SEC stands by ad hoc rulemaking in State Street appeals brief

July 20, 2015

Securities defense lawyers were surprised, and not in a good way, by a ruling last December in which the U.S. Securities and Exchange Commission, in a 3-to-2 decision, found two former State Street executives liable for deceiving investors, even though the two had been cleared by an SEC in-house judge. That fact alone was disquieting for defendants, but even more so was that the commissioners used the State Street case as a vehicle to reinterpret antifraud provisions of the securities laws – and then to hold one of the executives, John Flannery, liable under the reinterpretation.

To justify the commission’s right to interpret the law through an enforcement action, the SEC opinion implicitly invoked the U.S. Supreme Court’s 1984 deference to administrative rulemaking 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 (antifraud provisions) that have produced confusion in the courts and inconsistencies across jurisdictions,” the decision said.

When Flannery appealed the SEC ruling to the 1st U.S. Circuit Court of Appeals, his lawyers at McDermott Will & Emery argued that the commission reached the wrong conclusion about the Securities Act’s antifraud clauses, is not entitled to Chevron deference because the statute isn’t ambiguous and shouldn’t be permitted simply to announced new rules through an enforcement action. Even if the law were unclear, Flannery said, construing it against him would breach the rule of lenity, which requires that ambiguity in criminal statutes (or civil-and-criminal hybrids) must be resolved in the defendant’s favor. At the very least, Flannery said, the commission violated his due process right to fair notice.

Last month the U.S. Chamber of Commerce weighed in with an amicus brief backing Flannery’s rule of lenity and due process arguments.

Now it’s the SEC’s turn to have a say. In a July 15 brief at the 1st Circuit, the commission said Flannery and the Chamber are wrong about the merits of the SEC’s statutory interpretation, wrong about the deference the court must pay to the SEC’s interpretation and wrong about the agency’s discretion to issue and apply its new rule in Flannery’s case. (Hat tip to the White Collar Securities Defense Blog.)

Let’s look first at the SEC’s defense of its interpretation of the anti-fraud provision of the Securities Act. As I’ve explained, McDermott Will argued the SEC mistakenly conflated two of the three prongs of the provision in order to conclude that two alleged misstatements constitute a prohibited “course of business.” Flannery’s lawyers contend that each subsection of the Securities Act antifraud provision is intended to bar distinct conduct – misstatements are covered in the second prong and a deceitful course of business in the third – and so, according to them, the SEC reached beyond the statutory language to find Flannery liable under the third prong for supposed misrepresentations covered by the second clause.

The SEC, however, said its conclusion that two misstatements amounts to a fraudulent course of business follows directly from the text of the Securities Act. According to the agency’s brief, the Supreme Court said in the 1973 case U.S. v. Naftalin that each clause of the Securities Act provision is successively broader in scope. So under Naftalin, the SEC said, the third “course of business” clause is intended to encompass the second clause’s prohibition on misstatements.

The SEC said it regards its reading as the only one consistent with the language of the law, but it conceded that some courts have reached different conclusions. Given that uncertainty, the agency said, it’s up to the SEC to interpret the statute because it is the federal agency responsible for enforcing it. And it is up to the courts to defer to the SEC’s interpretation, the brief said, even if its view was announced in an enforcement opinion without being subject to litigation in the lower courts.

“As the Supreme Court has explained, it is the formality of the adjudicative process itself – not the nature of the arguments made – that makes deference to agency decisions appropriate,” the SEC said in its brief. “Indeed, it would turn on its head the entire justification for deference – the presumption that statutory ambiguity constitutes an implicit delegation of interpretive authority to an agency – to hold that the degree of deference somehow turns on how closely the agency hews to the parties’ litigating positions.”

Finally, the SEC argued that as an experienced securities professional, Flannery should have anticipated that drafting or approving allegedly false statements to investors would subject him to an enforcement action, so he had fair notice. As for the rule of lenity, the SEC said it simply doesn’t apply. According to its brief, lenity is only a consideration when “grievous ambiguity or uncertainty” over a statute’s provision remains even after the law has been interpreted. Here, the SEC said, whatever ambiguity exists in the Securities Act’s antifraud provision is not grievous.

And besides, according to the agency, when a statute is ambiguous, courts are supposed to look first to agency interpretation before deciding whether to apply the rule of lenity. The SEC said the Chamber of Commerce tried to gin up tension between agency deference and the rule of lenity, but there really isn’t any.

I reached out to Flannery counsel Mark Pearlstein of McDermott. He said his side will be filing a response to the SEC on Aug. 3 and declined additional comment.

(Reporting by Alison Frankel)

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