With this terse order by the D.C. Circuit, it is official, the SEC's conflict minerals rule is unconstitutional ... but only to the extent that it requires public issuers who did make use of conflict minerals to state on their disclosures that their products have “not been found to be ‘DRC conflict free.’” 

The idea is that this was forcing firms to declare that they had blood on their hands, and I find it all pretty unconvincing.  The SEC can require firms to make disclosures in particular ways, it can require firms to make climate change disclosures, and it can tell them to identify, say, risk factors of participating in a securities offering that make the issuer look bad.  This is all forced speech, and a disclosure based agency couldn't function if it couldn't require disclosures, including uncomfortable disclosures, permitting an inference that the issuer is incompetent, naive, whatever, and that the speaker would rather not say.  

There may be a line that can be drawn - the SEC can require firms to say uncomfortable things, but it can't require them to say an exact set of words that make them look bad.  I guess that would be a rule, but it wouldn't be much of a rule.

For example, consider the conflict minerals rule itself, which is both unconstitutional and very much in effect.  Although companies do not have to attest that the products they make are not DRC-conflict free, they do have to do everything else: investigate their supply chains, describe their investigation, and report on the results of that investigation, including whether it revealed that they make products involving conflict minerals.

Anyway, Congress hasn't lost its taste for conflict minerals, and bills have been introduced in the House and Senate to add to the SEC's policing in this area.  That's something that will not overjoy those in the agency who never thought of it as the tip of the spear in the spreading of human rights values.

There's a nice wrap over at Jim Hamilton's, and I've written about conflict minerals, as has Jeff Schwartz.

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The final rule is 686 pages long, which Corp Counsel describes, reasonably, as "humongous."  I'm generally fine with lengthy statues, and have no problem being opposed to arguments like "they wrote the Constitution on an index card and last year's budget on a pallet of A4, and look which one is better!"

But still, that's quite a long release for a rule that shouldn't be all that technical.  I think I'll wait for some law firm memos before I dive in.

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Rep. Scott Garrett has introduced a bill that would make administrative proceedings optional for all defendants, and also change the standard of proof for them.  It would basically kill things for SEC ALJs, and the enforcement division's new policy of directing cases their way (with one caveat that I bring up below).  The bill's introduction suggests that not everyone is happy with the agency's attempt to hold onto its discretion to bring enforcement actions administratively or judicially by lengthening the time for proceedings to eight months (from four), and permitting a smidgen of discovery.

Check out the language of the bill:

“(a) Termination Of Administrative Proceeding.—In the case of any person who is a party to a proceeding brought by the Commission under a securities law, to which section 554 of title 5, United States Code, applies, and against whom an order imposing a cease and desist order and a penalty may be issued at the conclusion of the proceeding, that person may, not later than 20 days after receiving notice of such proceeding, and at that person’s discretion, require the Commission to terminate the proceeding.

“(b) Civil Action Authorized.—If a person requires the Commission to terminate a proceeding pursuant to subsection (a), the Commission may bring a civil action against that person for the same remedy that might be imposed.

“(c) Standard Of Proof In Administrative Proceeding.—Notwithstanding any other provision of law, in the case of a proceeding brought by the Commission under a securities law, to which section 554 of title 5, United States Code, applies, a legal or equitable remedy may be imposed on the person against whom the proceeding was brought only on a showing by the Commission of clear and convincing evidence that the person has violated the relevant provision of law.”.

I've never heard of another place where a defendant has the discretion to insist that an enforcement action against her be dismissed - not move for it, just send notice that the defendant will be dismissing the action.  And I've never heard of this clear and convincing stuff before - the argument has been that the SEC has advantages before ALJs, but not particularly because of the burden of proof.  In one way, the bill would make the defendant's decision a bit more difficult.  On the one hand, she can have court whenever she wants, but on the other, administratively, she gets the benefit of a clear and convincing standard, more demanding (in theory) than a preponderance of the evidence standard.  Decisions, decisions.

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Our own Lisa Fairfax has been nominated to fill an opening on the Securities and Exchange Commission. Congratulations, Lisa! Well done, President Obama! Now Senate, do your part.

See the story here.

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I blogged a little more about the SEC and its ALJs at the Harvard Corporate Governance Forum.  Do check it out!

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Mike Norton, Rohit Deshpande, and Bhayva Mohan, all affilated with HBS, think that it would affect purchasing choices, likely more than if it were simply published in an investor disclosure statement.  Indeed, they're running a field experiment at an online retailer to see if it would.  It would be difficult to require an energy saver style label on every good by regulation, but perhaps retailers will respond to consumer tastes?  Here are some preliminary surveys:

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The Volcker Rule’s covered fund provisions have not received the attention they deserve. Like the more well-studied proprietary trading rule, the covered funds rule restricts bank investments in the name of limiting their risk-taking and mitigating their contribution to systemic risk. As with proprietary trading, legislators and regulators faced a decision with covered funds on how to define those bank activities that would be off-limits. However, unlike with prop trading, Congress, and federal regulators subsequently, chose to define the scope of the covered funds rule largely by reference to an existing statute.

In a recent short article just published in The Capital Markets Law Journal (an earlier ssrn draft is available here), I examine this decision by Congress and federal regulators. In crafting the statutory provision and the final rule respectively, Congress and federal regulators chose to apply the covered funds rule to bank investments in entities that would otherwise be investment companies but for the exemptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This importation from the Investment Company Act – in what I call a trans-statutory cross reference – has profound consequences.

A first cut

Using Investment Company Act exemptions to set the scope of the covered funds rule has advantages. The Investment Company Act exemptions set boundaries that have already been defined by regulators and market expectations. These particular trans-statutory cross references work to circumscribe bank investments in, and sponsorships of, a wide range of entities. Congress appears to have concluded that private equity and hedge fund investments posed inordinate risks for banks and the government safety net. Since those two types of funds typically use those two Investment Company Act exemptions, the trans-statutory cross references seem to accomplish Congress’s intended purposes. A range of other entities also use these two exemptions, but the five federal regulators that promulgated the final rule ultimately carved many of those entities out. Still, many non-real-estate-related securitization vehicles would be covered by the rule.
On the other hand, prohibiting banks from investing in particular exempted funds does not necessarily mean that banks will move their money to safer locales. Many real estate securitizations, for example, are not covered by the rule. Banks could move capital to other exempted funds or even restructure existing investments to fall under other Investment Company Act exemptions not covered by Volcker. More on this in a moment.

When securities law serves banking law purposes

Stepping back from its immediate market consequences: the trans-statutory cross references at the heart of the covered funds rule highlights the ways in which the Investment Company Act, in particular, and securities regulation, more broadly, can and cannot regulate effectively the systemic risk posed by banks and other financial institutions. In other words, the tools of securities relation are in some ways aligned and in some ways mismatched with the purposes of prudential regulation. The trans-statutory cross references exacerbate Volcker’s problems of under- and over-inclusiveness in limiting the risk-taking of banks. The portions of the Investment Company Act most useful for systemic risk are its restrictions on leverage, which are somewhat unique in the pantheon of securities laws and function most similarly to banking rules.

Trans-statutory cross references can delegate power from one agency to another

Volcker’s trans-statutory cross references have not only policy but also political implications. By using a securities law to define the scope of a banking law, the covered funds rule effectively transfers critical policymaking functions from one group of agencies (banking regulators) to another (the SEC). This has potentially profound implications given the differing statutory missions, cultures, and personnel of those agencies. Securities regulators also face different interest groups and have different institutional pressure points compared to their banking counterparts.

Shifting battlegrounds

How the SEC will wield this power to define the scope of a banking law remains to be seen. Some commentators have doubts as to the SEC’s interest and ability to pursue systemic risk regulation alongside its traditional investor protection role. The covered funds rule will provide one test of the SEC’s resolve. Banking industry interest will likely now focus on other Investment Company Act exemptions. SEC decisions to narrow or expand other Investment Company Act exemptions – particularly Section 3(c)(5) or Rule 3-a-7 – now have cascading consequences by virtue of Volcker’s covered fund provisions. After Volcker, banks and other parties in securitization markets may seek to structure securitizations to rely on one of these other exemptions. Efforts to narrow these exemptions will likely meet strong opposition from banks and the securitization industry. In considering whether to narrow or enlarge these exemptions, the SEC must now consider not only whether investors in collective investment funds are protected. It must also consider the effects on bank risk-taking and systemic risk.

A larger lesson

The political dynamics outlined in my paper point to lessons for policymakers considering using trans-statutory cross references in the future. Trans-statutory references may take power from one regulatory body and give it to another. In the case of the covered fund rules, power over prudential rules was, perhaps unintentionally, delegated to a securities regulator. This works well if the statutory drafters trust the agency from whom power was taken less or trust the agency to whom power was given more. It works if the concern is to check potentially overzealous pursuit of policy objectives by the traditional regulator or to remedy potential shirking by a captured body. However, trans-statutory cross references may fail if the newly empowered regulator works at cross purposes to the statute it now has authority over. Trans-statutory cross references reflect a lesson that is old but one that bears repeating nonetheless: technical drafting decisions can have outsized and unintended political consequences, particularly with respect to the most important question of all – who decides policy going forward.

Cross-posted at Columbia's Blue Sky Blog.

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I think they're doomed, but opponents of the 25 year old tradition of SEC administrative proceedings have had a good couple of days.  Distressed Debt Diva (or whatever the right sobriquet is) Lynn Tilton has convinced the Second Circuit to hear her claim that appearing before an ALJ would be unconstitutional, which, if the court ruled in her favor, would create a circuit split with the 7th Circuit.  

Also, the Wall Street Journal made much of a colloquy before Judge Richard Berman, who is one of the few judges who has ruled that ALJ proceedings are unconstitutional.  He wanted to know more about the farcical decision by the SEC to send one of its ALJs a letter inviting him to tell them whether he was biased against defendants.  He quite properly refused to answer, and they promptly reassigned him to another case.  "You'll want to come up with a good explanation why," Judge Berman approximately told the agency.  

I can't claim to understand what the SEC was doing with that missive to its ALJ, though it's always worth observing that ALJs work for the commissioners (much to their displeasure, ordinarily), and it isn't totally obvious that it is wrong to send a missive to an employee asking him to explain himself.  But, oddly, adjudicative subordinates have a great deal of independence, to the point where I think we could consider them to be comparable to those most independent of regulators, bank supervisors.  We wouldn't expect Janet Yellin to bother filing an affadavit explaining her thinking on interest rates if President Obama instructed her to do so, and there's no question that he is her boss.

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The Wall Street Journal reports that the White House is considering our colleague for the SEC.  Bainbridge thinks she'd be an excellent choice, and so do we.  I won't gush, but Lisa has it all - she would be perfect for the agency.

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I wrote in DealBook about SEC ALJs.  Here's a taste:

I read every decision issued by the S.E.C.’s administrative law judges from the enactment of Dodd-Frank in 2010 to March of this year. Graded toughly – on whether the S.E.C. received everything it wanted from the case – the agency’s rate of success is high, but not unblemished.

In those decisions where at least one of the defendants was represented by counsel, the agency received everything it asked for only 70 percent of the time; that is not too different from the “rule of thumb” rate for victories by any federal agency in a federal court.

Of course, there is not getting everything the agency asks for, and there is losing the case. It is true that S.E.C. administrative law judges are willing to reduce the penalties sought by the agency’s enforcement division, either by reducing the amount of money that the defendant must pay to the S.E.C. or by reducing the length of their bar from practicing in their industry.

But in my sample, the agency rarely lost cases that it pursued to the point at which an administrative law judge would issue a decision. I identified only six of the first 359 decisions issued since Dodd-Frank was enacted that rejected the arguments of the enforcement division wholesale.

Go read the whole thing!  And here's a link to the underlying paper.

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I wrote a paper on the SEC's ALJs, which I think are plenty independent and not at all unconstitutional. They cite federal judges and write sentences with the same degree of difficulty, and though the SEC usually wins before them, there are plenty of reasons for that.

It's forthcoming in the Texas Law Review, and here's the abstract.  Do give it a look and let me know if you have any thoughts.

The Dodd-Frank Wall Street Reform Act allowed the Securities & Exchange Commission to bring almost any claim that it can file in federal court to its own Administrative Law Judges. The agency has since taken up this power against a panoply of alleged insider traders and other perpetrators of securities fraud. Many targets of SEC ALJ enforcement actions have sued on equal protection, due process, and separation of powers grounds, seeking to require the agency to sue them in court, if at all.

This article evaluates the SEC’s new ALJ policy both qualitatively and quantitatively, offering an in-depth perspective on how formal adjudication – the term for the sort of adjudication over which ALJs preside – works today. It argues that the suits challenging the SEC’s ALJ routing are without merit; agencies have almost absolute discretion as to who and how they prosecute, and administrative proceedings, which have a long history, do not threaten the Constitution. The controversy illuminates instead dueling traditions in the increasingly intertwined doctrines of corporate and administrative law; the corporate bar expects its judges to do equity, agencies, and their adjudicators, are more inclined to privilege procedural regularity.

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Dan Katz (Michigan State), Michael James Bommarito, Tyler Soellinger (Michigan State), and Jim Chen (Michigan State) have posted a new paper that studies empirically the impact of SCOTUS opinions on the share prices of the winning and losing corporate parties.  WSJ Blog blurb here.  As corporate law professors know, the SCOTUS docket is not mainly corporate law cases or cases in which one corporation's prospects might be substantially changed (employment case, etc.), but the study did find 79 cases in the relevant period that seem to match changes in stock price equal to $140 billion.

Why do the authors think that's important?  Obviously, in cases in which corporations get large securities fraud lawsuits dismissed or on the other hand, get a ruling that opens the door to a class action or multiple lawsuits, the share price could react.  But what the authors are really interested is predicting that movement and exploiting it.  Here is there information market website:  https://fantasyscotus.lexpredict.com/.  Here is their algorithm:  http://arxiv.org/abs/1407.6333.  

From a securities law standpoint, I can't help but wonder when predictive trading on court decisions begins to cross the "outside trading" line.  No, the information isn't nonpublic -- the information is public, but only accessible through an enormous amount of computing power.  Bud Fox following a corporate raider around all day and making very informed guesses as to his next target is one thing, but following every CEO around with invisible drones is another.  At some point, does technology make information gathering cross the line?  I don't have an answer for this, but I know that Larry Ribstein and Bruce Kobayashi hinted at the positive aspects of this in "Outsider Trading as Incentive Device," which responded to Ian Ayres and Steven Choi's "Internalizing Outsider Trading" and the concern that the ability to trade in similar ways would lead to excessive search costs.  (None of the authors contemplated a scenario in which technology makes information that for all practical purposes was nonpublic and uses it for trading purposes.)  I look forward to hearing more.

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In what I think is the first appellate decision on the issue, the Seventh Circuit held that timing problems prevented courts from entertaining collateral attacks on SEC administrative proceedings.  It means that defendants have to raise their constitutional claims before the ALJs, and then the SEC itself on appeal, before they can get into court on appeal from that.

These timing issues have always looked really problematic for the plaintiffs.  Essentially, they have been arguing that they think the SEC is about to open an administrative case against them, and that a court should tell the SEC that it can't do that, because administrative cases are unconstitutional. Usually, claiming that you think the government is about to do something isn't a very good reason to sue the government.  Why not wait and see?  You'll save the court's time and keep it from issuing an advisory opinion.

Put that way, it's not surprising that a CEO anticipating administrative proceedings against her was told to make her constitutional arguments to the agency, if the agency does, in fact, file papers against her, before trying to get the courts involved.

On the other hand, the case that has ginned up these suits, Free Enterprise Fund v. PCAOB, let a couple of accountants make their constitutional claims against PCAOB before it had lifted a finger against them.  So the Seventh Circuit basically said "we don't think the Court meant to get rid of the doctrines of standing, finality, and exhaustion in that case," which is sort of hand waving, but probably true.

Anyway, it increases the likelihood that we will soon get an initial decision from an SEC ALJ ruling whether SEC ALJs are unconstitutional.  I'm very much looking forward to that.  You can find a gloss on the opinion here, and a link to the actual opinion at the end of the gloss.

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There's not too much new in the indictment for insider trading of the former partner of Philly firm Fox Rothchild.  The partner didn't work on the deal, but he overheard a conversation between one who was working on the deal and the legal assistant they shared.  And then he traded so unbelievably transparently you can barely believe that he was a lawyer.  He bought shares in his wife's IRA account, and then he bought shares in his own IRA account.  The next day, the merger was announced, the shares went up 80ish percent, and he instantly sold, making $75 grand.  Which doesn't do his wife any favors, in the end.

The SEC’s complaint filed in federal court in Philadelphia names Sudfeld’s wife, Mary Jo Sudfeld, as a relief defendant for the purpose of recovering insider trading profits in her brokerage account through trades conducted by Sudfeld.  The complaint charges Sudfeld with violating antifraud provisions of the federal securities laws and an SEC antifraud rule.  The SEC seeks a permanent injunction and financial penalties against Sudfeld and return of allegedly ill-gotten gains and prejudgment interest from Sudfeld and Mary Jo Sudfeld.

That is insider trading of the most "please, catch me!" variety.  But maybe this guy hasn't head of the duties of quasi-insiders, and thought he was an accidental tippee.

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Over at DealBook, I have a piece up on the state of cost-benefit analysis at the SEC.  Inadequacies in the CBA were how the SEC used to lose all its rulemakings in the D.C. Circuit; its latest rulemaking on clawbacks sets the stage for how seriously the agency takes cost-benefit analysis now, and how much it believes that analysis should be quantified.  A taste:

Throughout the cost-benefit analysis, the agency warns that it is “often difficult to separate the costs and benefits,” and that various effects of the rule are “difficult to predict.”

I suspect the agency thinks it doesn’t need to blow the court of appeals away with some numbers to survive, though of course the S.E.C. can do more cost-benefit analysis in the final rule. It does, however, believe that a lengthy consideration of the costs and benefits of a rule should be part and parcel of any proposal.

For those who think that cost-benefit analysis slows the pace of regulation, this may not be good news. Economists might wish that numbers were being appended to the discussion.

But I am happy enough to see rules without numbers. Justifying rules only with regard to their costs and benefits is pretty routine. As routines develop, it may become difficult for regulators and judges to consider new sorts of costs, and unforeseen benefits contained, for example, by the simple expression of what the rule favors and what it discourages.

Go give it a look!

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