Similarly, under Regulation FD, companies are not allowed to selectively disclose material non-public information to investors or analysts (among others).  To the extent that the information is distributed to these persons, it must also be disclosed to the public.  As the adopting release noted: 

The timing of the required public disclosure depends on whether the selective disclosure was intentional or non-intentional; for an intentional selective disclosure, the issuer must make public disclosure simultaneously; for a non-intentional disclosure, the issuer must make public disclosure promptly.

Exchange Act Release No. 43154 (Aug. 21, 2000). 

All of this begs the question as to what constitutes public disclosure.  The issue has come up because of reports that the SEC is looking into efforts by Netflix to disclose information over social media, particularly Facebook.  According to the WSJ, the SEC warned Netflix about disclosure over Facebook that Netflix "exceeded 1 billion hours of video streaming in a month for the first time."  

Using Facebook to reply, the CEO of Facebook equated disclosure over Facebook with disclosure to the public. 

• He said further disclosure at the time wasn't necessary because he has more than 200,000 subscribers to his Facebook page, which makes it a "very public" forum. Netflix had also disclosed on its blog in June that it was nearing the 1 billion streaming hours milestone, he said. Mr. Hastings, who is also on the board of Facebook, added that, at any rate, such information isn't a "material" event to investors.

The interaction, therefore, raises the question as to whether disclosure over social media constitutes public disclosure under the federal securities laws.  The answer is a decided "maybe." 

The SEC discussed this issue in the adopting release for Regulation FD.  The Release noted that public disclosure could occur through "press releases distributed through a widely circulated news or wire service, or announcements made through press conferences or conference calls that interested members of the public may attend or listen to either in person, by telephonic transmission, or by other electronic transmission."  Although social media was not in existence at the time of the release, the same rational would apply.

But it was not enough to simply post the information or diclose it in a conference call open to the public.  As the SEC noted, the "public must be given adequate notice of the conference or call and the means for accessing it."  The Commission, however, recognized that sometimes the public would be aware that important information was revealed through a web site.  See Id.  ("As technology evolves and as more investors have access to and use the Internet, however, we believe that some issuers, whose websites are widely followed by the investment community, could use such a method."). 

In 2000, when the release was issued, use of the Internet was uneven.  Companies often did not have web sites.  Move forward more than a decade and things have changed.  Most if not all public companies have web sites and most regularly post press releases, SEC filings, and other important information.  Today, disclosure over the Internet for most public companies likely meets the defintion of public disclosure.

Social media is not in the same position.  At least right now it does not appear to be a common avenue for the exclusive distribution of material nonpublic information.  Thus, it is not enough to contend that the information is accessible to large swathes of the public (as it surely is).  The issue is whether the information is regularly accessed by the investment community.

Eventually, social media will be a regular method of disseminating material nonpublic information.  In the short term, companies can enhance this possibility by giving notice of impending announcements so that the public (and the investment community) will know to access the source.  Moreover, as information is regularly distributed in this fashion, analysts and other members of the investment community will regularly access the source, making notice unnecessary. 

But for now, in this transitional period, companies are better off using social media as an additional rather than exclusive source of public disclosure. 

In fact, an examination of the statements issued by the five commissioners indicates a much more serious division than even the 4-1 vote suggests.  In a statement by the Chairman, she determined that the proposal was consistent with the "narrow mandate" required by Congress in Section 201 of the JOBS Act.  She noted other concerns raised in connection with the lifting of the ban and indicated that the Commission would "take a thorough look at the private placement market in the future."  Specifically, she noted the requirement in Dodd-Frank that the accredited investor standard be reviewed in its "entirety" beginning four years after the enactment of the Act. 

Commissioner Aguilar cast the one dissenting vote.  As he rightfully noted, the elimination of the ban on general solicitations was likely to result in an uptick in fraud.  This was not speculation but, as Yogi Berra would have said, deja vu all over again.  The SEC eliminated the general solicitation ban under Rule 504 in 1992 and had to reinstate it in 1999 because of the rise in microcap fraud.  Commissioner Aguilar declined to support a proposal that contained "no consideration of any of the commenters’ proposals that would have decreased investor vulnerability."  He noted a pair of them, including amending the definition of accredited investor and amending Form D. 

Commissioner Walter voted for the proposal but was "disappointed" that comments suggesting ways to "mitigate the risks that the proposed rule might pose" were not subject to a "meaningful[] discussion" in the release.

The two remaining commissioners voted for the proposal but objected to the failure to implement the rule as an interim final rule.  An interim final rule allows the rule to be effective immediately but permits comments in the post-effective period that may or may not be used to modify the rule at some later date.  In other words, they objected to the use of notice and comment prior to the effective date.  

Some of the anger was apparently derived from a sudden change in plans at the SEC.  Commissioner Paredes noted that "[f]or some time the Commission was set to consider an interim final rule" but that the Chairman "abruptly decided to change the rulemaking’s course, turning what was an interim final rule into a proposal."  He asserted that an interim final rule "would have allowed us to satisfy the clear statutory directive of the JOBS Act while setting the stage for a later rulemaking that would account for the actual consequences that resulted once issuers were given flexibility to more readily reach investors when raising capital."

Commissioner Gallagher made it clear that while voting yes "as a matter of substance" he "would certainly vote 'no' on the process that led up to" the proposal.  He noted that "[f]or months, the Commission had been told that the Staff was recommending that we vote on an interim final rule." Nevertheless, "earlier this month, we were told that the Chairman had reconsidered the draft interim final rule and wanted to re-cast it." 

In objecting to the approach, he took the position that the Commission can, "for good cause" adopt an "interim final release - a way to go ahead and make the required change, while at the same time soliciting market reactions to how the change actually works." Or, as he said later in his remarks, "I want to leave no doubt that, charged with quickly implementing Congress's explicit direction to implement a bottom-line mandate simply to remove the prohibition on general solicitation and general advertising in two well-traveled rules, we had plenty of 'good cause' to employ an interim final rule as our chosen procedural tool."

Putting aside the sudden shift in administrative strategy, the decision to avoid an interim final rule must be seen in the context of Business Roundtable v. SEC, the DC Circuit decision that struck down the shareholder access rule.  It is clear from that decision that all controversial rules are vulnerable to challenge and that the DC Circuit will provide little deference to the Agency.  To have undertaken an interim final rule, the SEC would have had to show "good cause."  Good cause is a term of art that means notice and comment was "impracticable, unnecessary, or contrary to the public interest." 5 USC 553(b).   

Courts do not allow notice and comment to be set aside easily.  They do so when there is an emergency.  They do not, typically, do so when the justification is a missed deadline for rulemaking.  See Petry v. Block, 737 F.2d 1193, 1203 (DC Cir. 1984) ("strict congressionally imposed deadlines, without more, by no means warrant invocation of the good cause exception.").  There are exceptions but they do not appear applicable in this case. 

Comments in the press suggested that litigation risk played a role in the Chairman's decision to not adopt an interim final rule.  See WSJ ("An SEC spokesman said implementing rules too hastily could expose the agency to court challenges.").  In the past, the pros and cons of rules were mostly resolved at the agency level.  In the Business Roundtable era, that is simply no longer the case.

We have, on this Blog, questioned the position taken by the SEC staff with respect to the exclusion of shareholder proposals seeking board consideration of mandatory rotation of auditors.  The staff allowed the proposals to be deleted from the proxy statement under the "ordinary business" exclusion in Rule 14a-8.  The letters are discussed here. 

The issue has been taken up by Commissioner Aguilar at the SEC.  In a recent speech before the NAPPA 2012 Legal Education Conference, the Commissioner took issue with the characterization of mandatory rotation as an "ordinary business" matter.  See id.  ("I am not convinced that the engagement of the independent auditor should necessarily be considered a matter relating to 'ordinary business operations' within the meaning of the Federal proxy rules.").  He pointed both to applicable legal authority and to the longstanding role of shareholders in the auditor selection process. 

In addition, Commissioner Aguilar took issue with the staff's determination that the public policy exception to the ordinary business exclusion was inapplicable. 

In those cases in which a proposal's underlying subject matter transcends the day-to-day business matters of the company and raises significant policy issues, the proposal is generally not excludable on such grounds.  This is particularly the case when an issue has emerged as a topic of “widespread public debate,” as this issue has been.  Given the extensive public discussion occasioned by the PCAOB’s concept release, and the long history of debate on this issue, a strong case can be made that shareholder proposals relating to auditor independence and objectivity and audit quality raise significant policy issues and should not be excluded on ordinary business grounds.

Mandatory rotation of auditors is an important matter of governance.  The staff's position interferes with the ability of shareholders and managers to collectively resolve the issue.  Perhaps it is time for the staff to reconsider its position.   

Pressure for shareholder access originally centered on the right of shareholders to submit bylaws that would require companies to include nominees in their proxy statements.  This would have allowed for a system of private ordering.  The Commission, however, opted to allow for the exclusion for these types of proposals.  As a result, pressure built for more direct access whereby shareholders could submit nominees for inclusion without having to first adopt the requisite bylaw.  Such a rule was adopted but was not implemented because of a weakly reasoned decision of the DC Circuit.  For an analysis of that case, go here. 

The same thing is likely to happen here.  Because auditors are paid by the companies they audit, there is always pressure to act in the interests of management rather than the company (and by extension shareholders).  Abuses will sometimes surface, something more likely to be uncovered with the creation of the PCAOB and its more rigorous approach to inspections.  Pressure will, therefore, build for reform.  In particular, pressure will continue to build for mandatory rotation of auditors.

Allowing shareholders to submit and vote on proposals that would require rotation take off some of the pressure for a mandatory and categorical rule.  Moreover, these proposals are not likely to be adopted except in companies that have shown through past behavior the need for greater auditor independence.

Yet by allowing for the exclusion of shareholder proposals regarding auditor rotation and independence, the staff at the Commission merely permits the pressure for reform to grow.  Shareholders and other interest groups will not get relief appealing to state law since these are management friendly jurisdictions and not likely to increase the authority of shareholders at the expense of management. 

They can appeal to other agencies, such as the PCAOB.  But as SOX has shown with respect to the separation of auditing and non-auditing functions and Dodd-Frank has shown with respect to say on pay, the more accommodating forum will be Congress.  Eventually when the right accounting scandal erupts, Congress will act and, when it does, the rule concerning rotation will likely be categorical.

Predicting the future is not easy, but in this case the direction is clear enough.  As long as the SEC gives shareholders no meaningful role in ensuring auditor independence, shareholders will seek, and eventually get, the authority from other sources.  

Finally, it should be noted that this issue with respect to staff interpretation is not limited to auditor independence.  In fact, the staff needs to essentially get out of the role of determining both "ordinary business" and public policy.  But that issue, discussed in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors, is for another day.

Therefore, Be It Resolved: That the shareholders of Dell Inc. request that its Board Audit Committee prepare and disclose to Company shareholders an annual Audit Firm Independence Report that provides the following:

1. Information concerning the tenure of the Company's audit firm if such information is not already provided, as well as the aggregate fees paid by the Company to the audit firm over the period of its engagement; 2. Information as to whether the Board's Audit Committee has a policy or practice of periodically considering audit firm rotation or seeking competitive bids from other public accounting firms for the audit engagement, and if not, why; 3. Information regarding the mandated practice of lead audit partner rotation that addresses the specifics of the process used to select the new lead partner, including the respective roles of the audit firm, the Board's Audit Committee, and Company management; 4. Information as to whether the Board's Audit Committee has a policy or practice of assessing the risk that may be posed to the Company by the long-tenured relationship of the audit firm with the Company; 5. Information regarding any training programs for audit committee members relating to auditor independence, objectivity, and professional skepticism; and  6. Information regarding additional policies or practices, other than those mandated by law and previously disclosed, that have been adopted by the Board's Audit Committee to protect the independence of the Company's audit firm.

Dell (May 3, 2012).  The staff again allowed for exclusion, again because the proposal intruded into the ordinary business of the corporation.  As the staff reasoned:

There appears to be some basis for your view that Dell may exclude the proposal under rule 14a-8(i)(7), as relating to Dell's ordinary business operations. In this regard, we note that while the proposal addresses the issue of auditor independence, it also requests information about the company's policies or practices of periodically considering audit firm rotation, seekig competitive bids from other public accounting firms for audit engagement, and assessing the risks that may be posed to the company by the long-tenured relationship of the audit firm with the company. Proposals concernng the selection of independent auditors or, more generally, management of the independent auditor's engagement, are generally excludable under rule 14a-8(i)(7).  Accordingly, we will not recommend enforcement action to the Commission if Dell omits the proposal from its proxy materials in reliance on rule 14a-8(i)(7).

The analysis was repeated in letters to Xilnx, McKesson, Computer Sciences Corporation, and CA, Inc.

In addition to the questionable analysis about the application of the ordinary business exclusion (and non-application of the public policy exception), these proposals raise another more critical issue.  The truth is that most companies submit the auditor to shareholders for approval.  This is discussed in see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

But the disclosure companies must give when submitting the matter to shareholders provide no meaningful basis for shareholders to determine the quality of the services provided.  For the most part, companies only have to disclose fees, dividing them into audit and non-audit services. Specifically, Item 9 of Schedule 14A does not require any meaningful qualitative disclosure. 

It does require disclosure of audit related fees, tax fees, and all other fees.  But this information is out of date and not particularly useful in the shareholder voting process.  These categories were developed prior to SOX when shareholders needed to know the relationship between audit and non-audit fees.  In SOX, however, Congress largely prohibited auditors from performing most non-audit services, rendering the disclosure for the most part irrelevant.

Thus, these proposals are designed to fill a gap left by the SEC's disclosure regime.  They seek to ensure that shareholders when approving auditors have available meaningful information on the qualitative aspects of the relationship. 

As we noted, the SEC has allowed for the exclusion of auditor rotation proposals under Rule 14a-8, agreeing that they constitute "ordinary business" and therefore fall into subsection (i)(7).  The staff, however, is wrong on this issue.

First, this is not a matter of ordinary business.  This is not the case where shareholders are asking the board to open a new office or change a term of employment.  This is an instance where shareholders are asking the board to ensure that a gatekeeper designed to protect the interest of shareholders can better peform that task.  For most of the history of the SEC, the staff took the position (as have the courts) that shareholders had a right to participate in the auditor selection process.  See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

Second, it is a matter of important public debate.  To argue otherwise is extraordinary.  The PCAOB issued a concept release on whether auditor rotation should be made mandatory.  The release chronicles the very public nature of the debate, something that has been ongoing for more than two decades. The release has generated a deluge of statements, meetings, and comments.  For a review of the 639 comment letters (as of May 24, 2012), go here.  That the matter is somehow deemed not sufficiently important to take it out of the ordinary business exclusion is to show the ruderless and standard less nature of the application of that provision. 

The staff, therefore, has gotten the analysis wrong.  Moreover, the burden with the exclusion of a proposal is supposed to rest with the party seeking exclusion.  Finally, to the extent companies disagree, they have yet another forum to litigate the issue.  If shareholders pass a resolution mandaing rotation, companies can challenge the provision in state law, arguing that it is a matter left to the discretion of the board. 

The ordinary business exclusion in Rule 14a-8 provides that management may exclude from the proxy statement matters that fall within the ordinary or day to day business of the company. The theory is that state law vests in the board, not shareholders, the authority to make ordinary business decisions.  The problem, however, is that there is very little state law dileneating what is and is not an ordinary business decision.  As a result, for the most part, the matter is within the discretion of the staff, unguided by state law, to determine. 

Moreover, whatever state law suggests, the SEC has grafted onto the exclusion an exception that is not contained in state law.  Since 1976, the staff has allowed the inclusion of proposals that implicate this exclusion so long as it implicated issues of important public or social policy.  The SEC was forced into this position after a history of allowing the exclusion of proposals that called for the end of segregation on buses and the production of napalm.  All of this is discussed in detail in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

This is another area where the staff has no meaningful guidance.  These are not terms of art.  There are no recognized standards.  And, because it is not an exception recognized under state law, there is not even meaningful philosophical guidance on when to apply the public/social policy exception.  Thus, this is determined entirely by the staff, a matter not within its traditional expertise and one that changes from Commission to Commission (another matter discussed in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors). 

The problems with the interpretation of the ordinary business exclusion can be seen with particular vigor in connection with the auditor rotation issue. 

In AT&T Inc. (Jan. 5, 2012), for example, shareholders submitted a proposal that called for the following:  

Be it Resolved: That the shareholders of AT&T Inc. hereby request that the Company's Board Audit Review Committee establish an Audit Firm Rotation Policy that requires that at least every seven years the Company's audit firm rotate off the engagement for a minimum of three years.

The staff, however, allowed for the exclusion of the proposal.  The reason?  It fell within the "ordinary business" of the company.  As the staff reasoned:

There appears to be some basis for your view that AT&T may exclude the proposal under rule 14a-8(i)(7), as relating to AT&T's ordinary business operations. In this regard, we note that the proposal relates to limiting the term of engagement of AT&T's independent auditors. Proposals concerning the selection of independent auditors or, more generally, management of the independent auditor's engagement, are generally excludable under rule 14a-8(i)(7). Accordingly, we will not recommend enforcement action to the Commission if AT&T omits the proposal from its proxy materials in reliance on rule 14a-8(i)(7).

The analysis was repeated in a number of other letters.  See ITT Corp. (Jan. 13, 2012), ConocoPhillips (Jan. 13, 2012), Dominion Resources (Jan. 4, 2012).  Moreover, the staff took the position irrespective of the particular circumstances at each company.  Thus, the staff allowed GE to exclude a mandatory rotation proposal (See GE (Dec. 23, 2011)) despite the fact that GE has been sanctioned for accounting problems (See SEC v. General Electric, Litigation Release No. 21166, Aug. 4, 2009) and appears to have a very, even excessively, close relationship with its auditor.

We will discuss the analysis use by the staff in the next post.

The debate for the most part is over a mandatory rule.  In other words, the proposal would potentially require all public companies to rotate their auditor after a specified number of years.  In general, this again triggers the debate over the choice between mandatory rules and private ordering.  Private ordering contemplates that each company will select the appropriate approach depending upon the company's particular circumstances.  In theory, private ordering involves a debate between owners and managers.  Thus, the approach contemplates some say in the matter by shareholders.  

Because management (specifically the audit committee) already has the right to select (and change) the auditor, a system of private ordering requires the creation of a mechanism for involvement by shareholders.  The obvious mechanism is Rule 14a-8, the shareholder proposal rule.  Under the rule, shareholders can submit proposals calling for mandatory rotation. 

To the extent a proposal is allowed, management can campaign against them and try to ensure their defeat by shareholders.  Alternatively, management can conceded the point or negotiate over a compromise to get the shareholders to withdraw the proposal.  Either way, shareholders have a say in the decision and mandatory rotation is resolved on a company by company basis.

Only the staff at the SEC has shut the door to proposals concerning mandatory rotation.  A series of noaction letters have found that these type of proposals can be deleted under Section (i)(7), the infamous "ordinary business" exclusion. We will discuss the use of this exclusion in greater detail in subsequent posts.  In the meantime, for a detailed history and analysis of the ordinary business exclusion, see Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

The other case, SEC v. Ruettiger, was described as a "classic pump and dump scheme" that gained publicity mostly because it named Daniel Ruettiger as a defendant.  Ruettiger was apparently the ndividual who "inspired" the 1993 movie "Rudy."  We think that SEC v. Ruettiger deserves some attention for more than just the connection to "one of the best 25 sports movies of the previous 25 years". 

In the traditional pump and dump scheme, the pump consists of false statements designed to encourage investors to enter the market, pushing up share prices.  In the Internet era, the statements are often distributed electronically, particularly through emails.  As interest increases and price/volume rise, the perpetrators of the fraud dump their shares.  When the shares are sold and the fraudulent statements stop or are exposed, the market price collapses.  The last one to hold shares watches his or her value plumet.

Usually the statements intended to pump the market are directorly related to earnings.  The SEC has brought cases alleging that the market was primed by statements included a "baseless share projection," business with nonexistent customers, relationships with well known public companies that in fact did not exist, and false claims about the nature of the company's business.       

In Ruettiger, however, the allegations were a bit more subtle and perhaps more long term.  According to the complaint, the scheme involved a company that manufactured a sports drink that was intended to compete in the national market.  As part of the pump process, the SEC alleged that the information was distributed that falsely claimed the company had partnership agreements with "two large soft drink distributors."  See Complaint, at P. 70. 

In addition, however, statements were made that in “a major southwest test, Rudy outsold Gatorade 2 to 1!”  Emails sent to prospective investors represented that in “several blind taste tests, Rudy outperformed Gatorade and Powerade by 2:1.”  See Complaint, P. 75.  The SEC alleged that both statements were "materially false or misleading."  Id.  

This latter group of misstatements for the most part went to the quality of the product.  They essentially asserted that "Rudy" was better than Gatorade.  The SEC's action, therefore, suggests that companies can be sued under the antifraud provisions on the basis of statements about product quality.  Moreover, the statements need not appear in missives sent directly to investors.  They can, for example, be in advertisements.  See In re Carter-Wallace, Inc. Secur. Litig., 150 F.3d 153 (2nd Cir. 1998).

It should be noted, though, that there were a number of factors that made SEC v. Ruettiger an easier case.  First, given the apparent importance of the sports drink to the company, the materiality of the statements about the sports drink seemed clear.  Second, the statement about quality included objective elements.  The statements about quality were dependent upon a "major southwest test" and "blind taste tests".  To the extent that these did not occur, the statement is objectively inaccurate.  Third, the material was sent directly to investors, demonstrating an attempt not to influence consumers but investors. 

Nonetheless, the case is a reminder of the reach of the antifraud provisions. 

• We believe the court was incorrect in requiring an admission of facts — or a trial — as a condition of approving a proposed consent judgment, particularly where the agency provided the court with information laying out the reasoned basis for its conclusions. Indeed, in the case against Citigroup, the SEC filed suit after a thorough investigation, the findings of which were described in extensive detail in a 21-page complaint.

• The court’s new standard is at odds with decades of court decisions that have upheld similar settlements by federal and state agencies across the country. In fact, courts have routinely approved settlements in which a defendant does not admit or even expressly denies liability, exactly because of the benefits that settlements provide.

Litigation carries risks.  Moreover, the SEC had alternatives.  It could have terminated the suit and refiled as an administrative proceeding.

But the appeal is the right step (and one we suggested on this Blog).  When courts make bad law, the SEC should not leave the matter unaddressed.  That is exactly what the Commission is doing.

The SEC alleged that Defendants engaged in a Ponzi scheme that promised investors high yields on stone pavers, defrauding over 140 people out of $16 million.  From March 2006 until 2010, according to the complaint, Aronson, Kondratick, and Buonauro sold unregistered securities to inexperienced investors.  These defendants used $10 million to repay earlier investors in “Ponzi-type payments” and $11 million to pay themselves and the Relief Defendants.  Aronson, Kondratick, and Buonauro were said to have spent investors’ money on home mortgage payments, luxury cars, Las Vegas gambling trips, and gentlemen’s club bills. 

According to the SEC’s complaint, Aronson founded PermaPave Industries in October 2006.  The company told its investors that it would buy and ship “permeable paving stone comprised of small rocks glued together” from Australia to be sold in the United States.  Aronson hired his brother-in-law, Kondratick, Buonauro, and Aaron, an attorney.  Aronson, Kondratick, and Aaron subsequently formed the other PermaPave companies.  For the next four years, Aronson, Kondratick, and Buonauro sold securities in the form of promissory notes and “use of funds” agreements.  The securities provided for annual rates of return between 94% and 400%.  Both men stated that the stone pavers were in high demand and the profits generated by the companies would be used to repay investors.  In reality, according to the SEC, the PermaPave companies and the stone pavers had never been profitable. 

The complaint alleged that when investors began demanding the return of their money in 2009, Aronson and Aaron persuaded them to convert their promissory notes and use of funds agreements into different securities that paid lower interest rates and deferred payments for two years.  In addition, “Aronson told investors that exchanging their promissory notes and use of funds agreements for convertible debentures was their only choice because the interest rates on the notes and agreements were usurious, and investors had committed a ‘class C felony’ by signing them for which Aronson could have had them arrested.” 

Among several other claims, the SEC asserted that Aronson, Buonauro, Kondratick, the PermaPave companies, and Interlink violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 by engaging in fraudulent transactions and obtaining investments by making “untrue statements of a material fact.”  The SEC also claimed that the Relief Defendants incurred unjust enrichment. 

The SEC is seeking a permanent injunction barring Defendants from engaging in similar practices and an order requiring Defendants and Relief Defendants to disgorge their ill-gotten gains plus prejudgment interest.  The SEC is also seeking to impose civil penalties upon the PermaPave companies, Aronson, Buonauro, Kondratick, and Aaron under Section 20(d) of the Securities Act, and to bar Aronson, Kondratick, and Aaron from serving as an officer of any publicly traded company or from participating in a penny stock offering.

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

For now, we focus on his discussion of the "commentary" on the “neither admit nor deny” policy.  First, he had this to say about settlements. 

• When the Division of Enforcement recommends that the Commission settle a case, it is because our informed judgment tells us that what we are obtaining in settlement is within the range of outcomes we reasonably can expect to get after we prevail at trial, taking into account the strength of the case as well as the delay and resources required for a trial and the benefits of returning money to harmed investors quickly – not to mention the chances that we might lose at trial, or win but be awarded less than what the settlement achieves.

Refusing to approve such a settlement was in his view an "unwise policy."  As for the purported fear of going to trial, Khuzami noted that the Division was not "reluctant to try cases."  Cases were settled for "the right reasons."  To believe otherwise, he noted, it would be necessary to believe:

• That we established and funded an entirely new specialized unit directed solely at investigating fraud related to structured and mortgage-related products that gave rise to the credit crisis … that we staffed that unit with dedicated and talented SEC staffers, some of whom have spent their careers in public service, and all of whom are committed to uncovering fraud in these markets and transactions … we hired private sector experts with market experience to cut through the jargon and the complexities and help us zero in on the possible areas of misconduct … we set up extensive training programs to teach these staffers the complexities of structured products and the markets in which we operate; the staff then went out and spent years pouring over millions of pages of documents, e-mails and 500-page prospectuses and indentures and flow charts to find evidence of fraud … then spent months and years in conference rooms questioning witnesses about these transactions in painstaking detail … and then we put together our case, charging both the company and the persons who were responsible for the deal.

Given that the SEC was going forward with a trial against the individual charged, the idea "that we nonetheless intentionally settle the case against the company on the cheap because we just don’t like to try cases, or for other, even more ridiculous reasons" reflected a "fundamental misunderstanding about the professionalism and commitment of the SEC staff".

Khuzami's discussion reflects the complex considerations that go into settlements and the use the "neither admit nor deny" approach.  The discussion demonstrates why implementation ought to be left to the Agency and the parties and not be a matter of judicial fiat.

But more importantly, the reasoning of the case ultimately threatens to harm shareholders and investors by forcing the SEC to litigate more cases. 

Litigation is expensive and uses up resources.  The SEC has already had an exceptionally hard time getting an adequate budget out of Congress.  To the extent having to litigate more cases, this would likely require the Agency to strip resources from other areas and other projects.  Most logically, at least some of the funds would come out of the budget used to pay those who investigate possible violations.  In short, there will be fewer investigations and fewer resources seeking the next Madoff.

Yet there is another even darker implication of this approach.  Given that big financial institutions have an almost unlimited budget to pay attorneys, they can afford to litigate cases to the bitter end.  Smaller entities and individuals may not have the same ability.  The result might be fewer cases against large businesses. 

And, indeed, this is something the WSJ implicitly suggested ought to happen.  An editorial in the paper had this to say about the consequences of making the SEC litigate more cases. 

• we might learn whether these cases have legal merit or are merely easy attempts to extort a deep-pocketed target. The SEC knows companies want to avoid reputational and legal costs, not to mention the risk of a trial lawyer pile-on. But how many cases would the SEC bring if it knew it had to prevail in court?

To some degree, the decision stands for the proposition that this type of language is never acceptable, at least where the relief is substantial.  The court itself all but said this.  See SEC v. Citigroup ("It is not reasonable, because how can it ever be reasonable to impose substantial relief on the basis of mere allegations?").  Of course, one could argue that injunctive relief enforced by contempt is always "substantial."  Were this to be the case, the SEC could no longer rely on settlements of this kind.  

This could significantly increase the number of cases that were litigated.  Particularly where the SEC sought to charge a scienter based claim, defendants would have considerable incentive to litigate, either in an effort to win or to provide delay.  Delay might, for example, give defendants time to settle any private litigation before there was a ruling in the SEC case.  Because the SEC has limited resources, more litigation would mean less money for other administrative activities.  The Commission could strip funds away from operating divisions and give them to Enforcement.  Or Enforcement would, within its own budget, be forced to spend more on litigation and less on investigations.  

Alternatively, the decision could paradoxically result in less protection for the public.  This could push the SEC to bring more settlements as administrative proceedings.  These proceedings are not subject to court approval.  Moreover, because violations are not enforceable through contempt proceedings, the public arguably gets less protection.

Certainly, the same court's opinion in SEC v. Gupta suggested that the SEC should have a strategic justification selecting an injunctive versus administrative forum.   Ease of negotiating and approving a settlement ought to qualify.  

The decision poses numerous problems for the Commission.  For one thing, it is internally inconsistent. 

The court characterized these settlements as having little evidentiary or other value.  The criticism is overbroad.  SEC cases provide can provide plaintiffs with a roadmap for their own action, often involve obtaining relief that cannot be obtained by private parties (as the court noted, the SEC can recover amounts for negligent behavior, private parties cannot), and they may have some evidentiary value.  See THE ANSCHUTZ CORPORATION v. MERRILL LYNCH, 785 F. Supp. 2d 799, 821 (ND CA 2011)(declining to dismiss motion to strike references to various investigations and resulting settlements conducted by the New York Attorney General and the SEC because "regulatory investigations and settlements may be relevant to issues in this case"). 

But more importantly, even to the extent true, the court declined to approve the settlement because of its very importance.  Thus, the SEC was seeking "substantial injunctive relief, enforced by the  Court's own contempt power".  Or, said another way, the SEC was asking the court "to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt". In other words, it was the serious impact of the settlement (which presumably equated to a public benefit) that required the court to insist on factual findings. 

The court also effectively overstated the value of factual admissions.  The parties could, for example, renegotiate the settlement and agree to a thin list of admissions.  To the extent the SEC continued to charge Citigroup only with negligence under Section 17, private litigants would still have to prove scienter. To the extent the facts admitted merely established an aiding and abetting standard, private litigants would still have to prove a primary violation.  In other words, the mere elimination of the "neither admit nor deny" language does not automatically result in substantial benefit to private litigants.