SEC Chairman Clayton identified significant issues for the SEC enforcement program in his Keynote Remarks to the Mid-Atlantic Regional Conference of the Commission’s federal and state partners in Philadelphia, Pa. last week (here). One point he identified involves the Supreme Court’s decision in Kokesh v. SEC, 137 S.Ct. 1635 (2017). A second involves Lorenzon v. SEC, 138 S.Ct. 2650 (2018). One the Chairman did not mention, but which has been percolating for years and was put into draft legislation introduced by Senators Marco Rubio and Bob Menendez at the end of last week, concerns the ability of the PCAOB to inspect the audits Chinese based issuers.
Initially, the Chairman made it clear that in his view Kokesh is impacting the Commission’s ability to return funds to investors harmed by violations of the federal securities laws. Specifically, Chairman Clayton stated that the case had an “immediate” effect on this issue: “In that particular case, only about $5 million out of the $35 million sought in disgorgement fell within the five-year period. The Division of Enforcement estimates that, for Fiscal Year (FY) 2018, the Court’s ruling in Kokesh may cause the Commission to forgo up to approximately $900 million in disgorgement in filed cases, of which a substantial amount potentially could have been returned to retail investors.”
The Chairman acknowledged the fact that statutes of limitations “serve many important functions . . .” At the same time he reiterated the offer he has made in Congressional testimony to work with law makers to address this gap in investor protection,” citing certain legislative actions by members of the House of Representatives and Senate on the question.
Not being able to recover ill-gotten gains and return it to investors who have suffered losses is regrettable. At the same time, as the Chairman noted, not only do statutes of limitations service important policy ends, but here the period is five years. That is longer than others in the federal securities laws. See, e.g., Securities Act Section 13 (statute of within 1 year of discovery or 3 years for repose).
What the Chairman did not address when discussing Kokesh is footnote 3 in the Court’s opinion. There the Supreme Court specifically reserved the question of whether the agency is entitled under the Securities Act or the Exchange Act to recover disgorgement at all. The reservation echoes a question raised by the Court during the oral argument of Kokesh. Nothing in the text of either statute specifically states that the agency is entitled to recover disgorgement.
Equally problematic for the Commission is the fact that as the remedy is viewed as a penalty. At the same time each statute specifically authorizes the SEC to seek certain defined statutory penalties. Viewed in this context SEC disgorgement is essentially an “implied remedy.” The disdain of many Justices for implied anything is readily apparent from the Court’s recent dismissal of the writ of certiorari as improvidently granted in Emulex Corp. v. Varjabedian, No. 18-459. There the question on which certiorari was granted revolved around whether negligence or scienter was the required mental state in a cause of action for damages under Exchange Act Section 14(e). The oral argument for the case was dominated by the question of whether in fact the implied cause of action for damages under Section 14(e) was appropriate as discussed here. Dismissal allowed the increasingly conservative Court to avoid resolving a question where the choices may have been to either allow the implication of a private cause of action for damages or strike down a recent decision of the Court on the question where a unanimous opinion was written by Justice Scalia. In any event, perhaps the most important point about Kokesh is that a Supreme Court decision precluding the agency from seeking disgorgement would be much more problematic for the Enforcement program than a five year statute of limitations.
Turing to Lorenzo the Chairman sought to end his “discussion on a high note – [with] the Division’s victory . . .”. As Chairman Clayton stated, “the Court affirmed the SEC’s long-held position that a person could be liable under the anti-fraud provisions for the knowing dissemination of false or misleading statements, even if he or she did not make the statements.”
To be sure, Lorenzo is an important victory for the SEC if for no other reason than it has been a considerable period since the agency prevailed in the High Court. More importantly, however, the agency has always had the ability to hold persons liable for making a false statement. The years long debate referenced by the Chairman focused only on if that person was a primary violator – the preference for the Commission – or an aider and abettor.
What Lorenzo permits the SEC to do is hold a person liable as a primary violator despite the dictates of the Court’s earlier ruling in Janus Capital Group, Inc. v. First Derivative Traders, 584 U.S. 135 (2011). Janus held that the person be the “maker” of the statement to violate subsection (b) of Rule 10b-5. Following that decision, the Commission relied on a “scheme liability” theory to support claims of primary liability for those who were not a “maker.” The rulings on the question were split.
Lorenzo does not discuss the Commission’s scheme liability theory. Rather, the Court simply reiterated its earlier Central Bank decision, noting that if the conduct falls within the language of the section there is a primary violation. That means, for example, that to establish primary liability for a non “maker” in a false statements case the SEC will have to plead and prove that the person engaged in “manipulative and deceptive practices. . .” or that the alleged wrongful conduct falls within other specific language of the section. While the Commission prevailed in Lorenzo, in the end the agency may not find the ruling quite the panacea it sought. That may be particularly true as the High Court trends more conservative, relying only the text of the statute and a dictionary for interpretation while eschewing traditional methods of statutory analysis.
Finally, a key point the Chairman did not mention is the issue reflected in the legislation proposed by Senators Rubio and Menendez – the PCAOB inspection of Chinese issuers. The bill seeks to effectuate the promise of the Sarbanes Oxley Act by requiring auditors of China based issuers to permit inspections. From the beginning the Chinese government has largely refused. Despite enforcement actions, and repeated discussions between U.S. and Chinese officials, little has changed over the years. The legislation seeks to remedy this situation. Whether the bill can be passed and signed into law is questionable at best. If it is, this legislation may have a significant impact. Likewise two points presented by Chairman Clayton may also have a significant impact on U.S. markets, investors and SEC enforcement.
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