SEC not entitled to deference in State Street fraud appeal – law prof

September 14, 2015

(Reuters) – When it comes to Securities and Exchange Commission enforcement litigation, the constitutionality of in-house proceedings is dominating journalists’ coverage (including mine). Former SEC officials, though, are dedicating a lot of attention of late to a less sexy – but perhaps more lastingly significant – question: Can the SEC redefine the parameters of securities fraud through a final determination in an enforcement action?

That question, as I’ve reported, is now before the 1st U.S. Circuit Court of Appeals in a case involving two former executives of the investment adviser State Street. Last December, in a 3-2 ruling, the SEC commissioners overruled their own in-house judge and held the former State Street execs liable; one, James Hopkins, under Rule 10b-5 of the Securities Exchange Act of 1934 and the other, John Flannery, under Section 17a of the Securities Act of 1933. The commission majority used its opinion in the State Street case to clarify liability for those it considers responsible for making misstatements to investors in the wake of the U.S. Supreme Court’s 2011 decision in Janus Capital v. First Derivative Traders.

Flannery’s lawyers at McDermott Will & Emery told the 1st Circuit in June that the SEC’s interpretation of the Securities Act’s fraud provision is a misreading of the statute – and, moreover, that the commissioners’ analysis is not entitled to deference under the 1984 U.S. Supreme Court decision in Chevron v. Natural Resources Defense Council because, among other reasons, Flannery didn’t receive fair notice of the SEC’s position, which was articulated for the first time in its ruling against him. The U.S. Chamber of Commerce chimed in with an amicus brief backing Flannery later that month at the 1st Circuit. The Chamber brief focused on the rule of lenity, which dictates that ambiguity in hybrid civil-and-criminal statutes must be resolved in favor of defendants.

The most thorough discussion I’ve seen of the defense side of the issue is a working paper by University of Virginia law professor Andrew Vollmer, a former deputy general counsel at the SEC. I’m a bit late to Vollmer’s paper, which he first posted at SSRN in July. (The excellent blog Securities Diary covered it at the time.) But Vollmer highlighted his work again last week at Columbia Law School’s Blue Sky Blog, so I figured it’s still timely, especially because the 1st Circuit hasn’t yet scheduled oral arguments in the Hopkins and Flannery appeals, although briefing is closed.

Vollmer believes the SEC’s analysis in the State Street opinion contradicts the Supreme Court’s consistent efforts to rein in liability for secondary players in Janus and the cases that led up to it, Central Bank of Denver v. First Interstate Bank of Denver and Stoneridge v. Scientific Atlanta. He also asserts the SEC used its opinion in State Street a vehicle to regain administratively the ground it lost in those Supreme Court cases – a troubling development, according to Vollmer.

“If these concerns have merit, the actions of the SEC, an administrative agency within the executive branch, are unsettling,” he wrote. “They take the stare out of stare decisis, rattle the stability of legal rules, upset traditional expectations about the role of the courts in the development of the law and head toward a society ruled by bureaucratic fiat rather than ordered by laws.”

But according to Vollmer, federal courts need not – actually, should not – pay deference to the SEC’s interpretation. Unless courts halt the SEC from issuing controversial new liability standards through enforcement decisions, the professor said, “it would empower the SEC to cut short and silence the normal process in the federal courts for testing and establishing the limits of liability provisions, and it would enable the SEC to tip the scales in enforcement cases by converting its litigating positions into nonreviewable legal interpretations.”

Vollmer offers a long list of justifications for denying the SEC Chevron deference on the interpretation of the Securities Act and even so-called Seminole Rock deference for its interpretation of its own Rule 10b-5, in addition to the due process and rule of lenity arguments I’ve already mentioned. For one thing, he said, the courts are actively engaged in determining the parameters of securities fraud liability for defendants who are not primarily responsible for deceptive statements. The commission “did not just want to add its voice to the debate among the courts [but] wanted to silence and win the debate,” he wrote. “The genius of the federal judicial system will reach considered and informed final conclusions about the scope of primary liability under the anti-fraud provisions. The courts should not let the commissioners’ claim to Chevron dominance cut this debate or process short.”

Moreover, defining securities fraud liability is nearly a pure question of law, and the SEC’s new interpretation in the State Street decision does “not tap into the SEC’s expertise in a material way,” according to Vollmer. “A reviewing court should treat the SEC adjudication as a trial court judgment,” he wrote. “The agency’s views on the law should be taken into account and might be insightful and persuasive, but the final decision is for a court not the SEC.”

So what is the SEC’s take? The commission filed its response brief in the Flannery and Hopkins appeals in July. The brief is mostly dedicated to defending the commissioners’ view of the facts of the State Street cases rather than the SEC’s right to clarify liability. The SEC contends its interpretation of the Securities Act flows directly from the text of the law and that to the extent the statute is ambiguous, the SEC’s interpretation is reasonable and should have been foreseen by the State Street defendants.

Arguments that the commissioners should not be able to adopt statutory interpretations through decisions in enforcement actions, according to the SEC, ignore Supreme Court precedent on the administrative process. “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 brief said. “Merely because Flannery disagrees with the end result of that process does not mean that deference is less warranted. 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.”

Not surprisingly, McDermott Will’s Aug. 4 reply to the SEC on behalf of Flannery cites Vollmer’s paper. It also claims the SEC lost its right to deference when the agency implied in its brief that the language of the Securities Act is not ambiguous.

As I mentioned, the 1st Circuit hasn’t yet scheduled oral arguments. But I’ll be keeping an eye on the docket.

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