The SEC’s Expansion of Primary Liability Under Section 17(a) and Rule 10b-5

In an administrative enforcement case called Flannery, a bare majority of SEC Commissioners adopted broad positions on primary liability under parts of the two main anti-fraud provisions in the securities laws, Rule 10b-5(a) and (c) and Section 17(a)(1), (2), and (3).  The Commission not only advanced expansive legal conclusions, but it also insisted that the courts accept the agency’s legal interpretations as controlling.

The SEC’s decision in Flannery raises thought-provoking issues about the role of administrative agencies in the development, enforcement, and adjudication of federal law.  In my comment on the decision, which is publicly available on SSRN, I discuss two of those issues.

The first part of the comment compares the Commission’s interpretations of the parts of Section 17(a) and Rule 10b-5 with the reasoning and analysis of a series of prominent Supreme Court decisions that imposed meaningful boundaries around aspects of primary liability under Rule 10b-5.  That comparison shows that much about Flannery is not consistent with, and is antagonistic to, the Supreme Court’s decisions in Central BankStoneridge, and Janus.

For example, the Commission would extend primary liability to a person who drafted, approved, or did not change a disclosure made by another person.  That result is not consistent with Janus, which held that a person working on a public disclosure was not the primary actor when another independent person issued and had final say about the disclosure.

Another example is that the Commission would extend primary liability to a person who orchestrated a sham transaction designed to give the false appearance of business operations even if a material misstatement by another person creates the nexus between the scheme and the securities market.  This construction disregarded the lesson of Stoneridge, which was that a person entering into a transaction with a public company, even a deceptive transaction, that resulted in the public company’s disclosure of false financial statements did not have primary liability when the public company was independent and had final say about its disclosures.

Flannery leaves the distinct impression that a majority of SEC Commissioners aimed to use the case as a vehicle to recover much of the territory lost in the enforcement area from the Supreme Court decisions and the lower federal courts that have been following the Supreme Court’s lead.  The ramifications of Flannery are therefore unsettling.  The effect of the decision is that the actions of an administrative agency within the Executive Branch could circumvent judicial precedent, rattle the stability of legal rules, and thwart the role of the courts in the development of the law.

The second issue discussed in the comment is whether the courts must or should treat the SEC’s legal conclusions in the adjudication of an enforcement case as controlling under ChevronFlannery made an overt bid for Chevron deference, but a reviewing court would have doctrinal and precedential grounds for refusing to accept the Flannery positions as controlling.  The comment discusses these reasons, starting with the text of the provision of the Administrative Procedure Act governing judicial review of agency actions and looking closely at the actual practice of the Supreme Court and courts of appeals when they review a legal conclusion in an agency adjudication.

The precedents identify good reasons for not granting Chevron deference to Flannery.  Giving controlling effect to the SEC’s decision would allow the agency both to avoid the teachings of leading Supreme Court authorities and to trump the Supreme Court and other federal courts on significant matters of statutory interpretation.  It would empower the SEC to cut short and silence the normal process in the federal courts for testing and establishing the limits of liability provisions, and it would enable the SEC to tip the scales in enforcement cases by converting its litigating positions into non-reviewable legal interpretations.  The cumulative effect of an agency’s decision to roll back Supreme Court precedent and to consolidate for itself ultimate decision-making power over questions of law traditionally left to the courts would seriously alter the balance of responsibility between agencies and courts long recognized in our system of government.

The preceding post comes to us from Andrew N. Vollmer, who is a Professor of Law, General Faculty and Director of the John W. Glynn, Jr. Law & Business Program at the University of Virginia School of Law.