The Supreme Court
The Supreme Court is about to begin a new term on Monday, October 3rd, so now is a good time to look back on the Court’s decisions from the last term and look ahead to some important cases the Court will be deciding in the coming months. That’s exactly what we have done in our recently-released report on the Court, focusing on cases in the areas of financial regulation, administrative law, and arbitration. While the Court’s decisions on controversial social policy questions have been dominating the legal headlines for some time, the fact is that every term, the Court also decides cases addressing important financial and economic issues that profoundly affect Americans’ lives and their financial well-being.
Our report also takes a closer look at the assault on the administrative state, the system of federal regulation that has protected Americans from environmental pollution, unsafe products, and predatory financial practices for 100 years. Notwithstanding its impressive track record, some believe, including several of the conservative Supreme Court Justices, that this regulatory framework must be cut back. The Court’s recent decision in West Virginia v. EPA, solidifying the “major questions” doctrine, is part of this assault. Our report analyzes the decision in detail and examines some other principles of administrative law that may be restricted or abolished in the next term: Will the Court continue to show deference to the way expert agencies read and apply the law, or will it give the courts more leeway to second-guess agency interpretations? And will the Court resuscitate the long-dormant non-delegation doctrine and use it as a weapon to strike down whole regulatory statutes? The answers to these questions could well make a huge difference in the lives of Americans, including investors and consumers.
Over the last few years, we’ve issued a number of reports highlighting such critically important economic and financial cases, 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.
A MAJOR WIN FOR THE SEC IN THE D.C. CIRCUIT
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. Although we profiled the decision in last month’s edition, we think it’s worth reviewing again:
MAKING THE MARKETS LESS RIGGED – Citadel Securities LLC v. SEC – 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”).
The issue. In 2020, the SEC approved an innovative new order type developed by a pro-investor exchange known as IEX. The “Discretionary-Limit” or “D-Limit” order helps neutralize the trading advantages that HFT firms like Citadel have through their high-speed trading technology and preferential data access. Using those tools in a strategy known as “latency arbitrage,” HFT’s in effect get a split-second preview of the direction that stock prices are about to move, and they can quickly trade on that insight ahead of other investors, locking in near-certain profits. In an effort to neutralize this unfair advantage, IEX implemented technology that allows the price of D-Limit orders to be updated before HFTs can pounce. Citadel sought to nullify the SEC’s approval of the D-Limit order to preserve its profits, so it went to court. It claimed that the SEC had violated the Administrative Procedure Act, the federal law that establishes the legal requirements all agencies must follow when writing rules or taking other types of actions.
What we did. Better Market filed an amicus brief in the case, explaining the advantages that HFTs enjoy and the harm they inflict on investors. We also showed how the D-Limit order, which automatically resets its price when HFTs are about to strike, helps neutralize the HFTs’ unfair advantage. We urged the Court to affirm the SEC’s decision.
The Court’s decision. On July 29, 2022, in a resounding win for the SEC and its efforts to make our trading markets more fair, the D.C. Circuit issued a unanimous decision denying Citadel’s petition for review. The Court rejected all of Citadel’s arguments, finding that the SEC based its approval of the D-Limit order on “substantial evidence” and further that the agency’s judgments were “reasonable and reasonably explained.” Specifically, for example, the Court found that the D-Limit order did not unfairly discriminate or unduly burden competition; that the SEC’s prior rejection of another exchange’s efforts to combat HFT strategies was not inconsistent with its approval of the D-Limit order; and that the D-Limit order is executed “immediately” (as it must under related rules), even though it is subject to a de minimis delay to allow for nearly instant re-pricing.
The Court also reaffirmed a number of basic principles of administrative law, including the general rule that an agency’s determinations “based upon highly complex and technical matters are entitled to great deference” from a court. And the Court clearly appreciated the threats posed by HFTs’ use of latency arbitrage, characterizing the case as one in which the SEC sought to “prevent [some] investors from buying and selling securities before other investors can know that market prices have changed.” In its conclusion, the Court approved of the SEC’s reasonable determination that latency arbitrage “actually harms the market,” representing essentially a “surcharge” imposed on investors by HFTs.
Why it matters. This case represents a significant win on two levels. First, of course, it leaves intact an important market-based, private-sector innovation that helps fight unfair HFT trading practices that have begun to dominate our securities markets. In short, it will help everyday investors protect their money from being siphoned away by HFT firms. Second, the decision will help reaffirm a number of beneficial principles of administrative law that govern judicial review of agency actions. Notable among them is that courts should show great deference to agency judgments, especially where an agency is grappling with highly technical and complex issues.
OTHER FEDERAL COURT CASES WE’RE WATCHING
WILL THE FIFTH CIRCUIT RE-THINK ITS ERRANT DECISION THAT THREATENS TO DISABLE THE SEC’S ADMINISTRATIVE ENFORCEMENT MECHANISM? – Jarkesy v. SEC – The SEC petitions all of the Fifth Circuit 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 unsuccessfully attacked the constitutionality of the ALJ forum, advancing his argument in a U.S. District Court, at the D.C. Circuit, and even at the SEC itself. Seven years after the SEC brought its case, and over ten years since his misconduct, Jarkesy finally faced justice in the form of $300,000 in civil penalties, plus an order requiring him to disgorge unlawful profits, imposing a cease-and-desist order against him, 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, 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 much influence on “executive [branch] functions.” 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—in other words, for 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. We have not yet seen a final decision on the SEC’s petition. Whether the Fifth Circuit rehears the case or not, we would not be surprised to see this case end up in the Supreme Court.
Why it matters. It is hard to imagine a wider or more fundamental assault on administrative enforcement, and not just under the federal securities laws. The two-judge majority took pains to paint administrative fine proceedings as too legislative, too executive, and contrary to the Bill of Rights. 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 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.
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 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. 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 we once again filed an amicus brief 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.
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 are still lies and they 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.
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.
Status. Briefing on the merits has wrapped up and oral argument is set for October 27, 2022.
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 are 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, no surprise, consistently favors the industry. Investors and consumers rarely obtain meaningful recovery.
Status. 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.
Status: 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.
Status: 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. DOL, 1:22-cv-01551 (D.D.C.).
Status: Briefing on dispositive motions is underway.