A small number of investigations by the Securities and Exchange Commission (SEC) end with the filing of a report rather than a complaint or administrative order. Section 21(a) of the Securities Exchange Act of 1934 authorizes the SEC “to publish information” relating to any securities law violations that it discovers. When the SEC issues a report pursuant to this authority, it typically recites its factual findings and discusses how the described conduct violated the securities laws.
SEC reports of investigation represent the views of an expert administrative agency in the context of a particular case. They are also an opportunity to convey the agency’s views about an issue of importance. The SEC has explained that it issues “reports of investigations relating to various subjects where, in the Commission’s judgment, substantial issues of public concern, widespread investor impact, or other matters of significance relating to the federal securities laws were involved.” One commentator has observed that, “in these Section 21(a) reports, the Commission criticizes policies and decisions made by subject parties, thus directing to all concerned the areas in which the Commission desires reform.” Reports of investigation are thus a way for the SEC to provide the industry guidance on significant matters.
Section 21(a) reports of investigation permit the SEC to publish an opinion even when it does not bring an enforcement action. When the report is not accompanied by an administrative order that imposes a sanction, the investigated party has less of an incentive to dispute the SEC’s public characterization of the facts. As a result, there is a risk that the report’s narrative can be one-sided. Reports may characterize contested facts as essentially established, omit counter-narratives, or overreach with respect to a legal theory.
The potential for the misuse of reports of investigation was highlighted more than 40 years ago by Roberta Karmel, the first woman to serve as an SEC commissioner and one of just a handful of commissioners who did not serve as chair to develop a national profile. In a case involving Spartek, a tile maker from Canton, Ohio, the SEC combined a Section 21(a) report of investigation with an administrative order instituting proceedings against the company. It did so because it only had authority to bring an administrative action for part of the misconduct it sought to sanction. The SEC thus used its power under Section 21(a) to describe its views about practices it disapproved of but did not have jurisdiction to punish. It then required the target of the investigation to adopt corporate governance measures to address the conduct that it did not have the power to sanction.
Karmel dissented in Spartek. She argued that SEC reports of investigation can only publicize a violation of the securities laws that the SEC has the authority to sanction. They cannot be used to expand the agency’s jurisdiction beyond what it was given by Congress. In exceeding its limits, the SEC risked undermining its legitimacy as a fair regulator. Karmel’s dissent was part of a broader criticism she famously advanced. The SEC had developed a tendency to engage in what she called “regulation by prosecution” – using enforcement actions to expand its authority and develop law rather than petitioning Congress to act or passing an administrative rule subject to notice and comment procedures.
While the SEC has generally used Section 21(a) judiciously in the modern era, some of the criticisms highlighted by Karmel’s dissent are applicable to an SEC report of investigation that was filed almost 40 years after her Spartek dissent. In the DAO Report, the SEC took the position that digital tokens issued by an investment fund were securities subject to its jurisdiction. The SEC applied the notoriously vague Howey test and made a close call that the tokens were securities under that test. The DAO, which described itself as a Decentralized Autonomous Organization, had been designed so that the purchasers of its tokens would vote on the investments that the fund would make. Such involvement would mean that an essential element of Howey, that the investors rely mainly on the efforts of others to generate a return, might not be satisfied. But the SEC took the position that because the founders of the fund pre-screened the investment proposals that would be voted on, the investors significantly relied upon their efforts and thus the DAO tokens were securities.
The DAO Report only expressed the SEC’s opinion on an unadjudicated case, but the SEC later cited it as putting the industry on notice that Initial Coin Offering (ICO) tokens were securities. The DAO Report only dealt with one, unique set of facts and did not shed much light on Howey’s application to the myriad of ICO tokens that were being developed and sold. While the SEC later provided more clarity on the issue as it brought additional cases, the DAO Report by itself was not enough to provide such notice.
Given the importance of the threshold question of whether an investment is a security, the SEC should have been more cautious in defining its own jurisdiction through the issuance of a Section 21(a) report. Courts give deference to agency interpretations of statutes, but it is not prudent for an administrative agency to define its own jurisdiction without any scrutiny by an Article III judge. More importantly, the fact pattern raised in the DAO Report was not a common one and left unclear the application of Howey to other tokens. Just as the Spartek case raised questions about the SEC’s legitimacy, the SEC’s aggressive citation of the DAO Report was questionable.
The SEC should refrain from using reports of investigation in closely contested cases, particularly those involving questions about its jurisdiction. Rather than unilaterally writing an advisory opinion that purportedly resolves the issue, the SEC should test its jurisdictional theories in federal court. Alternatively, it could make its reports of investigation more effective by discussing a range of fact patterns that give clearer notice to the industry about the agency’s position. In doing so, the SEC can better ensure the legitimacy of its enforcement efforts. The lessons of Karmel’s dissent in Spartek are still relevant for the SEC today.
 In the Matter of Spartek Inc. and John A. Cable, Exchange Act Release No. 15567, 1979 SEC Lexis 2151 (Feb. 14, 1979).
 Roberta S. Karmel, Regulation by Prosecution: The Securities and Exchange Commission vs. Corporate America 146–59 (1982).
This post comes to us from Professor James J. Park at UCLA School of Law. It is based on his recent article, “Karmel’s Dissent: The SEC’s Use and Occasional Misuse of Section 21(A) Reports of Investigation,” available here.