The Cato Institute Files Action Challenging SEC Gag Orders
On January 9, the Cato Institute filed suit against the Securities & Exchange Commission (the “SEC”), its chairman Jay Clayton, and its secretary Brent J. Fields. For decades, questions have been raised, and criticisms offered, of the SEC’s longstanding practice of requiring (or allowing, depending on one’s point of view) settling defendants in enforcement actions to sign consent decrees in which they “neither admit nor deny” the charges lodged against them. Thanks to a standard clause in their decrees, for the rest of their lives, the defendants will be prevented from explaining what really happened, if their views don’t coincide with the agency’s. These strictures apply to corporate as well as individual defendants.
The Cato Institute believes these SEC Gag Orders are wrong. Cato is a libertarian think tank located in Washington, D.C. It was founded in 1974 in Wichita, Kansas, as the Charles Koch Foundation, and was at first wholly funded by Koch. It’s by now considered one of the most influential think tanks in the world. Cato is not a public company, and is not regulated by the SEC. Ordinarily, it would have lacked standing to sue the agency, but thanks to special circumstances, it was able to file a complaint for declaratory and injunctive relief.
In the complaint, the Cato Institute explains that among other things, it’s a publisher that wants to publish a book “recounting perceived overreach on the part of the Securities and Exchange Commission.” It cannot publish the book because, it claims, the “SEC previously coerced the book’s author (as a condition of settling an SEC enforcement action that prompted the book in the first place) into a broad and sweeping SEC gag orders that effectively prohibits him from criticizing any aspect of the SEC’s enforcement actions against him.” Cato casts its own action as a civil rights suit that “seeks to end the federal government’s decades-long use of gag orders in violation of the First Amendment to the United States Constitution and to vindicate the Cato Institute’s basic First Amendment right to publish a book critical of official government conduct.”
And so it requests a declaratory judgment from the District Court for the District of Columbia to clarify the legal uncertainties that characterize this case, and Cato’s own “rights and responsibilities as a publisher.” What Cato hopes is that the court will decide the SEC’s insistence on settlement terms so unfavorable to the defendant violate his First Amendment rights, and so are unconstitutional. It also hopes the judge will permanently enjoin the agency from what it calls the “Gag Regulation.”
The “Gag Regulation”
Needless to say, the SEC has no rule it calls the “Gag Regulation.” That’s what the Cato Institute and other critics of the policy like to call it. It does exist, though, and was created in 1972, at the same time the modern SEC Division of Enforcement was formed. The SEC describes it as a “policy”:
“The Commission has adopted the policy that in any civil lawsuit brought by it or in any administrative proceeding of an accusatory nature pending before it, it is important to avoid creating, or permitting to be created, an impression that a decree is being entered or a sanction imposed, when the conduct alleged did not, in fact, occur. Accordingly, it hereby announces its policy not to permit a defendant or respondent to consent to a judgment or order that imposes a sanction while denying the allegations in the complaint or order for proceedings. In this regard, the Commission believes that a refusal to admit the allegations is equivalent to a denial, unless the defendant or respondent states that he neither admits nor denies the allegations.”
It’s a rather odd statement. The idea, obviously, is that in the case of a settlement, it would be undesirable for anyone to conclude that no wrongdoing had actually occurred. Were the defendant in the case allowed to insist he was not liable for that with which he’d been charged, doubt might creep into the minds of observers of the case. By the SEC’s tortuous reasoning, refusing to admit to the allegations made is equivalent to a denial, so in order to keep everyone happy, the defendant must state he neither admits nor denies the charges lodged against him.
The Cato Institute believes “the sole purpose of the Gag Regulation is to affect public perception of the SEC and the SEC’s enforcement activities.” It further points out that settling parties are forever barred from publicly asserting that any of the SEC’s allegations were untrue. But by the same token, they aren’t required to admit any of the SEC’s charges were true. And yet anyone who reads the charges, and then a notice of the consent judgment, is likely to assume the defendant was a bad actor who’d probably committed most of the offenses imputed to him or it.
Most civil suits filed in federal court, by government agencies or by private entities or individuals, do not go to trial. “Most” is an overwhelming majority: greater than 90 percent. Between 2002 and 2016, the SEC achieved a spectacular settlement rate of about 98 percent. Cato correctly notes that many federal defendants, especially those in complex cases, simply can’t afford to litigate forever. Legal fees are high; lawsuits are time-consuming and can be emotionally devastating. It’s easier to settle, and often less expensive than mounting a defense. However, Cato tries to make the case that what the SEC requires of settling defendants is somehow very different from what occurs in other settled civil cases. That could be disputed. Nearly all SEC settlement agreements are confidential. Once the parties sign, neither is free to discuss the litigation or the events that gave rise to it. In many civil cases, no one “wins” anything. The parties may simply walk away, paying their own costs. Yet onlookers unfamiliar with how these things work are likely to assume the plaintiff was victorious, and the defendant “lost.” The defendant is not free to correct that impression, no matter how much he may want to, because he’s signed a settlement agreement which, if breached, would require him to pay a considerable monetary penalty. Further breaches would prompt further payments.
The “Banned Book”
Cato explains that in 2018, Clark Neily, an attorney who’s currently the Cato Institute’s Vice President for Criminal Justice, was sent a manuscript written by a person who said he’d been a victim of prosecutorial overreach committed by the SEC. The complaint doesn’t identify the author, and is vague about the SEC’s allegations concerning him, but Neily explains more in the Cato Institute blog:
The case began when a well-known law professor introduced us to a former businessman who wanted to publish a memoir he had written about his experience being sued by the SEC and prosecuted by the DOJ in connection with a business he created and ran for several years before the 2008 financial crisis. The memoir explains in compelling detail how both agencies fundamentally misconceived the author’s business model—absurdly accusing him of operating a Ponzi scheme and sticking with that theory even after it fell to pieces as the investigation unfolded—and ultimately coerced him into settling the SEC’s meritless civil suit and pleading guilty in DOJ’s baseless criminal prosecution after being threatened with life in prison if he refused.
The unfortunate defendant, and the lawsuit itself, was presented in an over-the-top press release produced by Cato’s partner the Institute for Justice. The release is full of blurry photos and dramatic redactions that some may feel detract from the seriousness of Cato’s stated mission. The complaint is more restrained, noting only that the book’s author was “accused of substantial wrongdoing by the SEC” and “ultimately admitted to engaging in certain limited conduct in order to avoid crippling litigation expenses.”
Neily was intrigued by the manuscript, and believed it illustrated issues he’s been trying to shine light on for years: coercive settlements, routine over-charging, and more. And so in 2018, Cato signed a contract with the manuscript’s author to publish his work as a book. Since then, Cato has performed an “initial thorough edit of the text,” and so evidently feels it’s made its own investment in the manuscript’s publication. The fly in the ointment, of course, is the “gag order” that prevents the author from challenging the accuracy of the SEC’s allegations. It was fine for him to write the manuscript, and to let Neily read it, because those were “private statements of dissent,” but to publish it would be a public statement of dissent disallowed by the “gag order.”
Cato states unequivocally that “[a]s a direct result of this gag order, Cato cannot exercise what would otherwise be its contractual right to publish and promote the SEC manuscript.” We don’t know what’s in the contract referenced, but why would that be? The author of the book would run the risk of being in penalized, perhaps harshly, were he to publish, but what risk would Cato run? It made no undertakings to the SEC, or to any other federal agency. As a defender of the First Amendment, why shouldn’t it simply stand up for what it believes is right? Did the New York Times and the Washington Post back down from publishing the Pentagon Papers? Did they sue the federal government rather than get the presses running?
The “gag order” itself is not quite as draconian as it may at first glance seem. As part of this defendant’s actual settlement agreement, it specifies:
Defendant understands and agrees to comply with the Commission’s policy “not to permit a defendant or respondent to consent to a judgment or order that imposes a sanction while denying the allegation in the complaint or order for proceedings.” 17 C.F.R. § 202.5. In compliance with this policy, Defendant agrees not to take any action or to make or cause to be made any public statement denying, directly or indirectly, any allegation in the complaint or creating the impression that the complaint is without factual basis. Defendant may testify truthfully about any matter under oath in connection with a legal or administrative proceeding, whether or not under subpoena… If Defendant breaches this agreement, the Commission may petition the Court to vacate the Final Judgment and restore this action to its active docket. Nothing in this paragraph affects Defendant’s: (i) testimonial obligations, or (ii) right to take legal or factual positions in litigation or other legal proceedings in which the [SEC] is not a party including, but not limited to, legal proceedings arising out of the matters filed in the bankruptcy court.
So if the defendant is called to testify in any other legal action involving, or related to, the allegations made against him, he can testify truthfully and freely. Should he need to testify in cases to which the SEC is not a party, he’s free to do that as well. The passage quoted suggests he declared bankruptcy in connection with his pre-2008 misadventures, and would not have been barred from taking “legal or factual positions” related to the SEC enforcement action. So anyone—including Cato—who knew the name of the manuscript’s author could have examined whatever information was available from the DOJ in connection with the criminal case, and could have accessed the bankruptcy filings, which are often voluminous and informative, as well. Freedom of Information Act requests could have been made. While the SEC often rejects them, they’re worth a try.
However, that doesn’t alter the fact that the mystery author, though free to testify about specific elements of his case, if asked, cannot discuss it generally, and cannot bring up points he may wish to stress, about what the complaint calls the “unfairness” of his treatment. It’s perhaps worth noting that in 1972, when the “Gag Regulation” was born, the internet did not exist. The SEC News Digest began publication—on paper—in 1956, but it contained only brief snippets of information. Enforcement actions were quickly buried, and never fully explained. Today, anyone with a computer or a mobile device can instantly access litigation releases going back as far as 1995. The author’s case would be explained in a litigation release, and perhaps in a press release as well. The SEC’s complaint would also be only a click away. And only the SEC’s version of events would be explained.
Judge Jed Rakoff, an Unlikely Ally
The SEC’s method for settling litigation has had many critics over the decades, though most of them object to the fact that defendants who really were liable were often not obliged to admit to it. One of the fiercest of those critics is Judge Jed Rakoff of the Federal District Court for the Southern District of New York. Rakoff is a liberal, not a libertarian, and pro-investor rather than pro-business, but on this subject, he and Clark Neily can find common ground.
In the wake of the financial crisis of 2008, the SEC, faced with a heavy workload, encouraged staff to settle even important actions as quickly as possible. Many were pushed through the courts at the speed of light, and the presiding judges were expected to sign off on the settlements routinely and without objection. Judge Rakoff balked. In one case after another, he registered his dismay. His decisions were both clever and colorful, and attracted a large audience. He did in some cases accept the settlements presented to him, but not before offering a lecture.
On March 21, 2011, he handed down his decision in SEC v Vitesse Semiconductor Corporation, et al. The litigation was announced and the complaint filed on December 10, 2010. It was a settled action; that is, the defendants—Vitesse and four former senior executives—had already agreed to the SEC’s terms. The settlement was no doubt speeded along because two of the four executives had already pled guilty in a parallel criminal prosecution, and were helping to make the criminal case against the other two, who’d already been charged. The allegations were that over a ten year period, the company and the five executives had cooked the books and backdated or repriced stock option grants, so that the company failed to record about $184 million in compensation expenses. Consent decrees signed by three of the SEC defendants—the two who’d pled guilty, and Vitesse itself—went off to Rakoff for his blessing. The judge began his ruling by saying the consent decrees raise “difficult questions of whether the S.E.C.’s practice of accepting settlements in which the defendants neither admit nor deny the S.E.C.’s allegations meets the standards necessary for approval by a district court.”
Rakoff objected that the SEC had filed its proposed consent judgments without any explanation as to why he should approve them, or how they met the legal standards the court is required to apply. When informed of that, the SEC sent a letter brief. A hearing and some additional written submissions followed, after which the judge prepared his ruling. In a note to the letter, the SEC had pointed out that since 1972, such consent decrees, in which the defendant neither admits nor denies the allegations made in the complaint, were standard.
Rakoff observed that in fact, such consent decrees were common long before 1972, adding:
This was strongly desired by the defendants because it meant that their agreement to the S.E.C.’s settlements would not have collateral estoppel consequences for parallel private civil actions, in which the defendants frequently faced potential monetary judgments far greater than anything the S.E.C. was likely to impose. But there were benefits for the S.E.C. as well. First, the practice made it much easier for the S.E.C. to obtain settlements. And second, at a time when the S.E.C.’s enforcement powers were largely limited to obtaining injunctive relief, the S.E.C.’s focus was somewhat more centered on helping to curb future misconduct by obtaining access to the Court’s contempt powers than on obtaining admissions to prior misconduct.
But, by 1972, it had become obvious that as soon as the courts had signed off on such settlements, the defendants would start public campaigns denying that they had ever done what the S.E.C. had accused them of doing, and claiming, instead, that they had simply entered into the settlements to avoid protracted litigation with a powerful administrative agency.
So what happened in 1972 was that the SEC added a new requirement to its settlement policy: that defendants who signed consent decrees thereafter could not publicly deny any of the allegations the SEC had brought against them. Characterizing the result of this policy as “a stew of confusion and hypocrisy,” Rakoff goes on to say:
The defendant is free to proclaim that he has never remotely admitted the terrible wrongs alleged by the S.E.C.; but, by gosh, he had better be careful not to deny them either (though, as one would expect, his supporters feel no such compunction). Only one thing is left certain: the public will never know whether the S.E.C.’s charges are true, at least not in a way that they can take as established by these proceedings.
The judge then compared the SEC’s policy to the nolo contendere pleas of once upon a time, in which defendants pled guilty to criminal charges without admitting or denying the charges brought against them. The DOJ has long disfavored them, except in very unusual circumstances. Rakoff also noted that the guilty pleas of two of the defendants in the criminal case, and the company’s willingness to pay a penalty and contribute stock to a class action settlement fund, removed any doubt outsiders might have about the truth of the SEC’s allegations. He closed by saying he’d sign these consent judgments, while “reserving for the future substantial questions of whether the Court can approve other settlements that involve the practice of ‘neither admitting nor denying.’”
His opportunity to examine the question again came only seven months later, on October 19, 2011, when the SEC filed a lawsuit against Citigroup Global Markets. As with Vitesse, he was expected to sign off on consent decrees advanced by defendants who neither admitted to nor denied the allegations contained in the complaint. A few years earlier, Citigroup had dumped some doubtful assets into a newly-created fund, and sold securities issued by the fund to investors who hadn’t been adequately warned of the risk they were taking. Citigroup realized profits of $160 million; the investors lost more than $700 million. In his ruling, Rakoff did what he’d not done before: “[T]he Court has spent long hours trying to determine whether, in view of the substantial deference due the S.E.C. in matters of this kind, the Court can somehow approve this problematic Consent Judgment. In the end, the Court concludes that it cannot approve it, because the Court has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.”
The decision made waves in the press, who’d found a post-2008 hero in Judge Rakoff. Alarmed, the SEC and Citigroup joined together to appeal the case to the Second Circuit. On June 4, 2014, the appellate panel unanimously vacated Rakoff’s order and remanded the case to his court. Rakoff had believed, among other things, that the consent judgment was not in the public interest, or in the interest of the investors who’d lost so much money. The appellate judges felt Rakoff had applied an incorrect legal standard when reviewing the judgment, and held further that it was not the judge’s job to require the SEC to establish the truth of its allegations as a condition for his signature. On August 4, 2014, Rakoff signed the consent decree, observing that “[t]hey who must be obeyed have spoken.”
The First Amendment
Cato argues that the SEC’s enforcement of its “Gag Regulation” is a “content-based restriction on speech.” Such restrictions are unconstitutional unless they’re limited in scope and intended to serve a compelling government interest; according to Cato, “the SEC can present no evidence that requiring defendants to refrain from publicly denying the truth of allegations in perpetuity… is necessary to achieve any compelling government end.” Given that the ban on public denial of the allegations is a content-based restriction on speech, “that portion of the agreement is unenforceable as a matter of law.”
And that is what the Cato Institute hopes the judge in its case will do: declare the “gag order” on the author of the book Cato has agreed to publish unconstitutional and unenforceable as a matter of law. It would also like a declaratory judgment that all past gag provisions in consent decrees are unenforceable and a permanent injunction prohibiting the SEC from “continuing its practice of non-discretionary use of gag provisions in civil and administrative settlements.”
According to the docket, the judge who will hear the Cato Institute’s case is Amy Berman Jackson, who herself recently imposed a gag order on political grandstander Roger Stone. The SEC, Jay Clayton, and Brent J. Fields were served on January 28, but none has yet filed an answer to the complaint or another form of response. It will be interesting to see how the Cato Institute’s case proceeds.
This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
