by T. GormanPosted on Posted in SECActions

The Supreme Court may reshape SEC Enforcement by the end of this Term. The Court has already heard argument in Lorenzo v. SEC, No. 17-1077where the critical issue is the scope of primary liability under Exchange Act section 10(b). That case is discussed here and was analyzed at the Fifth Annual Federal Enforcement Forum here.

Argument later this year will be held in Emulex Corp. v. Varjabedian, No. 18-459. There the key question is whether Exchange Act section 14(e) provides a negligence-based cause of action for damages which echoes Securities Act sections 17(a)(2) and (3). The action is analyzed below.

Emulex

The issue for resolution centers on whether one component of section 14(e) imposes a negligence standard rather than scienter. The section provides in pertinent part that: “It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact . . . or to engage in any fraudulent, deceptive or manipulative act . . .” in connection with any tender offer.

Petitioner (defendant below) phrased the issue for resolution this way: “Whether the Ninth Circuit held, in express disagreement with five other courts of appeals, that Section 14(e). . . supports an inferred private right of action based on a negligent misstatement or omission made in connection with a tender offer.”

Respondent (plaintiff below) phased the issue for resolution differently: “”Section 14(e) . . . sets out two distinct forms of liability . . .” one for materially untrue statements and a second for manipulative or deceptive devices. “The question presented is: Whether an action premised solely on section 14(e)’s first clause, not its second, requires a pleaded of scienter to state a claim.” Neither party specifically presented the question of whether a cause of action for damages could be implied under the section.

Background

The action is based on the merger of two technology companies. One is Emulex, a producer of equipment for data centers. The other is Avago Technologies Wireless (USA), a leading designer and developer of analog semiconductor devices. The two firms jointly announced the merger on February 25, 2015. Under the terms of the deal $8 would be offered for each outstanding share of Emlex stock, a 26.1% premium to the stock closing price the day before the announcement.

The deal papers included the standard recommendations from the firm and a fairness opinion. A table compiled by Goldman Sachs, adviser to Emulex, was known as the Premium Analysis. According to Petitioner, that Table showed that “the 26.4% premium on the share price. . . was within the range of transaction premiums identified in these unrelated semiconductor transactions . . .” Respondents state that the “analysis revealed Emulex’s premium was decidedly below average . . .” Shareholders narrowly approved the transaction. This suit followed.

The district court dismissed the amended complaint with prejudice. The court rejected plaintiff’s claim that a negligence standard applied. The Ninth Circuit Court reversed. After noting that five circuit courts had adopted a scienter-based standard for section 14(e) private suits, the Court remanded the action to the district court for further consideration.

Petitioners

Petitioners’ (Defendants below) argument is built on three basic points: First, the Circuit Court’s decision contradicts the uniform judgment of every circuit which has considered the question. Second, the Circuit Court’s decision is wrong as a matter of law. Finally, the question presented here is of “exceptional importance.”

First, each Circuit Court which has considered the question agrees that section 14(e), like section 10(b), requires proof of scienter, not negligence. The first was the Second Circuit in Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480 F. 2d 341 (2nd Cir. 1973). There the Court noted the similarity of language between the two Exchange Act sections and concluded that negligence is not sufficient to contravene the provision. Subsequently, the Fifth, Sixth, Eight and Eleventh Circuit reached similar conclusions. Smallwood v. Pearl Brewing Co., 489 F. 2d 579, 606 (5th Circ. 1974); Adams v. Standard Knitting Mills, Inc., 623 F. 2d 422 431 (6th Cir. 1980); In re Digital Island Securities Litigation, 357 F. 3d 322 (3rd Cir. 2004); SEC v. Ginsburg, 362 F. 3d 1292, 1297 (11th Cir. 2002). While the Ninth Circuit recognized this fact, the Court concluded that the analysis of each Circuit was incorrect and not in accord with that of the Supreme Court’s decisions in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) and Aaron v. SEC, 446 U.S. 680 (1980).

Second, the decision of the lower court is incorrect because it “upsets” the statutory scheme enacted by Congress. The 1933 and 1934 Acts “constitute interrelated components of the federal regulatory scheme governing transactions in securities,” according to Petitioner. When Congress created express causes of action imposing civil liability it added significant procedural restrictions such as a short statute of limitations and a bonding requirement for defendant’s costs and attorney’s fees.

The same should be true here if there was a negligence-based claim which there is not. When the Supreme Court acquiesced and accepted the implied cause of action under section 10(b), it focused on the overall thrust of the statute and statutory words such as “fraudulent,” “deceptive, and “manipulative” which connote scienter, not negligence. The Court also noted that where Congress enacted civil remedies based on negligence there were significant procedural restrictions. Here the statutory language suggests scienter and the procedural restrictions necessary for negligence are absent.

Finally, the question presented in this case is “undeniably important and one that warrants this Court’s review,” Petitioner told the High Court. The proper administration of the federal securities laws is critical to the effective functioning of the capital markets. Even before the decision in this case the Ninth Circuit was a “magnet” for securities litigation. That highlights the important of employing the correct standard in securities litigation. Indeed, Judge Friendly observed in SEC v. Texas Gulf Sulphur Co., 401 F. 2d 833 (2nd Cir. 1968) that the consequences of implying a cause of action based on negligent misstatements or omission in a securities filing are “frightening.” The decision to adopt such a standard in this case is thus seriously misguided and should be rejected.

Respondents

Respondents brief is the reverse mirror image of Petitioners’. It is built on three key points: First, there is no circuit split. Second, the decision below is correct. Third the petition does not warrant consideration by the Court.

First, there is no circuit split on the on the standard of conduct required to violate the first clause of section 14(e): “Contrary to petitioners’ contention, the Ninth Circuit did not create a genuine circuit conflict. Petitioners cannot identify a single circuit actually deciding the issue after analyzing Section 14(e)’s first clause, especially in a case post-dating this Court’s authoritative decisions.” (emphasis original). Respondents then dissect each case cited by Petitioners in an effort to demonstrate that none properly considered the language in the first part of the statute in view of Hochfelder and Aaron:

· Second Circuit in Chris-Craft Industries: The case predates the Supreme Court’s decisions in Hochfelder and Aaron;

· Fifth Circuit in Smallwood: This case also predates the key Supreme Court cases;

· Sixth Circuit in Standard Knitting Mills: This decision is based on sections 10(b) and 14(a) but not 14(e).

· Third Circuit in In re Digital Island: In this case the issue regarding the applicable standard for section 14(e) was conceded by both parties – not decided by the court; and

· Eleventh Circuit in SEC v. Ginsburg: This is an insider trading case – the critical issue is not presented here.

Second, the question regarding the applicable standard should be governed by the plain language of the first clause in the section. Virtually the identical language regarding misstatements and omissions was considered by the Court in Hochfelder and Aaron. In each case the Court concluded that the plain text of the provision – either rule 10b-5 or Securities Act section 17(a)(2) and (3) reflected a negligence standard. For section 10(b) the words of the statute however controlled the broader language of rule 10b-5, mandating a scienter standard. That was not true in the case of Securities Act section 17(a). Here the same should be true – the plain text of the statute should govern. That mandates a negligence standard for the first clause.

The claim by Petitioner that the statute must be read in its totality, rather than evaluated clause by clause should be rejected. There is simply no reason to ignore the first clause of the section.

Finally, the question presented here is clearly not of import. Not only is there no Circuit split, in view of the Court’s prior cases there is more than adequate guidance for the lower courts. This counsels permitting the issue to be considered and developed by those courts.

The effort by Petitioners to “obliquely suggest the Court should grant review on a question the Ninth Circuit did not decide: whether Section 14(e) provides a private right of action at all should be rejected.” That issue was not presented or considered by the lower courts. It has not been presented here.

Comment

In granting certiorari in Emulex the Supreme Court has set the stage for having a significant impact on enforcement actions by the SEC as well as in private securities litigation. The issues presented by Lorenzo and Emulex each turn on a question of statutory interpretation – the scope of primary liability for the former and the state of mind requirement for the latter. The question in each case centers on an issue that will impact the scope of a cause of action in an SEC enforcement action and a private damage action – in each type of case the cause of action turns on the language of the statute. Lorenzo and Emulex may thus rewrite securities litigation.

Nevertheless, the collective impact of these cases may be negligible by the end of the Term. At oral argument the High Court showed little appetite for rewriting the scope of primary liability under section 10(b). To the contrary, the Court seemed much more inclined to reaffirm its earlier decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) which held that the text of the statute governs the scope of a cause of action under the section. Such a holding could give the SEC its first supreme court win in some time and permit the agency to continue using the approach to section 10(b) it has employed for years.

Finally, Emulex could be resolved by finding that there is no implied cause of action under section 14(e). While this issue has not been specifically presented by either party, it is in fact subsumed within the claim both parties agree has been properly presented. Such a ruling would not only be consistent with the Court’s apparent disdain for implied causes of action but its growing conservative tilt. The end result of Lorenzo and Emulex, viewed in this context, may well be the status quo.

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by T. GormanPosted on Posted in SECActions

The Government partial shutdown continued this week with no end in sight. That left the SEC with a skeletal staff handling essential matters such as litigation since the federal courts continue to operate even if their websites do not. Despite the dysfunction, the agency did manage to partially settled one enforcement action.

The Supreme Court agreed to hear another securities case this Term. The issue for resolution centers on whether Exchange Act section 14 has a negligence standard. Last month the High Court heard argument in Lorenzo which focus on the scope of primary liability under Exchange Act section 10(b), discussed at the Federal Enforcement Forum on December 5, 2018 (here). Together these two cases could have a significant impact on the scope of primary liability in SEC and private securities fraud and tender offer cases.

Foreign securities regulators continued to operate during the U.S. government partial shutdown. ESMA, the EU regulator, issued a release suggesting points to consider in the regulation of crypto currency. The U.K.’s Serious Fraud Office narrowed the scope of its corruption investigation involving Rolls Royce, notifying a number of individuals that they are no longer under investigation.

SEC

National Exam Program: The Commission’s Office of Compliance Inspections and Examinations or OCIE announced its 2019 Examination Priorities just before Christmas and the beginning of the current Government partial-shutdown (here). The focus of the 2019 Program differs from that of 2018, although its risk-based essence and key points are similar. This year the program is built on five points: Promoting compliance; preventing fraud; identifying and monitoring risk; and informing policy. Those pillars distill into five broad exam topics: Retail investors and seniors; registrants responsible for critical market infrastructure such as clearing agencies and exchanges; FINRA and MSRB; digital assets; cybersecurity; and AML.

Supreme Court

The High Court agreed to hear another securities case this week. Emulex Corporation v. Gary Varjabedian, No. 18-459. The question the Court agreed to hear, as phrased by Petitioner, is: “Whether the Ninth Circuit correctly held, in express disagreement with five other court of appeals, that Section 14(e) of the Securities Exchange Act of 1934 supports an inferred private right of action based on a negligent misstatement or omission made in connection with a tender offer.”

Private suits

Gage order: The Cato Institute filed suit against the SEC claiming that section 202.5 of 17 C.F.R. – what the it calls a “Gag Regulation” — violates the First Amendment guarantee of free speech. The section is the predicate for provisions in Commission settlement agreements that preclude those resolving an action without admitting or denying from later denying the allegations in the charging document. The Institute’s complaint is based on an agreement to publish a book by a person who settled a Commission enforcement action containing such a provision. The book contains claims of overreaching and misconduct by the SEC staff. The Gag Regulation prohibits the publication of the book, according to the complaint. The Institute seeks the entry of a permanent injunction “against enforcement of the Gag Regulation” and a declaratory judgment that the provision is “unenforceable as a matter of law.” The identity of the book’s author is not revealed in the complaint. Cato Institute v. United States Securities and Exchange Commission, Civil Action No. 1:19-cv-00047 (D.D.C. Filed Jan. 9, 2019).

SEC Enforcement – Filed and Settled Actions

No new enforcement actions were filed this week in view of the Government shutdown. One action was partially settled however.

Offering fraud: SEC v. American Growth Funding II, LLC, Civil Action No. 16-cv-00828 (S.D.N.Y.) is a previously filed action which named as defendants: American Growth; Portfolio Advisors Alliance, Inc., a registered broker dealer; Ralph Johnson, the managing member of the AGF entities; Howard Allen III, a registered representative and an indirect owner of PAA; and Kerri Wasserman, President of PAA. The complaint alleges that American Growth, which supposedly provides loans to businesses, raised about $8.6 million from 85 investors through the sale of its units under a private placement memo from early 2011 through the end of 2013. The sales were predicated on on a series of misrepresentations, according to the complaint. During the period the primary asset of American Growth was a loan from an affiliate that had greatly deteriorated in value and for which the likelihood of repayment was imperiled. Nevertheless, investors were promised 12% returns. The complaint alleges violations of Exchange Act section 10(b) and each subsection of Securities Act section 17(a). On January 4, 2018 Judge Kimba Wood held a settlement conference in anticipation of the start of trial on January 7. The company and Mr. Johnson agreed to settle. Although the terms were not disclosed, and no papers were filed with the Court, Judge Wood continued the trial as to the remaining defendant.

Court of Appeals

Rajat K. Gupta v. U.S., Nos. 15-2707 & 15-2712 (2nd Cir. Jan. 7, 2019). Defendant was at one time a director of Goldman Sachs and McKinsey & Co. Mr. Gupta’s initial appeal of his insider trading conviction centered on the question of whether certain wire tape evidence regarding the claimed illegal tips he made to Raji Rajaratnam of Galleon Fund should have been excluded while other evidence he offered should have been admitted at trial. The Court rejected the claims. U.S. v. Gupta, 474 F.3d (2nd Cir. 2014).

The current appeal was based on one key issue regarding the jury instructions – whether the personal benefit element of an insider trading claim was incorrectly defined. Specifically, the Court told the jury that the government must prove Mr. Gupta engaged in insider trading “in anticipation of receiving at least some modest benefit in return” and that the benefit “does not need to be financial . . . It could include . . . maintaining a good relationship with a frequent business partner . . .” In presenting this issue Mr. Gupta admitted that he failed to properly present the issue at trial, but argued that default should be excused because of prejudice or actual innocence.

To excuse the default Mr. Gupta was required to demonstrate either cause or actual prejudice, according to the Court. To sustain this burden defendant must establish some objective factor external to the defense. This means that “the prejudge that must be shown is ‘not merely whether the instruction is undesirable, erroneous, or even universally condemned,’ but rather ‘whether the ailing instruction by itself so infected the entire trial that the resulting conviction violates due process,’” quoting U.S. v. Frady, 456 U.S. 152, 165 (1982).

Although Mr. Gupta ties his objection to the Court’s determination in U.S. v. Newman, 773 F. 3d 438 (2nd Cir. 2014) which was decided after his trial, “he presents no viable claim that the personal benefit challenge was unavailable to his counsel on appeal,” the Court stated. More importantly, Mr. Gupta has failed to show prejudice – that the personal benefit instructions he challenged were “so flawed as to deny him due process.” Indeed, his contention that the personal benefit must be more than just the relationship between the two men and financial in nature ignores the context here and the teachings of the Supreme Court in Dirks v. SEC, 463 U.S. 646 (1983) and Salman v. U.S., 137 S.Ct. 420 (2016).

Finally, on the claim of actual innocence, Mr. Gupta failed to demonstrate in view of all the evidence that no reasonable juror would have convicted him. To the contrary, the record is replete with examples of Mr. Gupta calling Mr. Rajaratnam with inside information; of trading by Galleon in which Mr. Gupta had a stake and of profits being made. A record built on such evidence fails to establish actual innocence.

ESMA

Crypto currency: The European Securities and Market Authority published its Advice to the European Union Institutions – Commission, Council and Parliament. Specifically, ESMA, in conjunction with the National Competent Authorities, has analyzed the questions surrounding crypto-currency and identified a number of concerns. For those that qualify under MiFID, there are areas that require potential interpretation or reconsideration to ensure effective regulation. Where the assets are not financial instruments, at a minimum the Anti-Money Laundering requirements should apply. In addition, there should be appropriate disclosure so that consumers are aware of the potential risks prior to committing funds to crypto-assets (here).

Germany

CFDs: BaFin, the Federal Financial Supervisory Authority, published a general draft administrative act which is intended to maintain the existing prohibition against the use of contracts-for-a-difference or CFDs by retail investors. The ban was first imposed by BaFin in May 2017. Subsequently, ESMA implemented a similar ban in August 2018. The new draft is intended to keep regulations in accord with those of ESMA and prevent attempts to circumvent regulation.

Hong Kong

Consultation: The Securities and Futures Commission released a consultation paper on the reform of fees and costs discourse for superannuation and managed investment schemes. Specifically, the agency is seeking to ensure that consumers can obtain adequate information regarding fees and costs and that the disclosure regime is practicable for the industry (here).

U.K.

Insider trading: The Financial Conduct Authority announce that Fabina Abdel-Malek and Walid Anis Choucair will each be re-tried on five counts of insider dealing beginning on 15 April 2019 at Southwark Crown Court.

Corruption: The Serious Fraud Office has narrowed its investigation of bribery and corruption in the on-going Rolls-Royce inquiry. The company admitted wrongful conduct in entering into a deferred prosecution agreement with the SFO and U.S. and Brazilian regulators in 2017. The SFO has continued to investigate in an effort to identify those involved. Recently the SFO confirmed that it had notified a number of individuals that they were no longer suspects in the Rolls-Royce investigation. The charging decisions in the matter have not been made however (Jan. 8, 2019).

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