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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.


The Management Friendly Nature of Delaware Courts: Of Boards, Ostriches, and the Absence of a Duty to Create a “Better” Reporting System (Part 3)

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.  

Although allegedly percolating within the GM bureaucracy, the safety issues with respect to the faulty ignition switch did not arrive at the board until sometime in 2014.  

The governance structure, therefore, was not sufficient to ensure that this type of information was elevated to the board.  With respect to the governance and reporting at GM, Plaintiffs alleged that in 2010 the Board created a risk committee.  The Charter provided that the Committee would “review internal systems of formal and informal communication across business units and control functions to encourage the prompt and coherent flow of risk-related information and, as needed, escalation of information to management (and to the Committee and Board as appropriate).” 

The Board also created the position of chief risk officer (“CRO”).  The CRO was to report to the risk committee.   Approximately a year later, however, the position of CRO were eliminated and the responsibilities transferred to the General Auditor.  In 2012, the risk committee was eliminated and oversight transferred to the audit committee.

An internal report described the board process with respect to the reporting of vehicle safety related issues.  

  • "no single committee of the Board was responsible for all vehicle safety-related issues,” and that “the Board of Directors was not informed of any problem posed by the Cobalt ignition switch until February 2014.  Moreover, “the system put in place by the Board did not require that serious defects detected by GM's legal department, its engineering department, consumer protection organization, or law enforcement agencies be reported to the Board.” [The report author] concluded that the Board “did not discuss individual safety issues or individual recalls except in rare circumstances,” though it did receive “a wide variety of reports,” and that the litigation reports to the Board did not mention ignition switch or airbag issues. 

Plaintiffs asserted, therefore, that the report "describes GM's 'phenomenon of avoiding responsibility,' embodied in the so-called 'GM salute,' which involved 'a crossing of the arms and pointing outwards towards others, indicating that the responsibility belongs to someone else, not me.'”

For primary materials in this case, 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 2)

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.    

The case arose out of the faulty ignition switch installed in a number of GM cars.  As a result of the switch, GM engaged in massive recalls that resulted in costs of approximately $1.5 billion.  A fund set up to compensate victims of accidents arising out of the faulty switches, at the time of the litigation, received 1130 claims, with 23 death claims already approved.  Moreover, “[t]he Fund has no cap on overall payments.”  Private lawsuits and government fines increased the total cost. 

Shareholders brought a derivative suit seeking "to recoup some of the loss on behalf of the corporation itself, alleging that the directors breached their duty of loyalty by failing to oversee the operations of GM." Involving what the court called an “iconic American company” and corporate activity viewed as "particularly distressing,” the court nonetheless found that it had no choice but to dismiss the derivative claims for failure to have made demand.

The court did so, even though the standard of review involved “a whiff of irony, even tautology, in a Court determining, at the pleading stage, whether it would be futile to ask a director to decide, on behalf of her principal, to sue herself.”  Moreover, shareholders, in advance of filing suit, had adhered to the additional procedural hurdles imposed by the courts by seeking corporate records pursuant to Section 220.   

Nonetheless, dismissal was the order of the day. There would be no discovery, no trial.  There would be no holding that imposed on directors an obligation to be better informed about possible problems inside the company.  

So what did shareholders allege?

According to the allegations in the complaint, knowledge about possible problems with the ignition switch percolated inside the GM bureaucracy.  Specifically, by the end of 2013, notice of the problem had reached GM's Executive Field Action Decision Committee, but “once there, more questions were raised about root cause, and the decision-makers were hamstrung by a lack of accurate data about what vehicles were affected and how many people may have been impacted by the defect.”  

Information about possible problems with the ignition switch also came from private lawsuits. Reports in 2010, 2012 and 2013 about possible problems from outside counsel, including the warning that a jury would “almost ‘certainly’ find that the ignition switch was unreasonably dangerous” and possible exposure to punitive damages were never escalated to the general counsel or the board. The possibility of a design defect that resulted in the non-deployment of airbags was raised by a number of experts in cased brought against the company. 

Nonetheless, the information never made it to the board.  Plaintiffs asserted that the “Board prevented [Board-level reporting] from happening by failing to put into place common procedures and policies for the escalation of issues involving serious defects, large investigations, and punitive damages.”’’   Moreover, the plaintiffs asserted that "the Board failed to create a policy or procedure for reporting outside counsel warnings of punitive damages to the Board or General Counsel.” 

For primary materials in this case, 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 1)

The Delaware courts sometimes assert that they do not tolerate an "ostrich" approach to fiduciary obligations. See White v. Panic, 793 A.2d 256 (Del. Ch. 2000) (noting that “Director Defendants are not alleged to have ‘hidden their heads in the sand’ instead of addressing a source of potential liability”).  In other words, directors cannot escape liability by deliberately remaining uninformed.

Yet protestations to the contrary notwithstanding, the Delaware courts have in fact created a standard that encourages exactly this kind of behavior.  See In re Walt Disney Co. Deriv. Litig., 825 A.2d 275 (Del. Ch. 2003) (“The new complaint, fairly read, also charges the New Board with a similar ostrich-like approach regarding Ovitz's non-fault termination.”). 

Since the days of Caremark, 698 A.2d 959 (Del. Ch. 1996), it has been black letter law in Delaware that corporations need to have a system for keeping the board of directors informed.  Liability could arise where through “a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists”.  This could occur where “directors utterly failed to implement any reporting or information system or controls”. Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)(footnotes omitted).

Of course, the decision was no progressive beacon in the development of director duties.  Boards already routinely put these systems in place whether because of the sentencing guidelines or SEC requirements.  Indeed, if anything, it was late in the game – 1996 – that Delaware courts finally recognized these duties.

Reporting systems had the capacity to significantly increase the legal exposure of directors.  Once a matter of importance was reported to the board, directors could be liable to the extent consciously disregarding the concerns.  Thus, directors had an incentive to address what was reported but otherwise not request additional information, particularly on matters that could require them to act. 

Although boards had a fiduciary obligation to put in place a reporting system, the court left open the requirements of any such system.  The parameters of any reporting system depended upon the business judgment of the board. Nonetheless, as a practical matter, the obligation was to have a reporting system.   The actual mechanics hardly mattered.  Arguments that the reporting system should have been “better” were summarily dismissed.    

The result was that boards had an incentive to put in place a reporting system but had no incentive to ensure that the system was robust. Said another way, directors had no incentive to improve the quality of the system to ensure that they received the information needed to address ongoing problems or concerns within the company.   This was brought home with considerable clarity in In re General Motors Co. Derivative Litigation.


Irrefutable Claims of Fraud and Misrepresentation May be Precluded Under the Securities Litigation Uniform Standards Act

In In re Harbinger Capital Partners Funds Investor Litig., 2015 BL 88340 (S.D.N.Y. Mar. 30, 2015), the District Court for the Southern District of New York granted a motion to dismiss for failure to state a claim in favor of Harbinger Capital Partners, LLC (“HCP”) and Philip A. Falcone (collectively “Defendants”) in a class action lawsuit filed by Lili Schad, Anil Bhardwaj, The Edward M. Armfield Sr. Foundation, Inc., and The Randall Lang, Klein Family Partnership L.P., (collectively “Plaintiffs”). The court held The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) precluded the claims because the class action involved misrepresentations made in connection with the sale of covered securities.  The court further declined to exercise supplemental jurisdiction as to Plaintiff’s remaining state law claims.

According to the complaint, the Defendants in 2006 acquired SkyTerra and renamed the company Light-Squared, immediately taking the company private. Light-Squared was attempting to establish a 4G network but faced problems with GPS interference and opposition from the Pentagon, NASA, and the Department of Transportation. Nonetheless, the Federal Communications Commission (“FCC”) eventually granted conditional approval. Upon receipt of a report concluding that Light-Squared’s technology “could not operate without interfering with the GPS network”, the FCC revoked its approval and Falcone filed for bankruptcy. 

Thereafter, according to the allegations, Falcone and HCP settled a case brought by the Securities and Exchange Commission (SEC) “admitting that they made the personal loan to Falcone without disclosing it for five months, and granted favorable redemption terms to investors in Fund I exchange for investors' votes to impose more restrictive terms without informing Fund I's board of directors or other investors. “ (For a discussion of the settlement, go here).  

Plaintiffs were investors in a family of hedge funds managed by Defendants.  According to the complaint, they claimed that the Defendants made misrepresentations and fraudulent statements after acquiring SkyTerra. The Plaintiffs further alleged that Defendants breached their fiduciary duties in connection with the personal loan to Falcone and "side agreements" granting large investors more favorable redemption terms than the Plaintiffs. Finally, the Plaintiffs brought state-law derivative claims against Defendants.

The court considered the dismissal of Plaintiff’s sixth amended complaint under the Securities Litigation Uniform Standards Act (“SLUSA”).  SLUSA provides that “[A]llegations of misrepresentations and omissions related to covered securities will not trigger SLUSA preclusion if they are extraneous to the bases for liability alleged in the complaint.” 15 U.S.C. § 78bb(f).  Although the Plaintiffs’ sixth amended complaint provided more limited allegations than prior complaints, pertaining only to Defendants’ misrepresentations after acquiring SkyTerra, the court found Plaintiffs’ claims nevertheless triggered SLUSA preclusion because the claims could not be separated from the Defendants’ acquisition of covered SkyTerra securities.

The court also granted Defendants’ motion to dismiss the Plaintiffs’ breach of fiduciary duty claims. The court found that the failure to disclose claims were appropriately raised as direct rather than derivative.  Under Rule 9(b), false disclosure claims must be alleged with particularity.  A plaintiff must "(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent."

The Court found the Plaintiff’s did not indicate "where and when" any of the statements attributed to Defendants were made, did not state whether Falcone, Harbinger, or some other entity was responsible for informing them about the fraudulent loan, or exactly "when" the omissions occurred, and failed to identify any particular speakers with particular statements. Furthermore the Court found that Plaintiffs did not demonstrate any fraudulent statements were made to investors. Because the Plaintiffs failed to state with particularity the circumstances which constituted the fraud or mistake, the court also dismissed the Plaintiffs’ aiding and abetting the breach of fiduciary duty claims.

Finally, the court declined to exercise supplemental jurisdiction over the Plaintiffs’ state-law derivative claims.  Under 28 U.S.C. § 1367, “a district court may decline to exercise supplemental jurisdiction if it has dismissed all claims over which it has original jurisdiction.” Because the court dismissed Plaintiffs’ claims as to misrepresentation, fraud, and breach of fiduciary duty, the court also dismissed Plaintiffs’ derivative claims without prejudice.

The primary materials for this post can be found at the DU Corporate Governance website.


Sun River Energy, Inc. v. McMillan: Calculating the recovery of short-swing profits

In Sun River Energy, Inc. v. McMillan, 2015 BL 84085 (N.D. Tex. Mar. 25, 2015), the United States District Court for the Northern District of Texas determined the amount of short swing profits owed by Harry McMillan (“McMillan”) and Cicerone Corporate Development, LLC (“Cicerone”) on transactions involving shares in Sun River Energy, Inc. (“Sun River”). 

In an earlier decision, the court had found that McMillan and Cicerone (collectively “Defendants”) “beneficially owned more than 10% of the outstanding shares of Sun River common stock at all relevant times and were thus insiders subject to § 16(b).” Sun River sued under Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C 78p(b), to reclaim short-swing profits of $949,104.12 from McMillan, and $1,015,212.30 from Cicerone, with jointly and severally liability imposed for $697,807.90.  

Defendants conceded the sum sought from Cicerone in full and further conceded McMillan’s liability for $501,104.32. The Defendants asserted, however that: (a) McMillan was liable for only $168,000 more than ($669,104.32), and (b) that joint and several liability was less than $697,807.90.

First, Defendants argued that McMillan should only be accountable for half of the 350,000 shares of Sun River sold by Cicerone since he only held a 50% ownership interest in the company at the time of the transaction. Second, Defendants argued that the number of shares should be reduced by 70,000 to avoid counting shares twice.

Sun River asserted that all 350,000 shares were attributable to McMillan, because, he had a pecuniary interest in those shares. As the sole remaining investor in Cicerone, he would have enjoyed the risks and rewards of owning those shares had Cicerone not sold them. It also contended the 50% ownership interest not held by McMillan did not count because the owner of those shares had no opportunity to profit from the sale. 

Sun River pointed to language in Rule 16(a)(2)(i) defining a pecuniary interest as “the opportunity, directly or indirectly, to profit or share in any profit derived from a transaction". The court concluded that the definition identified a pecuniary interest but did not define the extent of the interest. 

Instead, the court pointed to language in the rule providing that a general partner’s indirect pecuniary interest in the portfolio securities is the general partner’s proportionate interest. 17 C.F.R. 240.16a-1(a)(2)(ii)(B) Therefore, the court held McMillan’s pecuniary interest in Cicerone at the time of the transaction was 50%.  Finally, the court reduced the number of shares attributable to McMillan to 105,000, since Sun River had already attributed 70,000 of those shares to McMillan as a result of other transaction.  

The court therefore, calculated the award of short-swing profits by multiplying 105,000 shares by $1.60 per share (the difference between the initial January 14, 2011 market share price and the April 8, 2011 market share price) resulting in a “short swing” profit of $168,000. The court added this to the conceded amount and held McMillan liable for $669,104.32. Because Cicerone did not have a pecuniary interest in the initial January 2011 transaction, the court found McMillan jointly and severally liable along with Cicerone in the amount of $501,104.32. 

The primary materials for this post can be found on the DU Corporate Governance website.


SEC v. Capital Financial Partners LLC. - Complaint

In a complaint filed on April 1, 2015 (“Complaint”), the SEC charged Capital Financial Partners, Capital Financial Holdings, and Capital Financial Enterprises (collectively, “Capital”), William D. Allen, and Susan C. Daub with violations of §10(b) of the Exchange Act, Rule 10b-5 of the Exchange Act, §17(a) of the Securities Act, and unjust enrichment. The SEC asserted that Allen and Daug knowingly schemed and defrauded investors through a “Ponzi” style business operation involving the use of professional athletes. 

The Complaint made the following allegations: 

Allen and Daub, acting through one Florida and two Massachusetts companies represented that they made loans loans to professional athletes "who need[ed] money while they wait[ed] to get paid under their sports contracts (i.e., during the off-season)." Investors were told that they could participate in loans for a "specific athlete."  The website indicated that the loans received a stated interest rate within a range of 9%-18%. Capital retained origination fees in the amount of 3% of the original loan. 

In April and May of 2014, Allen and Daub successfully raised $4 million from investors desiring to participate in a $5.65 million loan to a National Hockey League player.  According to the Complaint:  "The purported $5.65 million loan to the NHL player was a sham. The player did not sign the $5.65 million promissory note or the loan agreement shown to prospective investors. Capital Financial did not make a $5.65 million loan to the player."

In August 2014, Allen and Daub secured investors for a $300,000 loan for a Major League Baseball athlete. Allen and Daub represented to investors that Capital had already made the loan to the player. They provided investors with a promissory note and a copy of the loan agreement. According to the Complaint:  "However, Capital Financial's bank records reflect no payments to this player on or before the date ofthe supposed loan. Bank records indicate that Capital Financial used the money obtained from this investor to meet monthly payment obligations to other investors and to fund one of Allen's personal business ventures."  

Over a three-year period from July 2012 to February 2015, Capital received $13.2 million in repayments from athletes and paid $20 million to investors. As the Complaint described:  "Lacking any other significant source in revenue, it is apparent that Capital Financial managed to pay nearly $7 million more to investors than it received from athletes only because Allen and Daub recycled a substantial portion ofthe approximately $31.7 million raised from investors. In other words, they used money from some investors to pay other investors, while at the same time funneling millions ofdollars ofinvestor money to themselves -the hallmarks of a Ponzi scheme."

Based on these allegations, the SEC is pursuing this action against Capital. The complaint seeks final relief in the form of a judgment providing a preliminary injunction and freezing assets of the defendants; a permanent injunction prohibiting the defendants from engaging, directly or indirectly, in conduct to be described hereafter in violation of §10(b) of the Exchange Act, Rule 10b-5, and §17 of the Securities Act; and disgorgement of Defendants ill-gotten gains with directions to pay civil penalties pursuant to §21(d)(3) of the Exchange Act and §20(d) of the Securities Act. 

On June 12, 2015 the SEC announced the U.S. Attorney’s office in Massachusetts had filed criminal charges against Allen and Daub.  

The litigation release is here.  Other primary materials for the post are available on the DU Corporate Governance Website.


Special Projects Segment: Rewards-Based Crowdfunding, Gluten-Free Forever Magazine

Shortly after her first quarterly issue of Gluten-Free Forever hit the shelves in grocery stores across the nation, I had a telephone interview with Erika Lenkert. We discussed Lenkert’s vision for the new business venture, some of the obstacles encountered while raising capital with rewards-based crowdfunding, and thoughts on raising capital in the future now that the prospect of equity crowdfunding for non-accredited investors has emerged. Recently, with her Spring issue printed, we had another discussion over email about the status of Lenkert’s small business venture.

Gluten-Free Forever Magazine (“GFF”) began as Lenkert’s small vision to merge a world-class food magazine with gluten-free living. As a free lance journalist and culinary world traveler, Lenkert joined forces with Maren Caruso to create a magazine dedicated to delicious food that happens to be gluten-free.

On March 31, 2014, Lenkert and Caruso launched the GFF Kickstarter Campaign to reach a capital raising goal of $90,000 in 30 days. Because rewards-based crowdfunding cannot offer those who donate equity in the project, it is common to offer rewards instead. GFF rewarded its donors deliciously. Some of these rewards included:

•    $1 Donation—A sweet thank you card;
•    $40 Donation—A 1 year digital subscription; or
•    $5,000 Donation—A 1 year print plus digital subscription, two 1-page ads in the first and second issues (content appropriate), and an ad-page rate lock of $2,500 for the first two years in print.
The GFF campaign outlined how the raised capital would be spent, pricing and distribution, its long-term plan, risks and challenges, and some frequently asked questions.  \

On April 30, 2014—its last day on Kickstarter—with 822 backers, GFF successfully raised $94,587. The Inaugural Edition of GFF launched on October 2014. The Winter Issue followed in January 2015. And the Spring Issue printed in April 2015.

Lenkert shared her experiences with crowdfunding for small business capital raising with The Race to the Bottom. Overall, Lenkert expressed gratitude for the crowdfunding process as it provided a means to achieve her dream. She cautioned, however, there are many drawbacks with rewards-based crowdfunding for small businesses, especially if the business model focuses on a special niche, such as a gluten-free recipe magazine.

A major setback for the GFF campaign was joining the Kickstarter platform with the belief that there would be a preexisting “crowd” to support it. As the campaign progressed, Lenkert realized most of her backers were directed to the campaign by word-of-mouth. Lenkert and Caruso rallied the support of family and friends to participate in the campaign. This form of marketing, Lenkert said, “became exhausting and nearly an around the clock effort for the weeks leading up to the deadline.” It impacted not only her ability to prepare for the inaugural issue, but also her presence at home with her daughter. She expressed that this unexpected difficulty in finding a crowd cost her countless hours as she tried to hit capital targets. In retrospect, Lenkert wished she had formulated a marketing and promotion strategy prior to launching the GFF campaign.

Lenkert encountered a minor setback related to the Kickstarter transaction fee. Lenkert shared that joining Kickstarter under the presumption that there will be a preexisting crowd and committing to the 10% platform fee (which is 10% of the total raised capital) was unfortunate because much of the effort driving the campaign came from Lenkert and Caruso’s personal supporters, not a preexisting crowd. To small business owners like them, $9,458.70 was a steep fee to pay to host the GFF campaign on Kickstarter with little benefit other than the credibility behind its name. But Lenkert appreciates the draw that this business model creates—an assurance that if the project does not meet its capital goal, the pledged money will be returned to the backers and the small business entrepreneurs will not be penalized or charged a fee for failing to meet the objective.  

Now, with three issues printed, Lenkert and Caruso excitingly look to the future. The initial capital raised through Kickstarter provided seed money for GFF’s first year (4 issues). When discussing additional capital raising efforts for GFF’s future, Lenkert said she would not likely crowdfund again because of the substantial time demand. Instead, she and Caruso would rather seek like-minded private investors to join their culinary and artistic entrepreneurial vision. Lenkert believes that private investors would lower overhead campaign costs and allow the essential GFF personnel to focus their efforts on the business, which is their primary objective at this point.

I asked Lenkert to share her top 5 recommendations for other small business owners who may be considering rewards-based crowdfunding. She provided the following recommendations to consider before launching a crowdfunding campaign: (1) have a marketing and promotion plan in place; (2) consult with legal counsel; (3) form the legal structure; (4) weigh the cost of the transaction fee and the amount of time you will spend developing a crowd; and (5) consider realistic objectives for your project to ensure a sustainable business model after the initial crowdfunding period.


SEC v. Payton and Durant III: Memorandum in Support of Defendants’ Motion to Dismiss

In SEC v. Durant, S.D.N.Y., 1:14-cv-04644, Brief Feb. 23, 2015, ECF No. 29, the defendants, Benjamin Durant III and Daryl M. Payton (the “Defendants”) submitted a memorandum to the court arguing the SEC’s complaint (“Complaint”) failed to satisfy the basic pleading requirements for an insider trading scheme based upon the misappropriation theory, in violation of Section 10(b) of the Securities Exchange Act of 1934, against remote tippees. The Defendants argued that the Complaint failed to allege the existence of a personal benefit to the tipper and the Defendants’ knowledge of that personal benefit.  They relied extensively on the Second Circuit’s opinion in US v. Newman [United States v. Newman, 773 F.3d 438 (2d Cir. 2014)].  

According to the SEC’s allegations in the Complaint (as described in the Defendant's Memorandum): A junior associate at Cravath, Swaine & Moore LLP (“Cravath”) in the firm’s mergers and acquisitions group learned material, non-public information about IBM’s acquisition of SPSS, Inc., including the anticipated per share purchase price and the identities of the parties to the transaction (the “Information”). In May 2009, the associate, seeking "moral support" on the assignment, disclosed the Information to Martin.

Martin allegedly misappropriated the Information, made trades on it, and disclosed some of the Information to his roommate and nonparty, Thomas Conradt, a registered broker-dealer who worked with the Defendants. Conradt allegedly passed on this information to Payton.  With respect to the receipt of the Information by Durant, the Defendants describe the SEC's allegations as "entirely contradictory".  On July 28, 2009, when IBM’s acquisition of SPSS was announced, Durant and Payton allegedly netted profits of $53,000 and $243,000, respectively.

To prove tippee liability, the SEC must prove: (1) the corporate insider had a fiduciary duty; (2) the corporate insider breached his fiduciary duty by disclosing confidential information to a tippee in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach; and (4) the tippee used that information to trade or tip another for personal benefit. 

In their first argument for dismissal, the Defendants asserted that the SEC’s only possible alleged source of a personal benefit arose out of Conradt's friendship with Martin.  The Second Circuit, however, held in Newman that a personal benefit may not be proved based solely on the mere fact of friendship. Thus, the allegations in the Complaint were insufficient to establish personal benefit.   

Second, the Defendants argued the Complaint was devoid of any allegation that they knew Martin was receiving a benefit or that the allegations in the Complaint were too speculative. According to the Defendants, the Complaint alleged their knowledge in a conclusory fashion by asserting that when Conradt disclosed the Information to Defendants, he also told them that Martin, his roommate, had disclosed the Information to him. 

Third, the Defendants argue the Complaint failed to show they knew or had reason to know the Information was obtained and disclosed in breach of a fiduciary duty. Rule 10b-5 requires that to be found liable for insider trading, a defendant must inherently believe the information received was acquired in breach of a fiduciary duty. The Complaint only asserted that Conradt told the Defendants the source of the information was his roommate and friend. 

Finally, the Defendants contended that the Complaint failed to allege Durant was involved in a misappropriation scheme at all. The Complaint presented contradictory positions on a critical issue, the identity of the person who tipped Durant. The Complaint stated in paragraph 3 that Conradt tipped “several other representatives associated with the broker-dealer . . . including Defendants Payton and Durant,” but paragraph 63 contended that Conradt “learned that the information had also been communicated to Durant . . . .” If the Court accepts these allegations as true, it must assume that Conradt learned Durant was tipped, and also that Conradt tipped Durant. The Complaint simply alleged that Conradt was aware Durant knew the same information, but not how. 

For the reasons discussed above, the Defendants argued the SEC’s complaint failed to satisfy the elements of insider trading and tippee liability and their motion to dismiss should be granted. 

The primary materials for this case may be found on the DU Corporate Governance website

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