United States: 2015 Securities Law Developments

On balance, the securities litigation landscape in 2015 offered a glass half-full/glass half-empty perspective for issuers and their officers, directors and advisors. Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), the major securities law decision of the 2015 Supreme Court term, afforded defendants relatively greater protection from liability based on public statements of opinion, as long as those opinions are honestly held and have a reasonable factual basis. The SEC suffered several notable setbacks, with some federal courts striking as unconstitutional the highly debated conflict minerals rule and the SEC's method of appointing administrative law judges. The Second Circuit significantly restricted federal prosecutors' ability to pursue downstream recipients of non-public information, resulting in a spate of overturned convictions and withdrawn guilty pleas. And although decisions from lower courts within the Second Circuit dismissing derivative lawsuits will be subject to less deferential review, both the Second Circuit and the Delaware Supreme Court reaffirmed that decisions of independent and disinterested boards to reject stockholder demands are entitled to business judgment rule protection, thereby precluding minority shareholder second guessing in private lawsuits. Yet the results were not uniformly favorable to the defense. The SEC took an expansive view of Dodd-Frank's whistleblower anti-retaliation provision, formalizing its view that such protections apply to whistleblowers who allege retaliation for reporting internally (as opposed to reporting to the SEC). The Second Circuit endorsed the SEC's view shortly thereafter. And, the early returns from last year's second Supreme Court decision in Halliburton suggest that rebutting the Basic presumption of reliance through price impact evidence will be a lofty hurdle for defendants at the class certification stage. Below is a roundup of key securities law developments in 2015 and trends for 2016.

Omnicare – When Statements of Opinion Are Actionable

In March, the Supreme Court rejected a shareholder's argument that a statement of opinion is actionable under the securities laws simply because it turns out to be wrong. Yet Omnicare also does not create a complete safe harbor for statements of opinion. A statement of opinion may still be actionable, but only if the speaker did not believe the statement at the time it was made or the speaker omits material facts about its inquiry into or knowledge concerning the statement that conflict with what a reasonable investor would expect to form the basis for the statement.

Omnicarearose out of two statements by Omnicare in a registration statement expressing opinions regarding the company's compliance with state and federal law:

"We believe our contract arrangements with other healthcare providers, our pharmaceutical suppliers and our pharmacy practices are in compliance with applicable federal and state laws."

"We believe that our contracts with pharmaceutical manufacturers are legally and economically valid arrangements that bring value to the healthcare system and the patients that we serve."

Within months of filing the registration statement, Omnicare was sued by the federal government for violating anti-kickback laws in connection with its alleged receipt of bribes from pharmaceutical manufacturers. Certain pension funds then sued the company under Section 11 of the Securities Act of 1933, alleging that Omnicare's opinions regarding legal compliance were untrue statements of material fact and omitted material facts necessary to make the statements not misleading. The district court granted Omnicare's motion to dismiss, but the Sixth Circuit reversed, holding that the funds only had to allege that the stated opinions were objectively false and did not need to plead or prove that Omnicare did not believe the opinions.

The Supreme Court reversed. It first concluded that opinions can only be actionable as misrepresentations of fact if the speaker does not actually hold the opinion stated. This is because the only fact implied in an opinion is that the speaker actually believes the opinion. As the Court explained, "the coffee is hot" is a factual statement about the coffee, but "I believe the coffee is hot" states facts only about the speaker's belief and is not false even if the coffee happens to be lukewarm.

The Court then turned its attention to whether opinions can give rise to liability for related omissions. It noted that whether a statement is misleading (due to an omission of a material fact) is an objective inquiry that depends on the reasonable investor's perspective. While reasonable investors may understand that statements of opinion reflect uncertainty, they also understand those statements to convey information about how the speaker formed the opinion or the speaker's basis for holding a particular view. If the true facts are materially different from what a reasonable investor would expect, then the statement of opinion may be misleading for omitting that information. The Court made clear that an opinion will not be misleading merely because an issuer knows "some fact" contrary to the stated opinion. Instead, investors must identify particular and material facts going to the basis of the issuer's opinion, the omission of which makes the opinion misleading. The Court's belief that this would be "no small task for an investor" left it unmoved by Omnicare's concern that the Court's decision would threaten issuers with massive liability for offering opinions to the public.

So far, lower courts that have applied Omnicare at the pleading stage appear to have faithfully applied the case, insisting that plaintiffs allege particularized facts demonstrating a defendant's subjective disbelief in an opinion or the omission of specific material facts rendering an opinion misleading. For example, in City of Westland Police & Fire Ret. Sys. v. MetLife, Inc., 2015 U.S. Dist. LEXIS 121571 (S.D.N.Y. Sept. 11, 2015), the court granted MetLife's motion to dismiss claims under Section 11 and Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") based on the company's allegedly false opinion concerning the adequacy of its loss reserves. The court held that the plaintiff adequately alleged that MetLife's reserves proved insufficient. But under Omnicare, that MetLife's opinion turned out to be wrong did not plead an actionable claim. And the plaintiff did not allege the type of facts necessary to plead either MetLife's subjective disbelief of its opinion—such as facts regarding the methodologies MetLife employed to calculate its reserves or MetLife's analysis of the impact of various states' policies as they relate to its reserves—or that its opinion was offered without the foundation that a reasonable person would have expected. See also In re Fairway Group Holdings Corp. Secs. Litig., 2015 U.S. Dist. LEXIS 109941 (S.D.N.Y. Aug. 19, 2015) (granting renewed motion to dismiss for, among other things, plaintiffs' failure to sufficiently pleading particularized facts under Omnicare).

Although Omnicare clarified the standard for pleading and proving a securities claim based on a defendant's statement of opinion, it did not change the underlying evidentiary rules governing how to prove the claim. At least one court has held that direct evidence of the defendant's disbelief of his opinion, while helpful, is not necessary for a claim to survive to trial. A plaintiff may rely on circumstantial evidence to meet its burden. In SEC v. Goldstone, 2015 U.S. Dist. LEXIS 116847 (D.N.M. Aug. 22, 2015), the court held that the plaintiff need not present evidence that directly establishes the speaker's disbelief of his opinion where inferences drawn from circumstantial evidence in various emails created a genuine issue of material fact on the question.

Lower courts' continued application Omnicare will test the Supreme Court's stated belief that sufficiently stating a securities claim based on a statement of opinion will be "no small task." The quantum and type of allegations and evidence necessary to satisfy Omnicare remain unclear, and how courts address that issue will determine the level of protection Omnicare affords to issuers. Similarly, lower courts will likely continue to wrestle with where to draw the line regarding when a statement is one of opinion rather than fact.

Proving Lack of Price Impact at the Class Certification Stage Remains Difficult After Halliburton II

The long and winding road of the Erica P. John Fund's attempt to certify a class in its securities litigation against Halliburton Co. shows no sign of ending. After the Supreme Court issued its second decision in the case in 2014—Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) ("Halliburton II")—courts across the country, including the lower court in Halliburton itself, continue to wrestle with how to address price impact evidence at the class certification stage. Now Halliburton heads back to the Fifth Circuit for further guidance on just that question.

As is well known, Halliburton II addressed the continuing viability for purposes of class certification of Section 10(b) claims of the fraud-on-the-market presumption articulated in Basic Inc. v. Levinson, 485 U.S. 224 (1988). That presumption, in turn, rests on an economic theory known as the Efficient Capital Markets Hypothesis ("ECMH"), which posits that securities prices rapidly adjust to reflect new public information impacting the underlying value of the securities being traded. In such an ''efficient'' market, investors are justified in relying on the market price as a substitute for investigating corporate reports, which should be reflected in the market price. Any misrepresentation by the issuer would also be incorporated into the price until there is a corrective disclosure. The presumption that an investor who buys or sells stock on an efficient market is relying on the integrity of that price renders the issue of reliance common to the class.

Halliburton II received the most attention for declining to overrule the Basic fraud on the market presumption. The Court held that, notwithstanding a raft of academic and economic criticism of the ECMH, there was no justification for abandoning the presumption of reliance. The majority rejected Halliburton's argument that the Basic presumption is inconsistent with congressional intent. Id. at 2408-09 ("The Basic majority did not find that argument persuasive [in 1988], and Halliburton has given us no new reason to endorse it now"). While admitting the Basic presumption is a "judicially created doctrine," the Court held that it has become a "substantive doctrine of federal securities-fraud law." Id. at 2411.

Nor did the Court modify Basic to require plaintiffs to prove price impact at the class certification stage – a decision arguably in conflict with the Court's recent class action jurisprudence requiring plaintiffs to prove all the prerequisites to class certification before a class may be certified. See J. Halper & E. Rosenkranz, et al., Understanding Halliburton in Light of Recent Supreme Court Class Action Jurisprudence, Bloomberg BNA: Class Action Litigation Report (Dec. 12, 2014). However, the Halliburton II Court emphasized that Basic entitles defendants the opportunity to rebut the presumption of reliance at the class certification stage by demonstrating that an alleged misrepresentation had no price impact. Prior to Halliburton II, lower courts typically did not address or gave short shrift to such attempts by defendants to rebut the Basic presumption at class certification. Halliburton II made clear that defendants should have that opportunity.

Following remand, in July 2015, a Texas federal district court considered Halliburton's attempt to rebut the Basic presumption as to the six alleged misrepresentations at issue. See Erica P. John Fund, Inc. et al. v. Halliburton Co. et al., 309 F.R.D. 251 (N.D. Tex. July 25, 2015). The court initially found that Halliburton bore the burden of production and persuasion as to the lack of price impact on the misrepresentations. After examining the parties' dueling experts and event studies, the court found that Halliburton sufficiently proved a complete lack of price impact for all but one representation. As to that sixth representation, Halliburton's evidence focused on showing that the supposed corrective disclosure that plaintiffs pointed to for price impact was not actually corrective. However, the court held that whether a specific disclosure preceding a stock price decline was or was not corrective of an alleged misrepresentation was a merits question inappropriate for resolution at the class certification stage – a ruling that arguably appears to conflict with the Court's recent class action decisions. See Wal-Mart Stores, Inc., v. Dukes, 131 S. Ct. 2541 (2011) (A ''rigorous analysis'' of whether the "prerequisites of Rule 23(a) have been satisfied 'will entail some overlap with the merits of the plaintiff's underlying claim. That cannot be helped.'"); Comcast Corp. v. Behrend, 133 S. Ct. 1426 (2013) (a party must "be prepared to prove that there are in fact . . . common questions of law or fact" as required by Rule 23(a)). In November, the Fifth Circuit granted an appeal to address whether courts can or must address whether a disclosure is corrective in deciding whether to certify a class. See Erica P. John Fund, Inc. et al. v. Halliburton Co. et al., 2015 U.S. App. LEXIS 19519 (5th Cir. Nov. 4, 2015).

Notwithstanding the Court's directive that defendants have the opportunity to rebut the Basic presumption of reliance at class certification, recent attempts to do so by and large have not proven successful. In 2015, district courts in the Second and Third Circuits have held defendants' to a heightened burden of proving by clear, definitive, and compelling evidence a complete lack of price impact in order to defeat certification. See Carpenters Pension Trust Fund of St. Louis v. Barclays PLC, 2015 U.S. Dist. LEXIS 110382 (S.D.N.Y. Aug. 20, 2015) (rejecting defendants' argument that lack of price impact shown through plaintiffs' expert's failure to show price impact in his event studies); In re Goldman Sachs Grp., Inc. Sec. Litig., 2015 U.S. Dist. LEXIS 128856 (S.D.N.Y. Sept. 24, 2015) (defendants failed to demonstrate a complete lack of price impact through its experts' analysis, attempts to prove "truth on the market," or arguments that plaintiffs failed to show evidence showing price impact); City of Sterling Heights Gen. Employees' Ret. Sys. v. Prudential Fin., Inc., 2015 U.S. Dist. LEXIS 115287 (D. N.J. Aug. 31, 2015) (rejecting defendants' criticisms of plaintiffs' expert studies and finding that creating a "triable issue of fact" as to the lack of price impact through evidence of additional causes for a stock price change insufficient to rebut the Basic presumption).

Espinoza v. Dimon– Demand Refusal in Three Acts

In a series of opinions issued over the course of six months, the Second Circuit discarded a thirty-year-old standard of review in shareholder derivative cases and threatened to create additional potential exposure for corporate boards that do not respond issue by issue to every item raised in a shareholder litigation demand. At the end of the day—and after input from the Delaware Supreme Court—the Second Circuit reaffirmed the broad protections of the business judgment rule and upheld the dismissal of a shareholder derivative complaint against the JPMorgan Board of Directors. While the Second Circuit now will give closer scrutiny to dismissals of derivative complaints than it had previously, the underlying business judgment protection for corporate directors remains unchanged.

To Set the Scene: Our Story Begins with a Whale. JPMorgan's Chief Investment Office manages and invests excess cash from JPMorgan's other businesses. In 2009, a group of CIO traders in London led by Bruno Iksil—later known as the "London Whale"—began to invest more heavily in riskier synthetic credit derivative products. When the investments struggled, the CIO doubled down, attempting to recoup losses. Certain JPMorgan executives made public statements about the CIO's investment positions that allegedly were misleading. In May 2012, JPMorgan disclosed more than $6.25 billion in total losses resulting from the CIO investments.

Enter Espinoza. In the wake of that disclosure, several JPMorgan shareholders, including Ernesto Espinoza, demanded that the Board investigate issues falling into two main categories: (1) the underlying London Whale trading losses; and (2) the allegedly misleading statements by JPMorgan executives. Espinoza asked the Board to sue the responsible individuals and claw back their compensation, among other things. In response, the Board established a Review Committee, which oversaw a Management Task Force charged with investigating the London Whale matter. The Committee and Task Force conducted 22 interviews of current and former employees, reviewed 300,000 documents, met with regulators, and analyzed various public sources. Following this investigation, the Board responded to Espinoza's demand letter by declining to take further action, citing a host of significant remedial measures already undertaken. Espinoza then sued derivatively in the Southern District of New York, alleging that his demand was wrongfully refused. The District Court dismissed the claim, finding the Board's decision to reject the demand was protected by the business judgment rule, and Espinoza had pled no facts sufficient to overcome the presumption afforded by that rule that the board was independent and acted on an informed, good faith basis. Espinoza appealed.

Act 1: The Struggle to Conform. The Second Circuit initially rejected Espinoza's appeal, but expressed great discomfort in doing so. Espinoza v. Dimon, 790 F.3d 125 (2d Cir. June 16, 2015). That discomfort was not tied to the merits of Espinoza's claim, but instead to the standard of review that the court concluded it was bound to follow. As a derivative plaintiff, Espinoza was required to satisfy Rule 23.1 and plead with particularity that his demand was wrongfully refused. A long line of Second Circuit precedent held that dismissals under Rule 23.1 were reviewed for abuse of discretion, as distinct from the de novo standard generally applicable to pleading-stage dismissals. The court spent pages observing that applying different standards of review in comparable situations made little sense and suggested that, if it were deciding the issue anew, it would adopt a de novo standard. But it was not acting on a blank slate and thus reviewed the dismissal for abuse of discretion. Under that standard, the court easily concluded that the district court acted within its discretion in dismissing the complaint.

Act 2: The Reversal of Fortune. Two months later, after Espinoza moved for rehearing, the panel vacated its original opinion, cast aside three decades of precedent adhering to an abuse of discretion standard, and held that dismissals under Rule 23.1 should be reviewed de novo. Espinoza v. Dimon, 797 F.3d 229 (2d Cir. Aug. 12, 2015). The court concluded that appellate courts reviewing dismissals of derivative actions perform substantively the same tasks as when they review dismissals of other types of actions and that there was no justification for maintaining different standards of review. Turning to the merits, the court observed that while Espinoza's letter sought action in connection with both the underlying trading losses and the alleged public misstatements about the CIO, the Board's response letter addressed only the former issue and made no mention of the latter. Espinoza alleged that the Board did not investigate the misstatements issue and, as a result of its inaction on that front, could not invoke business judgment protection with respect to that issue. Faced with these allegations, the court confessed that it did not know what to do. While several Delaware courts opine that boards have wide latitude in how they choose to investigate a demand, none seemed to address this scenario—namely, that the Board did not investigate the substance of a portion of a shareholder demand. As the question ultimately was a matter of Delaware law (JPMorgan is a Delaware corporation), the Second Circuit certified the following question to the Delaware Supreme Court:

"If a shareholder demands that a board of directors investigate both an underlying wrongdoing and subsequent misstatements by corporate officers about that wrongdoing, what factors should a court consider in deciding whether the board acted in a grossly negligent fashion by focusing its investigation solely on the underlying wrongdoing?"

Intermission: A Trip to Delaware. The Delaware Supreme Court declined to answer the question posed on the basis that it was too general and abstract. Espinoza v. Dimon, 2015 Del. LEXIS 449 Del. Sup. Ct. Sept. 15, 2015). But it nonetheless proceeded to offer its "thoughts." A corporate board's rejection of a stockholder demand, it said, may only be set aside if the board has breached its duty of loyalty or duty of care, which in turn required a showing of gross negligence (a difficult burden to meet). When a board is alleged to have ignored a material aspect of a demand letter, the reviewing court must consider the "contextual importance of that issue in the overall scope of what the committee was charged with investigating" in deciding whether the board can be said to have committed gross negligence. The Delaware Supreme Court explained that it could not perform that contextual analysis in this case, and referred the matter back to the Second Circuit to analyze the materiality of the issue that Espinoza alleged was not addressed by the Board.

Act 3: All's Well That Ends Well. Considering the complaint a third time, applying de novo review and the Delaware Supreme Court's guidance, the Second Circuit ultimately affirmed the dismissal. Espinoza v. Dimon, 2015 U.S. App. LEXIS 21021 (2d Cir. Dec. 3, 2015). The court observed that JPMorgan's investigation was "exhaustive." An independent committee retained independent counsel assisted by expert advisors to review a task force investigation conducted by separate independent counsel. The investigation produced extensive written reports and led to a number of internal governance changes and remedial action against certain individuals. The court held that Delaware law does not require a point-by-point response to claims asserted in demand letters and instead prescribed only "minimal requirements for boards contemplating stockholder demands." Moreover, the alleged misstatements were only one of the numerous items Espinoza raised in his letter, and legal action against the speakers was only one of the numerous remedies he pursued. And the Board's letter suggested that it was aware of and considered the import of the statements Espinoza challenged. Accordingly, the court ruled that Espinoza had not alleged sufficient facts to overcome the business judgment rule.

Collectively, the Espinoza decisions set the stage for greater scrutiny by the Second Circuit of dismissals of shareholder derivative actions. Although the Second Circuit also raised the spectre of exposing corporate boards to liability if their investigation or refusal of demand does not directly discuss all issues raised in a multi-part shareholder demand, by the time the curtain fell on Espinoza's claim the court had made clear that the underlying business judgment standard remains undisturbed.

Early results from 2016 continue to show the Second Circuit enforcing rigorous Delaware pleading standards in shareholder derivative lawsuits, notwithstanding its heightened scrutiny of Rule 23.1 dismissals. Central Laborers' Pension Fund and Steamfitters Local 449 Pension Fund v. Dimon, 2016 U.S.App. LEXIS 48 (2d Cir. Jan. 6, 2016), arose out of Bernie Madoff's Ponzi scheme through Bernard L. Madoff Investment Securities LLC ("BMIS"), and JPMorgan's role as BMIS's banker. Plaintiffs contended that the directors breached their fiduciary duty of loyalty by failing to properly oversee JPMorgan's operations concerning BMIS and ignoring red flags of Madoff's fraudulent scheme. The trial court found that plaintiffs' claims were based on the board's alleged failure to monitor BMIS, which – under the seminal case In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996) – required allegations that the board failed to implement any reporting, information system, or controls. Plaintiffs' allegations against JPMorgan, however, conceded that such controls existed and alleged only that those controls were inadequate.

Plaintiffs appealed, contending that they could satisfy Caremark by pleading that the Board failed to "attempt to assure a reasonable information and reporting system exist[ed]." Thus, they argued, they were not required to allege a complete absence of controls; allegations that the board failed to ensure the controls were reasonable were sufficient. Applying the de novo standard of review, the Second Circuit affirmed the dismissal. First, the court disagreed that the "reasonableness" test plaintiffs articulated was the correct standard. Instead, Stone v. Ritter, 911 A.2d 362 (Del. 2006), a Delaware Supreme Court case that interpreted Caremark, required plaintiffs to plead the failure to implement any relevant controls. As a decision from Delaware's highest court on a matter of Delaware law, the district court and Second Circuit were required to follow it in assessing what Delaware law required. Second, the court held that plaintiffs' claims would have failed even under their interpretation of Caremark, as the record undercut their claims that the Board failed to attempt to assure that a reasonable information and reporting system existed.

Newman's Impact on Insider Trading Prosecutions of Downstream Tippees

The debate over the Second Circuit's controversial December 2014 decision in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), which overturned the insider trading convictions of two hedge fund portfolio managers, continued to dominate discussions of insider trading law in 2015. On October 5, 2015, the United States Supreme Court denied the Government's petition for certiorari. As a result, Newman remains the law of the Second Circuit, although it remains to be seen whether courts outside the Second Circuit adopt the decision and how lower courts apply it.

Newman, a former portfolio manager at Diamond Capital Management, and Chiasson, co-founder of Level Global Investors, were convicted in 2012 and sentenced to four-and-a-half and six-and-a-half years in prison, respectively. Lower-level financial analysts at Diamondback and Level Global allegedly passed on non-public earnings information from insiders at two public technology companies to Newman and Chiasson, who then executed trades on the basis of this information. The Second Circuit reversed Newman's and Chiasson's convictions, finding that the Government must show that an individual trading on inside information knew that the insider disclosed the information in exchange for personal benefit. The court went on to hold that the personal benefit must be more concrete than the mere fact of friendship between the insider/tipper and tippee/trader, including "proof of a meaningfully close relationship" that generates actual or potential pecuniary gain or something similarly valuable in nature. The court held there was insufficient evidence for a jury to find that the corporate insiders received a benefit, much less that Newman and Chiasson knew of such a benefit, and overturned the convictions. The court's ruling was seen by many as a blow to the Justice Department's Wall Street crackdown.

In its certiorari petition, the Government focused in particular on the Second Circuit's definition of "personal benefit," arguing that it could not be reconciled with Dirks v. SEC, 463 U.S. 646 (1983), which "did not require an 'exchange' to find liability for a gift of inside information." The Government also claimed that the "meaningfully close" requirement announced in Newman should be rejected because it found no support in Dirks. If the ruling were left in place, the Government argued, conduct long understood to be prohibited would "elude criminal prosecution," which would "hurt market participants, disadvantage scrupulous market analysts, and impair the government's ability to protect the fairness and integrity of the securities markets."

The Supreme Court's certiorari denial undoubtedly leaves a gap in the tools formerly available (at best to prosecutors in the Second Circuit) to pursue insider trading cases. But the appetite for pursuing such cases has not diminished. No fewer than three bills aimed at broadening the prohibition on insider trading were introduced in Congress following Newman (and more may follow in the wake of the Supreme Court's refusal to hear the case), although it seems doubtful in the current political environment that Congress will actually enact legislation in an area where to date it generally has declined to legislate.

One open issue is the extent to which other circuits will adopt Newman. Although still too early to assess, at least certain courts have expressed reluctance to follow the Second Circuit. In United States v. Salman, 792 F.3d 1087 (9th Cir. 2015), the Ninth Circuit held that the relationship between a tipper who shared confidential information with his brother qualified as the sort of "meaningfully close relationship" identified by the Second Circuit. Salman, a remote tippee, argued that the direct tippee's familial relationship with his tipper-brother was insufficient to demonstrate that the tipper had received a benefit because, under Newman, the tipper had to have received "at least a potential gain of a pecuniary or similarly valuable nature." The Salman court rejected that argument, holding that "[t]o the extent Newman [could] be read to go so far," the Ninth Circuit would decline to follow it. Some, including the Government in its certiorari petition, argued that Salman is in conflict with Newman, although as the Ninth Circuit found the conduct at issue in Salman appears to constitute illegal insider trading even under Newman. The Government also argued that the Seventh Circuit's decision in SEC v. Maio,51 F.3d 623 (7th Cir. 1995), was inconsistent with Newman because the Seventh Circuit "rejected the argument that the insider's 'disclosure was not improper because he did not receive any direct or indirect personal benefit as a result of his tip.'" If the circuits develop inconsistent approaches to remote tippee insider trading liability, it is possible that the Supreme Court will one day consider the issue. In the meantime, courts will continue to debate whether to adopt or how to apply Newman.

The Debate Over the Constitutionality of the SEC ALJ Appointment Process

In Dodd-Frank, Congress authorized the SEC to seek a broader range of remedies against unregistered persons through administrative proceedings rather than exclusively in federal court. The SEC seized on this opportunity and increasingly chose to litigate in its own administrative forum. The administrative law judges who decide these matters are employees of the SEC and, as has been widely reported, appear to give their employer a strong "home court advantage." For example, the Wall Street Journal reported in May that the Commission prevailed in 90% of the proceedings before its own ALJs between October 2010 and March 2015 (compared with a 69% success rate in federal court over the same period). See SEC Wins With In-House Judges, Wall Street Journal (May 6, 2015), available at http://www.wsj.com/articles/sec-wins-with-in-house-judges-1430965803. And the deck is further stacked when a defendant seeks to appeal because those appeals are heard by the SEC's five commissioners themselves. In effect, the agency acts as the prosecutor, judge, and reviewing body, and it is only following a decision by the SEC that parties can pursue an appellate process in federal court. For example, the First Circuit recently found that the SEC erred in imposing sanctions against two investment fund executives in a case which had originally been decided by an ALJ over four years earlier. See Flannery v. SEC, 15-1080 (1st Cir. Dec. 7, 2015); Hopkins v. SEC, 15-1117 (1st Cir. Dec. 7, 2015).

Defendants have begun challenging the legality of this internal adjudicative arrangement. Their primary avenue of attack is to contend that the process by which ALJs are appointed violates the Appointments Clause in the Constitution, which vests the President or "Heads of Departments" with authority to appoint "inferior officers." These defendants argue that ALJs are "inferior officers" because they exercise significant authority and discretion under the laws of the United States, their positions are established by law, they are vested with significant judicial authority, and their duties, salaries and appointments are specified by statute. Therefore, the argument proceeds, because the SEC ALJs are hired by the Chief ALJ and the Commission's Office of Human Resources, rather than appointed by the President or the SEC Commissioners, their appointment is unconstitutional. The response of federal courts to these arguments has been mixed. Some courts have concluded that they lack subject matter jurisdiction to hear any challenge to an administrative proceeding during the pendency of that proceeding. Others have rejected that supposed jurisdictional obstacle and have issued injunctions on the basis that the appointment of ALJs was unconstitutional. To date, no court has affirmatively held on the merits (as opposed to preliminarily) that the SEC's method of appointing ALJs is constitutional. However, the SEC has weighed in on its own behalf, concluding in an appeal from an ALJ decision that its appointment process was constitutional because ALJs are "mere employees" and not "inferior officers," and therefore their appointment is not covered by the Appointments Clause. In the Matter of Raymond J. Lucia Cos., Inc. et al., File No. 3-15006 (SEC) (Sept. 3, 2015).

The D.C. and Seventh Circuits are among the courts to essentially punt on the question, holding that federal courts do not have subject matter jurisdiction over challenges to ongoing SEC enforcement proceedings. See Jarkesy v. SEC, No. 14-5196 (D.C. Cir. Sept. 29, 2015); Bebo v. SEC, No. 15-1511 (7th Cir. Aug. 24, 2015). In contrast, Judge May of the Northern District of Georgia enjoined an SEC administrative proceeding upon finding that the appointment of the ALJs likely was a violation of the Appointment Clause. See Hill v. SEC, 15-cv-01801 (ND Ga. June 8, 2015), appeal 15-12831. The Hill decision has been appealed to the Eleventh Circuit and should be argued in February 2016. The Second Circuit also will consider this question in 2016 as it reviews conflicting decisions from the Southern District of New York. See Duka v. SEC, 15 Civ. 357 (S.D.N.Y. Aug. 12, 2015) (enjoining SEC ALJ proceeding), appeal 15-2732.;SEC v. Tilton (15-cv-2472) (S.D.N.Y.) (declining constitutional challenge based on lack of subject matter jurisdiction), appeal 15-2103 (argued Sept. 16, 2015).) Any resulting circuit split could lead to Supreme Court review.

A final determination finding that the SEC's appointment process is unconstitutional could have significant consequences on prior determinations, not to mention much of the administrative adjudicatory system nationwide. Although any decisions issued by ALJs whose appeals have been denied or whose time to appeal has expired would likely be considered final and binding, see Travelers Indem. Co. v. Bailey, 557 U.S. 137, 154 (2009) (res judicata and practical necessity prevent collateral attacks on jurisdiction on final orders), any adjudication that is not yet final would be vulnerable to a challenge that it was issued without authority. The decision may also impact other federal agencies that employ administrative law judges, who would likewise have to examine the constitutionality of their own appointment process.

Conflict Minerals

The Democratic Republic of Congo has been plagued for decades by violent conflict and human rights abuses financed by the exploitation and trade of the abundant mineral resources in the DRC and surrounding regions. Governments around the world have sought solutions to the humanitarian crisis caused by this conflict. Congress concluded that casting a spotlight on companies that buy "conflict" minerals from this region would help stop their trade and cut off this source of funding for the warring factions. In a Conflict Minerals Statutory Provision enacted as part of Dodd-Frank, Congress directed the SEC to establish disclosure rules surrounding companies' use of materials like gold, tin, tantalum, and tungsten, dubbed "conflict minerals," regardless of their source. Pursuant to that mandate, the SEC in 2012 issued its final rule requiring about 6,000 publicly traded companies to disclose the source of all conflict minerals used in their products and whether they were "conflict free."

Many commentators and affected companies bristled at this new compelled disclosure, and legal challenges to the rule followed soon after its implementation. Those challenges culminated in August when the D.C. Circuit issued its hotly-anticipated decision in National Association of Manufacturers v. Securities and Exchange Commission, 800 F.3d 518 (D.C. Cir. 2015) ("NAM II"). The appellate court re-affirmed its earlier decision that the disclosure requirement is unconstitutional compelled speech under the First Amendment to the U.S. Constitution. The SEC did not petition for Supreme Court review.

The court's prior decision, issued in April 2014, struck down the portion of the rule forcing companies to declare whether or not their products are "conflict free." National Association of Manufacturers v. Securities and Exchange Commission, 748 F.3d 359 (D.C. Cir. 2014) ("NAM I"). The D.C. Circuit held that this provision violated the First Amendment under the heightened scrutiny review standard articulated by the Supreme Court in Central Hudson Gas & Electric Corp v. Public Service Commission, 447 U.S. 557 (1980). Under that standard, laws compelling speech survive First Amendment scrutiny only if the disclosure requirement (i) addresses a sufficiently compelling governmental interest and (ii) would in fact alleviate the harm of that interest to a material degree. By "compelling an issuer to confess blood on its hands," the court explained, the law "interferes with [the] exercise of freedom of speech" and the government was unable to justify the disclosure law's effectiveness to the extent necessary under Central Hudson.

Soon after the NAM I decision, the D.C. Circuit addressed, en banc, another congressionally-mandated disclosure requirement involving country-of-origin labeling of meat. See American Meat Institute (AMI) v. U.S. Department of Agriculture, 760 F.3d 18 (D.C. Cir. 2014) (en banc). The AMI court held that requiring meat producers to disclose where an animal is born, raised, and slaughtered does not violate commercial free speech protections. The court held that "rational basis" review should be applied to First Amendment challenges regarding the commercial disclosure of "purely factual and uncontroversial" commercial information. Under that standard, a law requiring the disclosure of purely factual and uncontroversial information will survive a First Amendment challenge so long as the disclosure reasonably relates to an adequate government interest. This standard was originally set forth in Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626 (1985), but the D.C. Circuit had previously limited its applicability to cases involving consumer deception. See R.J. Reynolds Tobacco Co. v. FDA, 696 F.3d 1205 (D.C. Cir. 2012). AMI overruled cases interpreting Zauderer narrowly, and clarified that rational basis review applies more broadly to mandated commercial disclosures.

The NAM I panel granted rehearing after AMI, but again concluded that the conflicts mineral rule violates the First Amendment. The three judge panel remained divided, with the majority holding that AMI extends the more permissive Zauderer standard only to product labeling at the point of sale, a commercial function closely related to advertising. Moreover, conflicts mineral disclosure could hardly be considered "uncontroversial," taking it out of the ambit of Zauderer in any event. Even if Zauderer standard applied, the SEC had not met its burden to show the disclosure would help to achieve the legitimate governmental interest of reducing funding for violent groups through purchases of conflict minerals from the DRC.

NAM I and II relieve the burden of compelled disclosure from the many public companies otherwise subject to the conflict minerals rule. At a practical level, the decisions enable companies whose products contain conflict minerals to avoid the tracing costs necessary to determine the minerals' country of origin. They also signal that compelled speech will not be a viable mechanism for pursuing humanitarian and human rights aims. Congress is exploring options that are less burdensome than requiring companies to don scarlet letters in their SEC filings as punishment for failing to complete expensive tracing investigations.

Whistleblower Protections: Berman v. Neo@Ogilvy LLC

In August 2015, the SEC issued interpretive guidance articulating its view that Dodd-Frank anti-retaliation protections should be available to internal whistleblowers, not just whistleblowers who report to the SEC. Roughly one month later, a divided panel of the Second Circuit deferred to the SEC's guidance and held that an internal whistleblower was protected from retaliation under Dodd-Frank. The Second Circuit's decision created a conflict with the Fifth Circuit that may attract Supreme Court attention. This issue is significant because Dodd-Frank significantly expanded whistleblower protections beyond those available under Sarbanes-Oxley: Dodd-Frank allows for a longer time frame for bringing a retaliation claim (six years following retaliation versus 180 days), permits greater recoveries (two times back pay), and does not require pre-suit administrative exhaustion (as is required under Sarbanes-Oxley).

The dispute over whether internal reporting is covered by Dodd-Frank's anti-retaliation provisions is rooted in what the Commission has argued is conflicting statutory language. A "whistleblower" under the Act is defined as "any individual who provides, or two or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission in a manner established, by rule or regulation, by the Commission." 17 C.F.R. § 240.21F-2(a)(6). Whistleblowers, in turn, are protected for three different categories of reporting activity: (1) providing information to the SEC; (2) assisting in an SEC investigation; or (3) making "disclosures that are required or protected" under Sarbanes-Oxley, the securities laws, and other SEC regulations. 15 U.S.C. § 78u-6(h)(1)(A). Because the third category of protected reporting activity includes laws that protect internal reporting, a number of courts have held that the statute is internally contradictory and that the best way to harmonize the conflicting provisions is to read the third category's protection of certain whistleblower disclosures not requiring reporting to the SEC as a narrow exception to section 21F's definition of a whistleblower as one who reports to the SEC. See Somers v. Digital Realty Trust, Inc., No. C-14-5180 EMC, 2015 WL 2354807, at *1 (N.D. Cal. May 15, 2015); Connolly v. Remkes, Case No. 5:14-cv01344, 2014 WL 5473144, at *6 (N.D. Cal. Oct. 28, 2014); Bussing v. CorClearing LLC, 20 F. Supp. 3d 719, 729 (D. Neb. 2014); Yang v. Navigators Grp., Inc., 18 F. Supp. 3d 519, 533 (S.D.N.Y. 2014); Khazin v. TD Ameritrade Holding Corp., Civil Action No. 13-4149 (SDW) (MCA), 2014 WL 940703, at *6 (D.N.J. Mar. 11, 2014).

On the other hand, in Asadi v. G.E. Energy (USA), LLC, 720 F.3d 620 (5th Cir. 2013), the Fifth Circuit addressed the issue of whether Dodd-Frank applied to a GE Energy executive who reported a potential violation of the Foreign Corrupt Practices Act internally. He sued, claiming retaliation, after he was subsequently given a negative performance review, pressured to step down from his position, and ultimately fired. The court adopted GE Energy's argument that Dodd-Frank did not protect employees against retaliation in response to internal reporting, stating that "[u]nder Dodd-Frank's plain language and structure, there is only one category of whistleblowers: individuals who provide information relating to a securities law violation to the SEC." A number of district courts outside the Fifth Circuit have followed this holding. See, e.g., Wiggins v. ING U.S., Inc., Civil Action No. 3:14-CV-1089(JCH), 2015 WL 3771646, at *9-11 (D. Conn. June 17, 2015); Lutzeier v. Citigroup, Inc., 305 F.R.D. 107, 110 (E.D. Mo. 2015); Verfuerth v. Orion Energy Sys., 65 F. Supp. 3d 640, 646 (E.D. Wis. 2014); Englehart v. Career Educ. Corp., No. 8:14-cv-444-T-33EAJ, 2014 WL 2619501, at *9 (M.D. Fla. May 12, 2014).

In August, the SEC formally weighed in on the issue, advising of its position that reading Dodd-Frank's definition of "whistleblower" to exclude internal reporters "is inconsistent" with the reporting procedures in the law, and "would undermine [the Commission's] overall goals in implementing the whistleblower program." SEC Release No. 34-75592, Interpretation of the SEC's Whistleblower Rules Under Section 21F of the Securities Exchange Act of 1934, 17 CFR Part 241 (Aug. 4, 2015). In September, a divided panel on the Second Circuit deferred to the SEC's guidance in Berman v. Neo@Ogilvy LLC, No. 14-4626 (2nd Cir. Sept. 10, 2015). Judges Newman and Calabresi found that the "tension" between the definition of whistleblower in Section 21F-(a)(6) and the anti-retaliation coverage in 21F-(h)(1)(A)(iii) rendered the statute "sufficiently ambiguous to oblige [the court] to give Chevron deference to the reasonable interpretation of the agency charged with administering the statute." Thus, the panel followed the SEC's guidance and found that the plaintiff whistleblower who reported internally, rather than to the Commission, prior to being terminated, was covered under Dodd-Frank's anti-retaliation provisions. (Judge Jacobs dissented, reasoning that the statute was not ambiguous and restricted whistleblowers to only those reporting to the SEC.)

Although the defendant in Berman recently announced its decision not to petition for certiorari, this issue is unlikely to disappear, meaning Supreme Court review is a possibility.

Courts Continue to Wrestle Post-Morrison with Extraterritorial Application of US Law

Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010), limited the extraterritorial scope of Section 10(b), holding that U.S. securities laws applied only where a security either: (1) is listed on an American stock exchange; or (2) was purchased or sold in the United States. Although heralded at the time for its bright-line test, lower courts have been grappling with whether to apply the federal securities law to transactions that satisfy Morrison but have a significant foreign component. For example, the Second Circuit held that, under Morrison, a domestic transaction is "necessary . . . but not alone sufficient to state a properly domestic claim under the statute." Parkcentral Global Hub Ltd. v. Porsche Auto. Holdings SE, 763 F.3d 198 (2d Cir. 2014) (emphasis added); see also, e.g.,City of Pontiac Policemen's and Firemen's Retirement System v. UBS AG, 752 F.3d 173 (2d Cir. 2014) (finding that "the allegation that [a domestic plaintiff] placed a buy order in the United States that was then executed on a foreign exchange, standing alone, [does not] establish [] irrevocable liability in the United States"); Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60 (2d Cir. 2012)(where securities are not listed on a domestic exchange, "a plaintiff must allege facts suggesting that irrevocable liability was incurred or title was transferred within the United States").

Recently, courts have been trying to determine how and if Morrison's extraterritoriality principles apply in non-securities contexts. European Community v. RJR Nabisco, Inc., now set for review by the Supreme Court, may present an opportunity for the Court both to clarify the application of Morrison outside the securities context and, in so doing, shed light on how to apply Morrison in securities cases as well.

RJR is a decade-old case in which the European Union and twenty-six of its member states sued RJR Nabisco and related entities, alleging that the companies committed various RICO violations in connection with hiding the proceeds of illegal drug sales in Europe. The plaintiffs argued that the scheme was domestic in nature because it was orchestrated from the U.S. In 2011, applying Morrison, the Southern District of New York found that because RICO was silent as to extraterritorial application, it did not apply to extraterritorial conduct. European Community v. RJR Nabisco, Inc., No. 02-cv-5771, 2011 U.S. Dist. LEXIS 23538 (E.D.N.Y. Mar. 8, 2011). The District Court concluded that because the "focus" of RICO is the "enterprise" that conducts or is affected by racketeering (much like the "focus" of Section 10(b) is the purchase or sale of a security), RICO should not apply to foreign enterprises. But in April 2014, a three-judge panel for the Second Circuit reversed. It pointed to the incorporation of extraterritorial statutes into RICO as predicate acts of racketeering as a clear indication of Congress' intention that RICO apply extraterritorially (consistent with Morrison's focus on Congressional intent). European Community v. RJR Nabisco, Inc., 764 F.3d 149 (2d Cir. 2014). The panel then found that RICO also extended to foreign enterprises, reasoning that the alternative would be an "illogical" policy because then U.S. laws would not apply if the enterprise was foreign but the acts occurred in the U.S. After the Second Circuit denied RJR's petition for rehearing en banc in April 2015, European Community v. RJR Nabisco, Inc., 783 F.3d 123 (2d. Cir. 2015), RJR successfully petitioned the Supreme Court for certiorari. The Supreme Court is expected to hear the case in the first half of 2016.

RJR may present an opportunity for the Court to provide additional guidance on how to distinguish domestic and extraterritorial activity under Morrison and just what activities matter for purposes of determining whether U.S. laws apply. Though RJR does not involve claims under the federal securities laws, the Court's articulation of the test for the extraterritorial application of RICO could translate to the securities context, just as courts have looked to Morrison for guidance concerning the extraterritorial application of numerous federal statutes.

Merrill Lynch v. Manning: Supreme Court to Decide Scope of Federal Jurisdiction in Certain Securities Cases

On December 1, 2015, the Supreme Court heard argument in Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, in which the Court will resolve a circuit split as to whether Section 27 of the Exchange Act provides federal jurisdiction over claims that are asserted under state law but the state law violation in turn is premised on violations of regulations adopted under the Exchange Act.

Section 27 of the Exchange Act states that federal courts "shall have exclusive jurisdiction of violations of [the Exchange Act] . . . and of all suits . . . brought to enforce any liability or duty created by [the Exchange Act]." Plaintiffs in Manning alleged that defendants engaged in "naked short selling" of a specific stock, which caused plaintiffs' shares to decline in value. The claims were based on state law, but the operative complaint repeatedly cited the SEC's Regulation SHO as a basis for the state law violation. Merrill Lynch removed the case to federal court, arguing that it is subject to exclusive federal jurisdiction under Section 27.

Neither party disputed that the complaint included allegations of violations of federal law. Plaintiffs argued that the violations of federal law were not elements of their claims, but rather were merely part of a larger manipulative scheme that violated state anti-fraud provisions. Plaintiffs therefore sought to have the case heard in state court, arguing that all of the causes of action were created by New Jersey law and not predicated on violations of federal law. The Third Circuit agreed, finding that the plaintiffs' claims did not raise a federal question. The Second Circuit had previously adopted that view, while the Fifth and Ninth Circuits have held that Section 27 provides exclusive federal jurisdiction over this kind of case. The Supreme Court took the case to resolve that split.

At oral argument, plaintiffs argued that none of their causes of action sought to enforce any liability or duty created by the Exchange Act because they were all claims created under, and sought recoveries specified by, New Jersey law. They also argued that the complaint was not dependent on showing that Merrill Lynch violated federal regulations, although the complaint did allege that such violations had occurred. In particular, they argued that for their market manipulation claims, proving a violation of Regulation SHO merely set a "floor" and that additional facts had to be proven to prevail on their state law claims. Merrill Lynch, in turn, argued that the complaint was "artful[ly]" pleaded to try to keep the case out of federal court. It urged the Court to conclude that the plain meaning of Section 27 grants exclusive jurisdiction to the federal courts so that the federal securities laws could be uniformly interpreted and applied and such "artful pleading" should not defeat that purpose.

Justice Scalia's questioning expressed concern that Merrill Lynch's approach would impose "quite an onerous task" on federal judges to "sift through the complaint to see if any of the claimed causes of action under State law mirror a cause of action that happens to exist under Federal law, without even the hint that they mention the Federal statute." Justice Ginsburg noted that there are "many instances in which there is a State claim, say a State claim for negligence, and the negligent conduct is alleged to be a violation of a Federal safety standard . . . You wouldn't say that that is a claim that has to be brought in Federal court."

The SEC's absence from the case also interested the Court. Justice Breyer observed that he would have expected the SEC to intervene if it understood Section 27 to bar state actions in these circumstances. He added that if Congress had intended these kinds of cases to be heard only in federal court, the SEC's absence was "curious."

If the tone of the Court during argument accurately predicts the outcome of the case, a decision affirming the Third Circuit and allowing the case to proceed in state court appears likely.

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