering a diverse menu of options that includes someprudent alternatives from which investors could choose did not excuse breach of that duty.

The Court remanded the case to the Seventh Circuit so that it could reevaluate the plaintiffs’ allegations in light of the standard articulated in Tibble.  The Court also observed that, “[b]ecause the content of the duty of prudence turns on the specific circumstances prevailing at the time the fiduciary acts, the appropriate inquiry will necessarily be context specific.”[1]  And in another observation seemingly aimed at giving fiduciaries some flexibility, the Court added that “courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.”[2]  Thus, for now, the Court has helped reaffirm the high standard that retirement plan administrators must follow under ERISA, the law written to protect Americans’ retirement savings—albeit with some leeway for the appellate court still to reject the plaintiffs’ claims on remand.

 

Why It Matters.  At stake in Hughes was the ability of retirement savers to protect their hard-earned money from mismanagement by plan fiduciaries who include confusing, overpriced, and underperforming investment options in their retirement plans.  As we pointed out in the joint amicus brief we filed in this case, an administrator does not meet the stringent fiduciary standard by simply offering up a huge variety of options and leaving it to the participants (who will almost always lack the financial sophistication and expertise of the financial professionals who administer ERISA plans) to fend for themselves in trying to avoid the many expensive and poorly performing choices.  The Court agreed that the Seventh Circuit’s reasoning would have introduced an element of caveat emptor to ERISA plans that Congress specifically intended to eliminate—retirement plan participants and beneficiaries are entitled to have a fiduciary safeguard their assets and protect them from expensive and substandard investments that will siphon off their retirement savings.

The case is important in part because the data show that such costly investments, even with fee rates that are excessive but not exorbitant in absolute amount, can dramatically reduce retirement savings over the long term.  The evidence also shows that private lawsuits, expressly authorized under ERISA, have proven to be an effective means of curbing such fiduciary breaches and bringing fees down across the industry.  In this case, the Court at least recognized the importance of requiring retirement plan fiduciaries to monitor investment options and to remove the imprudent offerings.

We’ll see how the Seventh Circuit re-evaluates the case in light of the principles reaffirmed by the Supreme Court.  Oral argument is set for November 29, 2022.

SEEKING TO HOLD MARKET MANIPULATORS ACCOUNTABLE – In re: Overstock Securities, et al., a class-action lawsuit on appeal in the 10th Circuit – 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.

Briefing on the merits has wrapped up, and while oral argument was  set for October 27, 2022, the Court recently postponed it with a future date to be determined.

ATTEMPTING TO FORCE ARBITRATION ON SHAREHOLDERS – The Doris Behr Irrevocable Trust v. Johnson & Johnson, a lawsuit filed in New Jersey federal district court, and now on appeal – 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 (J&J’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 filed their “notice of appeal” to the U.S. Court of Appeals for the Third Circuit on April 8.  That means more briefing, oral argument, and then a decision from the appellate court months down the road.

SEEKING TRANSPARENCY ABOUT DIVERSITY ON CORPORATE BOARDS – Alliance for Fair Board Recruitment v. SEC, in the Fifth Circuit – 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. Briefing is underway.

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, and we’ll look for a decision in the coming months.

BEGINNING (FINALLY) TO ENFORCE REGULATION “BEST INTEREST” – SEC v. Western International Securities, Inc., No. 2:22-cv-04119 (W.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.  Finally, we’ll be looking for more guidance from the SEC that can put additional meat on the bones of Reg BI.

ATTEMPTING TO TEAR DOWN EVEN MODEST PROTECTIONS FOR RETIREMENT SAVERS – Federation of Americans for Consumer Choice v. DOL (N.D. Tex. filed February 2, 2022) and American Securities Ass’n v. DOL (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 case is just one example of the relentless assault on DOL’s efforts to protect retirement savers from harmful investment offerings and advice.  This summer, a retirement plan provider filed another lawsuit challenging cautionary guidance about cryptocurrency investment options, which was issued by the DOL in March this year.  That guidance appropriately cautioned employers to use special care before offering cryptocurrency investments through retirement plans, as cryptocurrencies are among the most volatile and risky investments available today. The lawsuit claims, once again, that the DOL’s guidance violated the APA and exceeded the agency’s authority.  See ForUsAll Inc. v. DOL1:22-cv-01551 (D.D.C.).

Briefing on dispositive motions is underway and we’ll continue to watch the case.

 

 

[1] Id. (citations omitted) (internal quotation marks omitted).

[2] Id.

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