Next big test for SEC rulemaking could be State Street execs’ appeal

March 2, 2015

There’s been a lot of discussion lately of the Securities and Exchange Commission’s authority to define insider trading, thanks to the 2nd U.S. Circuit Court of Appeal’s landmark December 2014 decision in U.S. v. Newman and a statement last November by U.S. Supreme Court Justices Antonin Scalia and Clarence Thomas that questioned whether the SEC has the power to determine what constitutes criminal conduct. The commission’s redefinition of the scope of liability for civil securities fraud – in a split opinion last December in an enforcement action against two former employees of the investment manager State Street – has received much less attention. But as an appeal of the SEC opinion by the former State Street executives, John Flannery and James Hopkins, moves forward at the 1st Circuit, it could test the SEC’s authority to interpret securities law through a specific enforcement action.

I didn’t realize the significance of the commission’s opinion in the Flannery and Hopkins case until I heard mention of the case Friday at the New York University Annual Survey of American Law conference, dedicated this year to the future of securities class actions. That reference led me to an analysis of the Flannery and Hopkins ruling by former SEC chief litigation counsel Matthew Martens, now a partner at Wilmer Cutler Pickering Hale & Dorr (published in Bloomberg BNA’s Securities Regulation report). Martens’ article, written with several other Wilmer lawyers, almost certainly sets a new record for use of the words “surprising” and “perplexing” to describe an opinion by the SEC commissioners.

The decision, as the Wilmer lawyers and a couple of other commentators point out, uses the SEC’s case against Flannery and Hopkins as a vehicle to address uncertainty in the lower courts about the Supreme Court’s 2011 holding in Janus Capital v. First Derivative Traders. In Janus the Supreme Court said that only the “maker” of a false statement can be liable in a private action under Rule 10b-5 of the Securities Exchange Act of 1934. In the Flannery and Hopkins opinion (from which the two Republican-appointed SEC commissioners dissented), the SEC said that defendants who draft or devise a misstatement can still be liable under different clauses of Rule 10b than the provision the Supreme Court addressed in Janus. That interpretation, as the SEC said, is at odds with decisions by the 2nd, 8th and 9th Circuits, which have concluded that all claims involving misstatements are covered by the clause addressed in Janus and so are restricted to those who make the misrepresentations.

The SEC opinion in the Flannery and Hopkins case also defined how Janus impacts enforcement actions under Section 17(a) of the Securities Act of 1933, which has broader language about prohibited conduct than Rule 10b. According to the SEC, Janus restrictions don’t apply to Section 17(a) cases. “A defendant may be held primarily liable if he uses a misstatement to obtain money or property, even if he has not himself made a false statement in connection with the offer or sale of a security,'” the Flannery and Hopkins opinion said.

There are all sorts of additional consequences from the SEC decision’s 15 pages of policy discussion and interpretation, which ventures far from the specific facts of the commission’s actions against Flannery and Hopkins. Wilmer’s analysis, for instance, said that the SEC’s language on primary liability under 10b would expose drafters of supposedly misleading statements to private liability. And the commission’s expansion of liability under Section 17(a), according to Wilmer, could rope in counterparties to legitimate transactions that the other company used for deceptive purposes. The implications, according to Wilmer, are “potentially staggering.”

The SEC opinion justifies its de facto rulemaking by indirectly invoking the Supreme Court’s test for deference to agency interpretation in Chevron v. Natural Resources Defense Council. “By setting out our interpretation of these provisions – which is informed by our experience and expertise in administering the securities laws – we intend to resolve the ambiguities in the meaning of Rule 10b-5 and Section 17(a) that have produced confusion in the courts and inconsistencies across jurisdictions,” the decision said.

In late January, lawyers for Flannery and Hopkins filed a notice of appeal at the 1st Circuit, opting for the defendants’ home court instead of the D.C. Circuit. The appeals court hasn’t set a briefing schedule and Flannery’s lawyer, Mark Pearlstein of McDermott Will & Emery, declined to comment on the issues he intends to raise. (Hopkins counsel John Sylvia of Mintz Levin Cohn Ferris Glovsky & Popeo didn’t respond to a request for comment.)

It will be very interesting to see whether the former State Street officials tailor their appeal narrowly to the SEC’s holdings against them – or challenge the commission’s broad policy interpretations. If Flannery and Hopkins do not, I suspect business groups will want a say before this case is decided.

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