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Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 3a)

The Rules

The rules, as adopted, are intended to implement the legislative intent as expressed in the statute and to make crowdfunding a feasible alternative to the normal methods of capital formation by small businesses in Colorado—a “friends and family” private placement or intrastate offering, venture capital financing, or a state- or federally-registered public offering. Because the CF Act is based on the federal intrastate exemption, it can only be used by Colorado businesses soliciting funds from Colorado residents, primarily for use in Colorado. The securities offered and sold pursuant to the CF Act must “come to rest” in Colorado—meaning that there have to be transfer restrictions imposed under Rule 147 to ensure that, for at least twelve months, they are not transferred to persons who are not Colorado residents.

The Issuer and Disclosure. The CF Act contemplates, and the rules provide for, the issuer giving a broad public notice to persons who may be interested in the offering. The notice may be in print format or in electronic format (through email, social media, or otherwise), but must be limited to Colorado residents. Following the guidance of SEC Compliance and Disclosure Interpretation 141.04, Colorado Rule 3.24.I provides that where an electronic-based notice “sent by or on behalf of the issuer” has appropriate legends and warnings, the public notification is permitted, even where it may be accessible to non-Colorado residents.

The CF Act and the rules (especially Rule 3.22.B) impose the obligation for full and fair disclosure on the issuer seeking to raise funds from the crowd. The rules include Form CF-2 which forms the basis for disclosure, although it is expected that many issuers will also use a memorandum format or a business plan for disclosure which they will incorporate by reference into the Form CF-2. It is likely that prospective investors will want to perform further due diligence and make inquiries of the issuer. Where the discussions with prospective investors lead the issuer to disclose material information not already contained in the Form CF-2 disclosure, the issuer must amend the Form CF-2 disclosure within five business days (Rule 3.22.D). Where material events have occurred after the filing of the initial Form CF-2 (or after the filing of any amendment), the issuer must appropriately amend the disclosure within five days.

The Investors. The investors must be Colorado residents. In fact, using language similar to SEC Rule 506(c), the CF Act requires that before making any sales, “the issuer shall obtain documentary evidence from each prospective purchaser that provides the seller with a reasonable basis to believe that the purchaser meets the [Colorado residency] requirements.” (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)) This arguably requires more than a simple investor affirmation as to residency since it requires “documentary evidence.” This language suggests that the issuer must review and maintain copies of the investor’s driver’s license, state voting registration, utility bills, or other documentary evidence to establish residency in addition to the investor’s affirmation.

No person may invest more than $5,000 in a crowdfunding offering unless that person is an “accredited investor” as that term is defined by the SEC. If a person is an accredited investor, there is no statutory limitation on the investment amount (subject to the maximum limits of the crowdfunding offering). In determining whether a person is an accredited investor, Rule 3.24.A.1 requires the issuer to have a “reasonable basis” for establishing the accredited investor status. This is language that is similar to Rule 506(c)(2)(ii) (which requires that the issuer “take reasonable steps to verify that purchasers” are accredited investors). It is not likely that an investor self-certification will be sufficient if challenged.

In any crowdfunding offering in Colorado, the prudent issuer will require the purchaser to sign (electronically or on paper) a subscription agreement or investment letter warranting residency and acknowledging the restrictions on ownership and further transferability of the security. The subscription agreement or investment letter will also likely follow the normal form for such documents and include warranties by the purchaser that:

  • he/she has been fully informed about the transaction, the risks, and the issuer;
  • the purchaser is acquiring the securities for investment purposes only and without a view toward further distribution;
  • the purchaser is aware of the transferability restrictions to which the crowdfunding securities are subject; and
  • the purchaser has consulted with legal counsel and other advisors as the purchaser has determined to be necessary or appropriate in the circumstances.

These investor representations and supporting documentation are information that the issuer and the on-line intermediary must maintain for at least five years. (Rules 3.23 and 3.25)

The On-Line Intermediaries. The CF Act contemplates, and the rules provide for, the crowdfunding offerings being accomplished through broker-dealers, sales representatives, or on-line intermediaries. Where broker-dealers or sales representatives are involved, the CF Act and the rules defer to FINRA which regulates broker-dealers and sales representatives. The Colorado Securities Act was amended to define “on-line intermediary” (C.R.S. § 11-51-201(11.5)) and to describe certain prohibited activities (C.R.S. § 11-51-308.5(3)(c)(III)). As set forth in the statute and the rules (and especially Rule 3.29.A):

  • On-line intermediaries cannot handle or possess funds or securities in the offering process.
  • On-line intermediaries cannot own a financial interest in any crowdfunding participant or receive compensation that is based on the amount raised.
  • On-line intermediaries cannot be affiliated with or under common control with an issuer conducting a crowdfunding offering through that intermediary.
  • On-line intermediaries cannot offer investment advice or recommendations or solicit purchases or sales of securities displayed on its website (but is merely a repository for the information displayed).
  • On-line intermediaries must post the disclosure documents, and likely will have extensive terms and conditions, risk warnings, and investor acknowledgements that must be accepted as a condition precedent to the investor continuing to the funding site.
  • On-line intermediaries have specific record-keeping obligations, and must take steps to ascertain that the persons viewing crowdfunding offerings through their website are in fact Colorado residents.
  • On-line intermediaries may generally advertise their website but may not “identify, promote, or otherwise refer to a security offered by it.’ (C.R.S. § 11-51-308.5(3)(c)(V)).

The CF Act amended the Colorado Securities Act to exempt on-line intermediaries acting within the limitations of the CF Act from the registration requirements for broker-dealers and sales representatives. (C.R.S. § 11-51-402(1)(c)) Where an on-line intermediary reaches beyond the narrow scope of permissible actions described in the statute and the rules, the on-line intermediary may venture into broker-dealer territory. For example, an on-line intermediary who sends out an issuer-specific notification to its email list may be considered to be “engaged in a solicitation”; on the other hand, an affiliate of the on-line intermediary that is not an alter ego of the on-line intermediary may be able to provide these and other services in the nature of “marketing” or “crowd formation” to the issuer. Transaction-based compensation and direct solicitation and marketing is likely to result in broker-dealer classification, however. In this consideration, it is important to note that a number of on-line intermediaries doing business in other states are in fact licensed broker-dealers.

Subject to the requirements of Rules 3.27 and 3.28.C (discussed below), the role of an on-line intermediary may be passive—a bulletin-board like posting service. In some cases, the on-line intermediary may have a more active role. The rules contemplate that an issuer may contract with an on-line intermediary to collect residency information and preserve records for the benefit of the issuer, but this remains the issuer’s responsibility. (Rule 3.23.B) To help on-line intermediaries identify the boundaries of its role as compared to that of a broker-dealer, the rules also provide that an on-line intermediary that “does nothing more than collect information regarding the purchase of securities” and “provides a link to transmit funds to the escrow agent” is not conducting a prohibited act. (Rule 3.29.B)

Rules 3.27 and 3.28.C impose certain obligations on on-line intermediaries which require the on-line intermediary to be more involved than the typical bulletin-board posting.

  • Rule 3.27 requires on-line intermediaries to establish “written supervisory procedures and a system for applying such procedures that is reasonably expected to prevent and detect violations of the Colorado Securities Act, given the limited role of the on-line intermediary under the CF Act.”
  • More significantly, Rule 3.28.C requires that the on-line intermediary affirmatively “deny access” to an issuer where the on-line intermediary has a “reasonable basis for believing”:
    • that the issuer is not in compliance with § 11-51-308.5;
    • has not established a means to keep accurate records; or
    • that the issuer or offering presents the potential for fraud or otherwise raises concerns regarding investor protection.

The use of the phrase “reasonable basis” in the context of Rule 3.28.C does not necessarily impose a due diligence obligation on the on-line intermediary; it does not permit the on-line intermediary to ignore facts that would come to its attention that might suggest the negatives set forth in the Rule. The wording of this rule creates an affirmative obligation to “deny access” only when the intermediary reasonably believes wrongdoing is occurring. This prohibits “willful blindness” on the part of the on-line intermediary; however, it does not require the same level of due diligence as (for example) the rule requiring the issuer to reasonably believe that the investor is a Colorado resident (C.R.S. §§ 11-51-308.5(3)(a)(I) and (VIII)), which requires documentary confirmation, or Rule 3.24.A.1, which requires an affirmative “reasonable basis” for determining that a purchaser is an “accredited investor” to take advantage of that provision.

With experience, the on-line intermediary may become the driving force behind crowdfunding in Colorado. Where the on-line intermediary has established a successful track record of relationships with escrow agents and investors, they may attract issuers. Where the on-line intermediary has offered record retention services and other permitted services at a reasonable cost, the on-line intermediaries will be instrumental in the success of the offering and compliance with the CF Act. Because an investor may use an on-line intermediary for more than one crowdfunding investment, the on-line intermediaries will likely look at the investors as their clients—not the issuers. Hopefully this will assist in the goal of investor protection which is the focus of the Colorado Securities Act.

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 2)

The Colorado Crowdfunding Act

The CF Act requires that the issuer and the offering be exempt from the registration requirements of federal law pursuant to the intrastate exemption set forth in § 3(a)(11) of the Securities Act of 1933 and Rule 147 adopted by the Securities and Exchange Commission (the “SEC”). The CF Act was discussed in detail in the April 2015 Business Law Section Newsletter, but the CF Act was not self-implementing. Although effective August 5, 2015, the CF Act required rulemaking from the Colorado Division of Securities (the “Division”) to be implemented.

In order to be adopted before the effective date of the CF Act, on July 29, 2015, the Division acted on an emergency basis to adopt Rules 3.20 through 3.30 after publishing draft rules and receiving public input. (The rules are found in the Code of Colorado Regulations available through the Secretary of State’s website at 3 CCR 704-1:51-3.20 et seq.) Formal decision making under the Colorado Administrative Procedure Act (C.R.S. § 24-4-101 et seq.) will occur this fall. C.R.S. § 24-4-103(6)(a) provides that emergency rules are effective for no more than 120 days after adoption. The final rules will be considered at a hearing to be held on August 31, 2015, at 1:30 pm.

It is important to note that no issuer may use the CF Act “in conjunction with any other exemption pursuant to section 11-51-307, 11-51-308, or 11-51-309 during the immediately preceding twelve-month period” (C.R.S. § 11-51-308.5(3)(a)(XI)). The precise meaning of this statutory language is not clear. Does it mean that an issuer that has issued securities pursuant to one of those Colorado exemptions in the prior twelve months is unable to raise funds under the CF Act? Or does it mean that the prior offering and the crowdfunding offering somehow have to be related, part of a “single plan of financing”?

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 1)

House Bill 2015-1246, the Colorado Crowdfunding Act (“CF Act”), became effective August 5, 2015. The CF Act added C.R.S. § 11-51-308.5 to the Colorado Securities Act (§§ 11-51-101 et seq.) to establish an exemption from registration under the Colorado Securities Act for capital formation for small businesses seeking up to $1 million ($2 million if audited financial statements are available) from a crowd of prospective investors in what looks much like a public offering of securities. The primary sponsors were Representatives Pete Lee and Dan Pabon and Senators Mark Scheffel and Owen Hill, and it passed through the 2015 Colorado General Assembly almost unanimously. According to the legislative declaration:

  • Start-up companies play a critical role in expanding economic opportunities, creating new jobs, and generating revenues; and
  • Lack of access to capital is an obstacle to starting and expanding small business, inhibits job growth, and has negatively affected the state’s economy.

The General Assembly also determined that, in its judgment, costs and complexities of compliance with the existing registration or exemption requirements of the federal and state securities laws “can outweigh the benefits to Colorado businesses seeking to raise capital by small securities offerings” and that “crowdfunding…raising money on-line through small contributions from a large number of investors…will enable Colorado businesses to obtain capital, democratize venture capital formation, and facilitate investment by Colorado residents in Colorado start-ups, thereby promoting the formation and growth of local companies and the accompanying job creation.” Will the CF Act meet these goals?

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association,  August 2015


Trinity Wall Street v. Wal-Mart Stores, Inc: Judicial Rewriting of the Proxy Rules (Part 3)

We are discussing Trinity Wall Street v. Wal-Mart Stores, Inc   792 F.3d 323 (3rdCir. 2015).

The majority purports to “empathize” with “those who labor with the ordinary business exclusion and a social-policy exception that requires not only significance but 'transcendence. . .'" Id.  The majority ascribes this need for empathy to the Commission,  Id. (“Despite the substantial uptick in proposals attempting to raise social policy issues that bat down the business operations bar, the SEC's last word on the subject came in the 1990s, and we have no hint that any change from it or Congress is forthcoming.”), and calls on the Commission to revisit the area.  Id. (“We thus suggest that it consider revising its regulation of proxy contests and issue fresh interpretive guidance.”). 

But in fact the “transcend” concept is not a problem of the Commission's making but a fabrication of the majority of the panel.  


Trinity Wall Street v. Wal-Mart Stores, Inc: Judicial Rewriting of the Proxy Rules (Part 2)

We are discussing Trinity Wall Street v. Wal-Mart Stores, Inc   792 F.3d 323 (3rdCir. 2015).

There are any number of problems with the court’s reasoning.  First, the court adopted an interpretation that is simply not there. In relying on the "transcend" element, the court quoted language from a staff bulletin adopted in 2009.  See SEC Staff Legal Bulletin No. 14E, 2009 WL 4363205, at *2 (Oct. 27, 2009)  ("where “a proposal's underlying subject matter transcends the day-to-day business matters of the company and raises policy issues so significant that it would be appropriate for a shareholder vote, the proposal generally will not be excludable under Rule 14a–8(i)(7).”).  According to the court, the term was used by the Commission “to refer to a policy issue that is divorced from how a company approaches the nitty-gritty of its core business.” 

In fact, the use of the term "transcend" by the Commission had no such connotation.  The language appeared for the first time in a 1998 release that rewrote Rule 14a-8 into plain English. As a result, there was no attempt to add a new “transcend” element to the exclusion.  In fact, in that Release, the Commission had this to say:      

  • The policy underlying the ordinary business exclusion rests on two central considerations. The first relates to the subject matter of the proposal. Certain tasks are so fundamental to management's ability to run a company on a day-to-day basis that they could not, as a practical matter, be subject to direct shareholder oversight. Examples include the management of the workforce, such as the hiring, promotion, and termination of employees, decisions on production quality and quantity, and the retention of suppliers. However, proposals relating to such matters but focusing on sufficiently significant social policy issues (e.g., significant discrimination matters) generally would not be considered to be excludable, because the proposals would transcend the day-to-day business matters and raise policy issues so significant that it would be appropriate for a shareholder vote. 

In other words, the quote is essentially the exact opposite of the Third Circuit’s interpretation.  The first sentence referenced nitty gritty matters (hiring, promotion, termination, decisions on production quality and quantity).  The second, however, noted these matters were overridden by the public policy exception.  

Second, the interpretation flies in the face of accepted interpretation.  In 1976, the SEC expressly added the “public policy” exception as part of the ordinary business exclusion after having been chastised by the court for allowing the omission of a proposal dealing with the manufacture of napalm by Down Chemical.  See Medical Comm. for Human Rights v. SEC, 432 F.2d 659 (DC Cir. 1971), vacated as moot, 92 S. Ct. 577 (1972).  Under the Third Circuit’s interpretation, however, napalm involves the nitty gritty of product selection and is presumably not subject to the public policy exception. 

Indeed, the traditional standard was only that the ordinary business matter “relate” to a public policy concerns.  As one of the originators of the exclusion described: “Innovative ways sometimes were found in these discussions to allow more proposals to be included in proxy statement than had previously been the case. . . . Another was to create an informal exception to the provision that allowed proposals relating to a company’s ordinary business operations to be excluded from the company’s proxy materials.  If the proposal was deemed to involve a matter of significant public policy interest, the Division expressed the view that the ‘ordinary business operations’ provision did not apply.” Statement of Peter Romeo, SEC Historical Society, Feb. 20, 2014 

Third, the word transcend appears in a 1998 release that only added “minor conforming changes” to the ordinary business exclusion.   Exchange Act Release No. 40018 (May 21, 1998).  Nothing in the adopting or proposing release suggests that the Commission intended to make a major substantive change in the public policy exception.  To the extent that there was any additional guidance, it came from the Commission reversing Cracker Barrel by concluding that the public policy should be expanded not narrowed when it came to employment practices. 

Fourth, the court made untenable distinctions.  Public policy does not apply to the mix of products sold by a large retailer.  Id. (“For major retailers of myriad products, a policy issue is rarely transcendent if it treads on the meat of management's responsibility: crafting a product mix that satisfies consumer demand.”).  On the other hand, it does apply to “employment practices” of companies.  Id. (‘By contrast, a proposal raising the impropriety of a supermarket's discriminatory hiring or compensation practices generally is not excludable because, even though human resources management is a core business function, it is disengaged from the essence of a supermarket's business.”).  Yet both very much involve day to day business activities, the nitty gritty so to speak, and both involve the “meat of management’s responsibilities”.  The court does not really include a principled basis for distinguishing the two situations.

In effect, the court has read out of the rule a public policy exception for ordinary business matters (relabeled "core" business areas).  The court seems to object to the ability of shareholders to make an issue out of ordinary business matters.  Thus, the court explicitly determined that the “transcend” concept was necessary, otherwise “shareholders would be free to submit ‘proposals dealing with ordinary business matters yet cabined in social policy concern.’” 

But of course that is exactly what shareholders are allowed to do. As the concurring opinion notes: “The Majority's test, insofar as it practically gives companies carte blanche to exclude any proposal raising social policy issues that are directly related to core business operations, undermines the principle of fair corporate suffrage animating Rule 14a–8: shareholders' ‘ability to exercise their right—some would say their duty—to control the important decisions which affect them in their capacity as ... owners of [a] corporation.


Trinity Wall Street v. Wal-Mart Stores, Inc: Judicial Rewriting of the Proxy Rules (Part 1)

In Trinity Wall Street v. Wal-Mart Stores, Inc   792 F.3d 323 (3rd Cir. 2015), a majority of the Third Circuit upheld the exclusion of a proposal submitted to Wal Mart because the proposal involved the ordinary business of the company and did not "transcend" the day to day business.  In doing so, the court invented a new test that effectively eliminated the public policy exception for broad categories of ordinary business matters.  

Shareholders submitted a proposal to Wal-Mart that requested that the board to "amend the Compensation, Nominating and Governance Committee charter ... as follows: 

  • Providing oversight concerning [and the public reporting of] the formulation and implementation of ... policies and standards that determine whether or not the Company should sell a product that:
  • 1) especially endangers public safety and well-being;
  • 2) has the substantial potential to impair the reputation of the Company; and/or
  • 3) would reasonably be considered by many offensive to the family and community *330 values integral to the Company's promotion of its brand.” 

The staff granted no action relief finding that the proposal implicated the company's ordinary business and did not fall into the public policy exception.  Shareholders sued, alleging that the omission of the proposal violated Rule 14a-8.  In effect, the case asserted that the staff of the SEC was wrong in allowing exclusion.

The district court agreed with shareholder but the Third Circuit reversed.  The Third Circuit found that the proposal implicated the company's ordinary business.  The court suggested that the proposal raised public policy considerations.  Nonetheless, the court upheld the exclusion of the proposal because the public policy implications did not "transcend" the company's business.  

We will discuss the reasoning in the next post.


Investor Shaming, Disclosure, and Shareholder Access

The WSJ published an article suggesting the need for the elimination of some quarterly reports.  The article is here.  Wachtell Lipton circulated a memorandum that discussed efforts in Europe to seek the "discontinuation of company quarterly reporting".  

The analysis was based upon efforts this summer by "Legal & General Investment Management, a major European asset manager and global investor with over £700 billion in total assets under management" and the contacts made by the firm with "the Boards of the London Stock Exchange’s 350 largest companies to support the discontinuation of company quarterly reporting"  The memo, posted on the Harvard Governance site, is here.  

The idea of scrapping quarterly reports is largely based upon the view that these reports encourage corporate management to take short term perspectives in connection with the management of the company.  But share prices are based upon the future expectation of profits and future profits require long and short term planning. Companies like Amazon do amazingly well even with low profitability because investors believe that the company is managing in a manner that will benefit shareholders in the long term.

To the extent that companies have an excessively short term perspective, it is hard not to call this mismanagement.  The decision about the day to day business of the company is made by management and it is management that has the fiduciary obligation to manage in the best interest of investors.  Delaware courts routinely overturn efforts by shareholders to intrude into the ordinary business of the company and the SEC staff use this prohibition as a significant basis for excluding proposals under Rule 14a-8.  The idea of protecting management from short term strategies by denying investors information is really a form of blaming or "shaming" investors for the failures of those managing the company.

Moreover, the elimination of some quarterly reports needs to be considered in the context of the fight over shareholder access.  Long term shareholders want the right to include nominees in the company's proxy statement.  In this proxy season, a record number of shareholder access proposals were submitted.  Of the 81 proposals that went to a vote, only "[t]wo companies, including Citigroup, determined to support the proxy access shareholder proposal contained in their proxy statements." In other words, for the most part, management objected to a process that would make easier the election of directors nominated by large shareholders. Of course, shareholders had other ideas, providing majority support for 48 proposals and giving all 81 an average of 54.7%.  

So putting these together, companies will be better run if the owners of the business receive less relevant information and are excluded from participation in the board of directors. That is certainly a point of view but one unlikely to receive much traction for actual owners.  


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 9) 

As suspected, the Commission has appealed Duka and Bebo is front and center.  The Commission as asked the district court to stay the preliminary injunction pending appeal.  In addition to the "inferior officer" issue, the Commission asserted

  • To start, the district court lacks jurisdiction over this matter, as the Seventh Circuit recently held in a case involving constitutional challenges to an SEC administrative proceeding (including an Article II challenge to the presiding ALJ). Relying upon the Supreme Court’s decisions in Elgin v. Department of Treasury, 132 S. Ct. 2126 (2012), and Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010), the Seventh Circuit ruled that it is “fairly discernible” from the securities laws that “Congress intended plaintiffs [bringing Article II challenges to SEC administrative proceedings] ‘to proceed exclusively through the statutory review scheme’ set forth in 15 U.S.C. § 78y.” Bebo v. SEC, -- F.3d --, 2015 WL 4998489, at *1 (7th Cir. Aug. 24, 2015) (quoting Elgin, 132 S. Ct. at 2132-33). In so ruling, the Seventh Circuit rejected the basis upon which this Court found jurisdiction, holding instead that judicial review is not inadequate merely because it occurs after the allegedly unconstitutional administrative proceeding had taken place. Id. at *9. The Seventh Circuit’s decision is in accord with binding Second Circuit precedent, as the Second Circuit has held that the securities laws generally require respondents in SEC administrative proceedings “to bring challenges in the Court of Appeals or not at all.” Altman v. SEC, 687 F.3d 44, 45-46 (2d Cir. 2012) (per curiam). In accordance with Altman— which this Court did not cite—the only other judges in this Court to have considered the precise question here have likewise held that they have no jurisdiction. See Tilton v. SEC, No. 1:15-cv- 02472, 2015 WL 4006165 (S.D.N.Y. June 30, 2015) (Abrams, J.), appeal pending, No. 15-2103 (2d Cir.); Order, Spring Hill Capital Partners, LLC v. SEC, No. 1:15-cv-04542, ECF No. 23 (S.D.N.Y June 29, 2015) (Ramos, J.). In light of this overwhelming precedent, the SEC is likely to prevail on the jurisdictional issue.

So it may but this only postpones the ultimate day of reckoning.  This saga is destined to continue.



Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 8)

As all of this plays out, the SEC did win a major victory in the 7th Circuit in Bebo v. SEC.  

The case did not involve a challenge to the system of ALJs under the Appointments Clause but did raise other issues in a collateral challenge to the administrative hearing process.  See Id. ('Bebo contends that § 929P(a) of Dodd-Frank is facially unconstitutional under the Fifth Amendment because it provides the SEC “unguided” authority to choose which respondents will and which will not receive the procedural protections of a federal district court, in violation of equal protection and due process guarantees. She also contends that the SEC’s administrative proceedings are unconstitutional under Article II because the ALJs who preside over SEC enforcement proceedings are protected from removal by multiple layers of for-cause protection."). 

The 7th Circuit held that the district court did not have jurisdiction to hear the collateral challenge.  Instead, the issues needed to be raised in the administrative hearing where they would be reviewed (assuming the case got that far) by the US Court of Appeals.  As the court reasoned: 

  • We affirm. It is “fairly discernible” from the statute that Congress intended plaintiffs in Bebo’s position “to proceed exclusively through the statutory review scheme” set forth in 15 U.S.C. § 78y. See Elgin v. Dep’t of Treasury, 567 U.S. —, 132 S. Ct. 2126, 2132–33 (2012). Although § 78y is not “an exclusive route to review” for all types of constitutional challenges, the relevant factors identified by the Court in Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477, 489 (2010), do not adequately support Bebo’s attempt to skip the administrative and judicial review process here. Although Bebo’s suit can reasonably be characterized as “wholly collateral” to the statute’s review provisions and outside the scope of the agency’s expertise, a finding of preclusion does not foreclose all meaningful judicial review. If aggrieved by the SEC’s final decision, Bebo will be able to raise her constitutional claims in this circuit or in the D.C. Circuit. Both courts are fully capable of addressing her claims. And because she is already a respondent in a pending administrative proceeding, she would not have to “‘bet the farm … by taking the violative action’ before ‘testing the validity of the law.’” Id. at 490, quoting MedImmune, Inc. v. Genentech, Inc., 549 U.S. 118, 129 (2007). Unlike the plaintiffs in Free Enterprise Fund, Bebo can find meaningful review of her claims under § 78y. As a result, she must pursue judicial review in the manner prescribed by the statute. 

The reasoning would seem to apply with equal vigor to the cases challenging the SEC's system for appointing ALJs.  This is only one circuit and, for administrative law purposes, not the critical DC Circuit.  Nonetheless, the reasoning will at a minimum need to be addressed in other cases where the SEC appeals (Hill for example) and argues that the district court never should have heard the case in the first instance.

To the extent that the appellate courts fall into line with Bebo, the approach takes the matter out of the hands of the district courts and gives the SEC the first crack at taking a substantive position on the issue.  Moreover, the approach ultimately delays a determination of the constitutionality of the ALJ appointment process until the matter can make it through the SEC's AP process and it can get to the court of appeals.

Finally, once the SEC has ruled in one case (the matter is before the SEC in Timbervest) and assuming the Commission finds the system of appointment constitutional (because the ALJs are employees and not inferior officers), courts may, at least psychologically, be more open to collateral challenges.  After all, forcing a party through an administrative process when the outcome has already been determined may be viewed as an unnecessary burden.


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 7)

So where does that leave the Commission?

Hill is on appeal.  In Duka, the government "is actively considering whether to appeal the preliminary injunction". Letter to Judge Berman from SEC, August 12, 2015.  The issue is apparently before the Commission as part of an appeal of an AP.  See DEFENDANT’S OPPOSITION TO PLAINTIFFS’ MOTION FOR PRELIMINARY INJUNCTION, Timbervest v. SEC, No. 15-cv-2106, ND Ga., June 29, 2015), at 2 (“The Commission has heard oral argument in the appeals from the SEC ALJ’s initial decision, including argument on Plaintiffs’ Appointments Clause challenge.”).  To the extent that the Commission does not find the appointment process unconstitutional, the matter will presumably be appealed, most likely to the DC Circuit.

Resolution, therefore, may not occur until the appellate courts have spoken.  Moreover, they may not all say the same thing, requiring the matter to go to the Supreme Court.  Until resolution, any party wanting to take their chances in district court rather than in an AP have a ready made argument.

Perhaps some courts will come out on the side of the Commission by finding that ALJs are not inferior officers. Moreover, at least one ALJ may be insulated from these challenges.  Commission involvement in the designation of Judge Murray as the Chief provides an argument that in fact the appointment process meets constitutional requirements.  Whether designation as chief is the same as appointment to the position of ALJ remains to be determined.  

Nonetheless, mysteries remain.  It is unclear why the SEC has not tried harder to develop a fall back in the event that the courts find that ALJs are inferior officers.  While its clear that the Commission has not approved the ALJs at the SEC (Chief Judge Murray a possible exception), it is possible, for example, that Judge Elliot was properly appointed as an ALJ while at Social Security.  If true, this appointment may be sufficient for constitutional purposes.  

More directly, however, there would presumably be available an argument that those appointing ALJs at the SEC (whether HR or the Chief Judge) are doing so pursuant to delegated authority from the Commission and, as a result, meet constitutional requirements.  

Section 4A of the Exchange Act specifies the requirements for delegations.  As the provision provides:   

  • In addition to its existing authority, the Securities and Exchange Commission shall have the authority to delegate, by published order or rule, any of its functions to a division of the Commission, an individual Commissioner, an administrative law judge, or an employee or employee board, including functions with respect to hearing, determining, ordering, certifying, reporting, or otherwise acting as to any work, business, or matter.  

15 U.S.C. § 78d-1(a). To the extent applicable, the SEC must delegate through order or rule, which was not done here.  Of course, it is open whether the Commission can delegate hiring authority without an order or rule or can delegate in a manner that is inconsistent with the statute but sufficient to meet constitutional standards. Moreover, delegation presumably can be implicit.  The whole concept of Chevron deference is built around implicit delegation by Congress to agencies.  The same should be true of delegation within an agency. One wonders whether there is an argument that the Commission has the authority as a Department Head and has delegated the authority to the Chief Judge.

The other possible "fall back" is to have the Commission go ahead and appoint the existing ALJs.  Presumably this is the "cure" that the court in Duka anticipated. Commissoin appointment would at least cut off arguments on a going forward basis. There is no explanation as to why this step has not been taken.

Perhaps there is a Commission that is divided on the issue.  Perhaps the Commission is concerned that approval would somehow constitute an admission that the system was unconstitutional. To the extent the latter, the approval could be phrased in a manner that approved the appointment but specified that the Commission did so out of an abundance of caution and should not, therefore, be characterized as some type of admission. Moreover, having the Commission approve commissioners as a matter of bureaucratic practice is probably a good idea.

For primary materials in the Duka case, go to the DU Corporate Governance web site


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 5)

In Duka v. SEC, the plaintiff challenged the appointment process for ALJs at the SEC as part of a collateral attack on the SEC's efforts to initiate an administrative proceeding against plaintiff.  This case arose in the SD of NY.

Following the institution of an administrative proceeding on January 2015, Duka moved for a temporary restraining order and a preliminary injunction in an effort to prevent the AP from moving forward.  The court denied the motion in April.  It looked like the hearing scheduled for Sept. 16, 2015 would proceed.  

A second round of motions, however, began in July.  This time plaintiff argued that the system for designating ALJs violated the appointments clause.  Once again, the SEC defended the allegation by arguing that ALJs were not inferior officers and therefore not subject to the Appointments Clause.  As for the process of appointment, the Commission acknowledged that “it remains unclear who appoints SEC ALJs”.  Plaintiff described the Commission’s position as one of “apparent disarray.”  See MEMORANDUM OF LAW IN SUPPORT OF PLAINTIFF BARBARA DUKA’S MOTION FOR A PRELIMINARY INJUNCTION, at 3. 

Whatever the precise method, the one undisputed fact was that the ALJs were not appointed by the Commission.  That was enough for the court.   

  • There appears to be no dispute that the ALJs at issue in this case are not appointed by the the SEC Commissioners. Indeed, in an Affidavit, dated June 4, 2015 that was taken in In the Matter ofTimbervest, LLC et al, Jayne L. Seidman, Deputy Chief Operating Officer ofthe SEC, stated that, "[b ]ased on [her] knowledge of the Commission's ALJ hiring process, [SEC] ALJ [Cameron] Elliot was not hired through a process involving the approval of the individual members ofthe Commission." In the Matter ofTimbervest, LLC et al., Admin. Proc. File No. 3- 15519 (attached as Ex. 1 to Am. Compl., dated June 10, 2015). 

The decision, however, had a cure.  As the court noted:   

  • Judge May [in Hill] also determined that "the ALJ's appointment could be easily cured by having the SEC Commissioners issue an appointment or preside over the matter themselves." (Id. at 44.) Plaintiffs counsel in the instant case reached the same conclusion at a conference held on June 1 7, 2015, stating that "I think that [having the Commissioners appoint the ALJ s] is one of [the easy cures]." (See Tr. of Proceedings, dated June 17,2015, at 4.) 

Moreover, the Commission was apparently mulling its choices.  Id. ("And, it appears that the Commission is reviewing its options regarding potential "cures" of any Appointments Clause violation(s). (See Tr. of Proceedings, dated June 17, 2015, at 10.)").  The court, therefore, delayed implementation of the injunction and gave the SEC 7 days to "notify the Court of its intention to cure any violation of the Appointments Clause."

The Commission ultimately informed the court that there would be no cure.  As counsel noted in a letter to the judge: 

  • As this Court is aware, respondents in several pending SEC administrative proceedings have raised before the Commission Appointments Clause challenges to the authority of the SEC ALJs who presided over the initial stage of their proceedings. In at least one proceeding, the Commission has heard argument on the constitutional challenge and has also ordered supplemental briefing. Although the Commission in its adjudicatory capacity may decide in due course whether SEC ALJs’ appointments violate the Constitution and, if so, the appropriate remedy for such a violation, as of the filing of this letter, the Commission has not issued a decision or otherwise taken any public action on these questions. 

A few days later, the court granted the injunction sought by plaintiff, finding a likelihood of success on the claim that the process of designating ALJs at the SEC violated the Appointments Clause.  The court reiterated that the SEC did not appoint ALJs as required by the Clause. Opinion, Aug. 12, 2015 ("Here, the Court has determined that the ALJs at issue were not appointed by the SEC Commissioners. See August Decision & Order at 5. As they were not appropriately appointed pursuant to Article II, their appointment is likely unconstitutional in violation of the Appointments Clause.”).  

For primary materials in the Duka case, go to the DU Corporate Governance web site.  


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 4)

The lack of direct Commission involvement in the ALJ selection process provided an opening for challenging the constitutionality of the appointment process.  

In Hill v. SEC, plaintiff seeking to halt an impending AP argued that ALJs at the SEC were “not appointed by the President, the Courts, or the [SEC] Commissioners. Instead, they are hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions, and the Office of Personnel Management”.  In other words, the ALJs were not appointed by the SEC.

The Commission (through the DOJ lawyers handling the case) conceded this point. See DEFENDANT’S OPPOSITION TO PLAINTIFF’S EMERGENCY MOTION TO SUPPLEMENT BRIEF, No. 15-cv-1801, May 29, 2015, at 2 ("In light of Plaintiff’s intention to amend the Complaint to add an Appointments Clause claim, SEC now similarly acknowledges in this case that, consistent with SEC ALJ James E. Grimes’s status as an agency employee and not a constitutional officer, he was not appointed by the SEC Commissioners.").  

The Commission contested the constitutional challenge mostly by asserting that ALJs were not inferior officers and therefore need not be appointed by the Head of a Department. The approach, however, left little room for a constitutional appointment process in the event that the court found that the ALJs were inferior officers. The district court in Hill made exactly that finding, concluding that the ALJs at the SEC were inferior officers. As a result, the court enjoined the SEC from pursuing the administrative proceeding against plaintiff.  Nor would a stay pending appeal be granted.     

  • the Court finds that the SEC has not made a strong showing it is likely to succeed on the merits. As well, the Court notes that the SEC is only foreclosed from conducting an administrative proceeding in front of an ALJ who was not appointed by the SEC itself—the SEC Commissioners may conduct the hearing against Plaintiff at any time or appoint the SEC ALJ directly. They may also elect to bring their claims in district court. Thus, the Court does not find the SEC is irreparably injured or the public interest is affected as the SEC still has a channel to pursue Plaintiff—even through an administrative proceeding if it chooses. However, if the stay is lifted, Plaintiff would have to participate in a likely unconstitutional proceeding which would cause a substantial injury.

The same court made similar findings in Timbervest LLC v. SEC. Because, however, the challenge came after completion of the administrative proceeding, the court declined to enjoin the SEC.  As the court reasoned: 

  • Plaintiffs waited until the ALJ had issued his initial decision and this case was before the SEC itself before filing this motion. Plaintiffs have already gone through the entirety of the administrative procedure before the ALJ—thus, no injunction will cure or prevent Plaintiffs’ prior obligation to defend itself before the ALJ. And any harm which Plaintiffs have already suffered by virtue of the initial decision being published has already been experienced; removing the ALJ’s initial decision from the website would not prevent a future harm.

The Georgia court, therefore, became the first to rule that the appointment process for ALJs at the SEC was unconstitutional.  The SEC has appealed the decision in Hill.   The isolated decision was not, however, to last.

For primary materials in Duka can be found at the DU Corporate Governance web site.  


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 3)

So how are ALJs appointed at the SEC?

In In re Timbervest, the SEC staff explained the appointment process this way:   

  • Pursuant to current statutes and regulations, the hiring process for Commission ALJs is overseen by the U.S. Office of Personnel Management ("OPM"), which administers the competitive examination for selecting all ALJs across the federal government. See 5 U.S.C. §§ 1104, 1302; 5 C.F.R. § 930.201(d)-(e). As do other agencies, the Commission hires its ALJs through this OPM process. See 5 U.S.C. § 3105; 5 C.F.R. § 930.20l(f). When the Commission seeks to hire a new ALJ, Chief ALJ Murray obtains from OPM a list of eligible candidates; a selection is made from the top three candidates on that list. See 5 U.S.C. ·§§ 3317, 3318; 5 C.F.R. §§ 332.402, 332.404, 930.204(a). Chief ALJ Murray and an interview committee then make a preliminary selection from among the available candidates. Their recommendation is subject to final approval and processing by the Commission's Office of Human Resources.  It is the Division's understanding that the above process was employed as to ALJ Elliot, who began work at the agency in 2011. 

The staff, however, acknowledged that the process may have been different in the past.

  • As for earlier hires, it is likely the Commission employed a similar, if not identical, hiring process. But the Division acknowledges that it is possible that internal processes have shifted over time with changing laws and circumstances, and thus the hiring process may have been somewhat different with respect to previously hired ALJs. For instance, Chief ALJ Murray began work at the agency in 1988 and information regarding hiring practices at that time is not readily accessible.

See Notice of Filing, In re Timbervest, Admin File No. 3-15519 (admin proc June 4, 2015).  

The process was apparently followed with some ALJs but, as quickly became clear, not with respect to Judge Elliot.  As he noted, the description was "erroneous" with respect to his appointment.  The description fit the appointment of Judges Patil and Grimes.  Transcript, In re Bebo ("And just by way of background, there’s two ways for a federal agency to hire an administrative law judge.  One is in the manner described in this paragraph, and that is in fact how Judge Patil and Judge Grimes were hired at the SEC, within the last year, roughly.").  

Judge Elliot, however, was already an ALJ at Social Security when he applied to the SEC.  As a result, he did not need to repeat the entire OPM vetting process.   As he described:   

  • the other way of being hired is if you are already an administrative law judge for a federal agency, then you don’t have to go through this process.  Instead, you just go through the process that essentially everyone else with the federal government goes through, which is you have USA Jobs, which is the federal government’s job-posting website, you respond to the advertisement, and then you get hired in the usual fashion.  

Thus, the vetting process by OPM had been done when Judge Elliot applied at Social Security, not when he applied at the SEC. 

  • So in my case, for example, I saw a posting on USA Jobs when I was at Social Security.  I sent in my resume, I had an interview, I got an offer; its as simple as that.  What’s described in the Division’s notice of filing in Timbervest is if you’ve never been an ALJ before.  And, as I said, I did in fact go through that process, just not when I was hired by the SEC.  

The actual selection process, however, did not involve the Commission.  As he described:   

  • I interviewed with Judge Murray, with Jayne Seidman, who at the time was – I think she was with human resources, and an attorney with the general counsel’s office, whose name escapes me at the moment.  I was supposed to interview with the general counsel himself at the time, but he didn’t bother to show up.

He received an offer, something confirmed by HR.  Id.  ("And then . . . once I accepted the offer, I don’t know for sure exactly what the process was, but when I – I pulled out one of my forms that I got from HR, and it appears that someone in HR did sign off on my hiring, ok?").  Although signing the papers, HR was not responsible for the appointment.  Id.  ("I mentioned about my hiring, that someone in HR had signed a paper, and I want to make it clear.  I’m not saying that the person who signed the paper or the paper itself was my appointment.  It was simply an SP50, as Standard Form 50, which is the customary document for the federal civil service – the document changes to personnel status, and it was signed by someone in HR, because they always are signed by someone in HR.").  

As for the source of the apppointment, he didn't know.  Id. ("I would have to say no, I don’t know.  I have an educated guess, but its really just an educated guess.  No, I don’t know the answer.").  There was, however, no direct involvement in the appointment process by the Commission.  Id.  ("The bottom line, for purposes of the Article II arguments, is that I was – I was not appointed by the Commission.  The Commission, as far as I know, did not issue any sort of order appointing me as an ALJ.").  

The process for joining the Commission, therefore, seemed clear enough.  The actual source of the appointment, however, was less clear.  HR was one possibility; the Chief ALJ was another.  Given the disclaimer, it wasn't OPM.  There seemed to be agreement that the Commission played no role in the process, except that sometimes it did.  As Chief Judge Murray stated in another case, "I was appointed as Chief Administrative Law Judge by the Commission on March 20, 1994."  In In re Bama Biotech, Release No. 836 (admin proc July 20, 2015).  

The statement is a bit delphic, noting only that she had been designated Chief by the Commission, not that she had been appointed as an ALJ by the Commission.  

For primary materials in the Duka case, go to the DU Corporate Governance web site


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 2)

The Appointments Clause provides that the President has the authority to appoint Officers of the United States but allows Congress to vest the appointment of "inferior officers" "in the President alone, in the Courts of Law, or in the Heads of Department."  To the extent that ALJs at the SEC are "inferior officers" (as opposed to employees), therefore, they must be appointed by the Commission. 

With respect to the appointment of ALJs, each agency is allowed to determine the number that it needs. See 5 U.S. Code § 3105 ("Each agency shall appoint as many administrative law judges as are necessary for proceedings required to be conducted in accordance with sections 556 and 557 of this title. . . .").  

After having determined the number, the actuall appointment process involves substantial input from the Office of Personnel Management ("OPM").  OPM screens the candidates and must approve a selection or povide a list of eligible candidates.  See 5 CFR § 930.203a ("An agency may make an appointment to an administrative law judge position only with the prior approval of OPM, except when it makes its selection from a certificate of eligibles furnished by OPM.").  

OPM, however, emphatically disavows any final decision making with respect to ALJs.  See 5 CFR 930.201 ("OPM does not hire administrative law judges for other agencies").  The law seems clear, therefore, that agencies, not OPM, select ALJs.

Within each agency, the system for appointment often rests with the head of the agency.  See 42 U.S.C.A. § 2000e-4 (Chairman of EEOC, on behalf of the Commission, approves ALJs); 50 U.S.C.A. § 2412(c)(4) ("An administrative law judge referred to in this subsection shall be appointed by the Secretary [of Commerce] from among those considered qualified for selection and appointment"); 29 U.S.C.A. § 661(e)("The Chairman [of OSHA] shall be responsible on behalf of the Commission for the administrative operations of the Commission and shallappoint such administrative law judges and other employees as he deems necessary to assist in the performance of the Commission's functions"); 30 U.S.C.A. § 823 ("The [Federal Mine Safety and Health Review] Commission shall appoint such additional administrative law judges as it deems necessary to carry out the functions of the Commission.");  20 U.S.C.A. § 1234 ("The administrative law judges (hereinafter "judges") of the Office shall be appointed by the Secretary [of Education] in accordance with section 3105 of Title 5.").  

The appointment process at the SEC, however, is less clear.

For primary materials in the Duka case, go to the DU Corporate Governance web site


US Court of Appeals for the DC Circuit Strikes Down the Conflict Minerals Rule—So Now What?

The long-running saga of Section 1502 of Dodd-Frank (the “Conflict Minerals Rule”) continued on August 18th as the US Court of Appeals for the DC Circuit struck down the Conflict Minerals Rule on First Amendment grounds.  The decision has long-ranging implications not only for the Conflict Minerals rule but for compelled speech issues in general.

As readers of this blog know, (see here) the court had initially struck down the disclosure rule in April of last year, but agreed to reconsider the decision in light of the D.C. Circuit’s en banc decision upholding the U.S. Department of Agriculture’s meat country-of-origin labeling requirements in American Meat Institute v. USDA. 

In this opinion the Court, in a literary reference laced opinion by Judge Raymond Randolph, left little doubt as to its position despite a vigorous dissent.  It gave multiple grounds to support its finding that the Rule is unconstitutional so as to protect its decision even if its perhaps most controversial finding (that Zauderer applies only to voluntary advertising) is struck down. 

Take Away Points From the Majority Opinion

Disclosure Requirements do not pass muster simply because they were passed by the SEC

Before we offer our legal analysis, a pervasive theme of the dissent deserves a brief response. To support the conflict minerals disclosure rule, the dissent argues that the rule is valid because the United States is thick with laws forcing “[i]ssuers of securities” to “make all sorts of disclosures about their products,” Charles Dickens had a few words about this form of argumentation: “‘Whatever is is right’; an aphorism that would be as final as it is lazy, did it not include the troublesome consequence, that nothing that ever was, was wrong.”

Besides, the conflict minerals disclosure regime is not like other disclosure rules the SEC administers. This particular rule, the SEC determined, is “quite different from the economic or investor protection benefits that our rules ordinarily strive to achieve.”

For this Court, Zauderer applies only to cases involving “voluntary advertising” or advertising by the company’s “own choice”.

The Court reviewed relevant Supreme Court precedent and concluded that the more lenient review afforded by Zauderer applies only when compelled disclosures are connected to advertising or product labeling at the point of sale.  Because the Conflict Minerals Rule is not, the Court found that Zauderer had no application to this case.

Having concluded that Zauderer did not apply, the Court ordinarily would have analyzed whether “strict scrutiny or the Central Hudson test for commercial speech” applies. Instead, relying on “the reasons we gave in that opinion,” the Court found that “the SEC’s “final rule does not survive even Central Hudson’s intermediate standard” and that it “need not repeat our reasoning in this regard….” 


Even if the Court is found to be wrong in its analysis regarded the reach of Zauderer, the Conflicts Minerals Rule is still unconstitutional because the SEC cannot prove that the Rule is an effective method to achieve the stated governmental interest or objective in passing it.

 The Court recognized “the flux and uncertainty of the First Amendment doctrine of commercial speech and the conflict in the circuits regarding the reach of Zauderer” and there stated “we think it prudent to add an alternative ground for our decision. It is this. Even if the compelled disclosures here are commercial speech and even if AMI’s view of Zauderer governed the analysis, we still believe that the statute and the regulations violate the First Amendment.”

Under Central Hudson the government must identify a goal or objective intended to be served by the regulation under scrutiny.  In the case of the Conflict Minerals Rule, “the SEC described the government’s interest as “ameliorat[ing] the humanitarian crisis in the DRC.” We will treat his as a sufficient interest of the United States under AMI and Central Hudson.

The second prong of Central Hudson requires the government to establish that the regulation under review is effective in achieving it and it is here where the Court found the Rule to be constitutionally infirm.  According to the Court, “the SEC had the burden of demonstrating that the measure it adopted would “in fact alleviate” the harms it recited “to a material degree.”  However, “[t]he SEC has made no such demonstration in this case and, as we have discussed, during the rulemaking the SEC conceded that it was unable to do so.

The Court also pointed to “post hoc evidence” questioning the effectiveness of the Rule in achieving its aims.  “[T]he conflict minerals law may have backfired. Because of the law, and because some companies in the United States are now avoiding the DRC, miners are being put out of work or are seeing even their meager wages substantially reduced, thus exacerbating the humanitarian crisis and driving them into the rebels’ camps as a last resort. This in itself dooms the statute and the SEC’s regulation.


Even if the Court is wrong in its analysis of the reach of Zauderer and it is found to not be limited to advertising it still requires that disclosure requirements be limited to  purely factual and uncontroversial information’ about the good or service being offered” a standard that the Conflict Minerals Rule cannot satisfy.

In our initial opinion we stated that the description at issue– whether a product is “conflict free” or “not conflict free” –was hardly “factual and non-ideological.  We put it this way: “Products and minerals do not fight conflicts. The label ‘[not] conflict free’ is a metaphor that conveys moral responsibility for the Congo war. It requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups. An issuer, including an issuer who condemns the atrocities of the Congo war in the strongest terms, may disagree with that assessment of its moral responsibility. And it may convey that ‘message ’through ‘silence.’ See Hurley, 515 U.S. at 573. By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment. We see no reason to change our analysis in this respect. And we continue to agree with NAM that “[r]equiring a company to publicly condemn itself is undoubtedly a more ‘effective’ way for the government to stigmatize and shape behavior than for the government to have to convey its views itself, but that makes the requirement more constitutionally offensive, not less so.”

So now what?  With regard to the Conflict Minerals Rule, the statutory requirement for the SEC to craft disclosure requirements regulating the issue remains in place.  At this point, either the SEC must either seek an en banc review of the decision, go back to the drawing board and start over or Congress must repeal Section 1502. 

The implications for disclosure regulation in general are serious.  If the opinion holds and Zauderer is limited to voluntary advertising it will be more difficult for governmental regulators to justify disclosure requirements of the type involved in the Rule.  Further, requiring seemingly concrete proof of a disclosure regimes effectiveness will often be difficult as naysayers can always find someone willing to provide evidence to the contrary.  Finally, by limiting the definition of factual and non-controversial, the Court greatly reduces the application of Zauderer.  The decision is a victory for those opposed to mandated disclosure.  Whether it stands is therefore of great importance.


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 2A)

We will pick up with the series on the legal challenges to the SEC's administrative hearing process tomorrow (on Friday).  The series is delayed by an interlude from Professor Celia Taylor that examines the recent conflict minerals decision out of the DC Circuit.


Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 1)

Administrative law judges (ALJs) have been around for decades. Moreover, the system of appointment has rarely caused controversy, until now.  

The SEC has traditionally had a choice between bringing actions in federal district court or in administrative courts before an ALJ. The two forums were different, sometime benefiting the SEC and sometimes the defendant. Defendants wanting a jury benefited from actions in federal district court. At the same time, injunctions in district court had collateral consequences and could, for example, be enforced through actions for contempt.  In the case of an AP, the Commission historically had a more narrow set of remedies. For example, until the adoption of Dodd-Frank, the SEC could not obtain penalties against a non-regulated entity. Determining where to litigate, therefore, required the Commission to weigh a variety of factors, with no particular forum having a decisive advantage.  

That, however, has changed.  With the reforms set out in Dod-Frank, one of the notable disincentives to bringing APs for the Commission was eliminated.  Penalties against non-regulated persons were now permitted.  

In addition, district court judges, particularly those in the southern district of New York, seemed a bit less accomodating with respect to SEC enforcement proceedings.  The rejection by Judge Rakoff of the settlement in Citibank was an example. The SEC also had a better track record in APs than in federal district court. In the fiscal year ending Sept. 30, 2014, the SEC won all six litigated APs.  The record in federal district court:  less advantageous (11 trial victories out of 18).  

Whatever the precise reason, the SEC began to make greater use of APs. According to a Cornerstone Report, the SEC traditionally brought about 60% of its cases as APs, a percentage that had increased to 80% in the first half of the 2015 fiscal year.  

While some defendants presumably continued to prefer the administrative forum over federal district court (the collateral consequences are still likely to be less), some did not.  In attacking the use of the APs, defendants began to raise a number of constitutional challenges. There was precedent. In Gupta v. SEC, 2011 WL 2674840 (S.D.N.Y. July 11, 2011), Judge Rakoff allowed a collateral challenge to an AP to go to discovery.

In addition, FEF v. PCAOB, 561 U. S. 477 (2010) provided a possible avenue for challenge.  With ALJs subject to removal only for cause, ALJs at the SEC were subject to a double layer of insulation from the President, an issue similar to the one raised with respect to members of the PCAOB.  ALJs were even referenced in the case. As Justice Breyer noted in dissent:

  • The Court suggests, for example, that its rule may not apply where an inferior officer “perform[s] adjudicative … functions.” Cf. ante, at 26, n. 10. But the Accounting Board performs adjudicative functions. See supra, at 17–18. What, then, are we to make of the Court’s potential exception? And would such an exception apply to an administrative law judge who also has important administrative duties beyond pure adjudication?

For the most part, however, the courts were unsympathetic to these arguments.  The challenges generally failed, sometimes because there was insufficient likelihood of success on the merits and sometimes because the courts declined to hear a collateral challenge, forcing parties to litigate the issue in the AP and have the analysis reviewed by the Commission then the court of appeals.  

The success rate, however, took noticeable turn into positive territory with the advent of challenges under the appointment clause.     

For primary materials in the Duka case, go to the DU Corporate Governance web site.  


The Non-Disclosure of Interim Voting Information

Broadridge, as agents for brokers and other intermediaries, collects and tallies voting instructions.  Eventually the information will be included on a proxy card and sent to the issuer.  Until then, however, Broadridge is in the possession of interim voting information, information that is strategically important to companies and shareholders.  As we have discussed and as the SEC's Investor Advisory Committee has noted, the interim voting information is not distributed on an impartial basis.  In exempt solicitations, the information is routinely given to issuers.  Shareholders engaging in a solicitation, however, do not automatically receive the information.  In that regard, we note these passages from a letter sent to the SEC by CII: 
  • It is our understanding that during this proxy season many companies simply refused to respond to shareowner proponent requests for preliminary voting results. We are hopeful that companies and Broadridge will heed your call and promptly establish a mechanism prior to the 2016 proxy season “that provides interim vote tallies to shareowner proponents.
  • In our view, in order to level the field, any possible solution must include, as you described, an “agree[ment] or consent[]” by companies and Broadridge to promptly provide the interim vote tallies to shareholder proponents when requested. In that regard, we note that the potential agreement, referenced in your remarks, that the Council, the Society and Broadridge had been working on—and for which Broadridge unexpectedly rejected—was a positive step forward. The potential agreement, however, fell far short of a “possible solution” because it failed to include any formal or informal agreement or consent by companies to participate in the arrangement.
  • If companies and Broadridge are unwilling or unable to establish a mechanism prior to the 2016 proxy season that provides interim vote tallies in an impartial manner to shareowner proponents, we respectfully reiterate our prior requests, consistent with the recommendation of the Securities and Exchange Commission’s (SEC or Commission) own Investor Advisory Committee, that the Commission take prompt action, in your words, “to level the playing field, such that everyone gets preliminary vote tallies, or nobody gets them.”

The playing field needs to be leveled, something that will apparently require direct action by the Commission.


The Delaware Courts and Material Non-Public Information

We have been discussing  In re General Motors Co. Derivative Litigation.

In culling through the assorted filings (we like to post primary materials on the DU Corporate Governance web site), we noticed a letter from the Vice Chancellor to counsel providing a copy of the opinion in the case before release to the public.  The opinion was sent to counsel on June 26.  The opinion was made public on June 29. the judge did so as a courtesy to the lawyers involved.  As the letter stated: 

  • I note that the Complaint in this matter was filed under seal, and wish the parties to have the opportunity to review the Memorandum Opinion for confidential mateirla.  Unless any party indicates cause by Monday, June 29 at 4:00 p.m. that portions of this Memorandum Opinion should be redacted, I will release the Memorandum Opinion publicly at that time.

Certainly it is better to catch these things before, rather than after. an opinion is issued.  Nonetheless, the approach raises an interesting hypothetical, worthy of a law school exam.  A court decision can at least sometimes move a company's share prices.  Thus, a decision may be material.  To the extent that it is, advance knowledge may provide trading benefits.  

This raises the obvious question as to whether trading on advance knowledge of an opinion, to the extent the result is material, constitutes insider trading.  The answer, of course, is that it depends. 

O'Hagan, the Supreme Court case that approved of the misappropriation theory of insider trading actually involved trading by a lawyer at a firm. O'Hagan was alleged to have engaged in insider trading by violating a duty of trust and confidence to his firm and to the firm's client.  See 521 U.S. at 653 ("In this case, the indictment alleged that O'Hagan, in breach of a duty of trust and confidence he owed to his law firm, Dorsey & Whitney, and to its client, Grand Met, traded on the basis of nonpublic information regarding Grand Met's planned tender offer for Pillsbury common stock."). 

An early release of an opinion, however, is information received not from the client but from the court. So it does not fall within the privilege.  Trading on the information by a lawyer could still violate a policy of confidentiality at the law firm, depending upon whether the policy reaches information not received from a client. 

At the same time, the policy would presumably not prevent the law firm from using the information for proprietary trades unless subject to a duty of confidentiality from another source. The letter from the judge in this case did not expressly impose an obligation of confidentiality.    

What about the lawyer's decision to give the information to his or her client?  The first issue is whether the lawyer is a tipper.  At the time the opinion was released, the judge (or vice chancellor) could have expected that the content and result remain confidential.  Providing the information to the client could violate that obligation, rendering the lawyer a tipper. On the other hand, the lawyer would probably need to benefit from the tip (whether classic insider trading or misappropriation), something unlikely in this fact pattern.  If the tipper is not guilty of insider trading, neither is any tippee.

To the extent, however, that the client accepts the information with the expectation of confidentiality, the company becomes the tipper.  To the extent the company (or one of the company's employees) trades on the information, there may be a colorable claim for misappropriation. 

For a copy of the letter, go to the DU Corporate Governance web site. 


The Management Friendly Nature of Delaware Courts: Of Boards, Ostriches, and the Absence of a Duty to Create a “Better” Reporting System (Part 4)

We are discussing In re General Motors Co. Derivative Litigation, a recent case in the Chancery Court holding that directors had no obligation to ensure that a reporting system was sufficiently robust to ensure that certain vehicle safety issues were reported to the board prior to 2014.  

In assessing the applicability of the Caremark claim brought by plaintiffs, the court noted that there were no allegations of a “total lack of any reporting system”.  Instead, plaintiffs challenged the inadequacy of the system.  “[T]he Plaintiffs allege the reporting system should have transmitted certain pieces of information, namely, specific safety issues and reports from outside counsel regarding potential punitive damages. In other words, GM had a system for reporting risk to the Board, but in the Plaintiffs' view it should have been a better system.”

For the court, however, it was enough to have a reporting system that allowed for "some" oversight.  Id. ("Stated more generally, in criticizing the Board's risk oversight and its delegation thereof, throughout the Complaint, the Plaintiffs concede that the Board was exercising some oversight, albeit not to the Plaintiffs' hindsight-driven satisfaction.").  

Allegations that the reporting system could have done "better" would not be enough. Id.  (“It shows, perhaps, an overly bureaucratic system of 'information silos,' but not a conscious disregard of fiduciary duties by the Board. In other words, the Plaintiffs complain that GM could have, should have, had a better reporting system, but not that it had no such system.”).  Said another way, "[c]ontentions that the Board did not receive specific types of information do not establish that the Board utterly failed 'to attempt to assure a reasonable information and reporting system exists'”.  

But of course the plaintiffs were not alleging merely that the system could have been better. The characterization came from the court.  The Complaint, in contrast, asserted something far more fundamental: "The Director Defendants herein, have a fiduciary duty to adopt internal information and reporting systems that are reasonably designed to provide to senior management and the board itself, with timely, accurate information sufficient to allow management and the Board, within the scope of their duties, to reach informed decisions concerning the corporation’s compliance with the law and its business performance."  The Board allegedly violated that duty by failing to "create a policy whereby serious defects detected by various Company sources were reported to the Board as well as litigation matters which would incur punitive damages." 

In other words, it wasn't enough to have a reporting system.  The system must also ensure that directors receive the information needed to exercise their fiduciary obligations to monitor the activities of the company. The court, however, made no attempt to assess the qualitative importance of the omitted information to General Motors, to shareholders, or to the board's duties.  Instead, it was enough to have a reporting system. The actual content of the reported information was not particularly important to the analysis.    

The approach creates an incentive to have a reporting system.  It does not create an incentive to have a robust system that ensures the board receives information material to the well being of the company.  The analytical approach suggests that the incentive to improve the quality of a reporting system will need to be a matter of federal law.  Preemption, in other words.   

For primary materials in this case, go to the DU Corporate Governance web site.