Trends
Impact of Loper on SEC Rulemaking and Enforcement
Background
Earlier this year, in Loper Bright Enterprises v. Raimondo (Loper), the U.S. Supreme Court historically overturned the Chevron doctrine, which guided judicial deference to administrative and regulatory agencies' expertise where legal ambiguity exists. Before Loper, the Chevron two-step framework required courts considering a challenge to a federal agency’s interpretation of a statute to (1) evaluate whether the language of a statute was ambiguous; and (2) if ambiguity was found, the court would defer to the agency’s interpretation if it was (a) “reasonable” and (b) supported by agency expertise.
In Loper, the Court held that federal agency expertise has the power to persuade a court but not to determine its decision. Courts are thus still permitted to consider the subject matter expertise of regulators as a factor to guide judicial decision-making (known as “Skidmore respect”).
Loper evidences the Court’s trend toward limiting the regulatory power of agencies, including by minimizing the role of agency expertise in the evaluation and enforcement of regulations, based on concerns about constitutional and statutory overreach.
Takeaways
The greatest impact likely to result from Loper is an increase in both the volume and success rate of challenges to regulatory actions. In fact, Loper’s reversal of Chevron has already begun to impact attitudes, processes and outcomes, as evidenced by a number of recent decisions rejecting reliance on regulatory expertise as a major factor in judicial decisions. By stripping away the deference previously afforded to agency statutory interpretations and signaling a decreased respect for agency expertise, the Court has opened a new avenue for litigants to challenge regulations and delay their implementation. As a result, regulators are expected to adopt a more cautious attitude with regard to both rulemaking and enforcement, which could result in additional public input prior to a new rule's promulgation or an increased appetite for settlement by consent order rather than litigation.
Emerging technologies, which are often not expressly addressed by existing law, are likely to be most affected by Loper's reversal of Chevron, as the applicability of existing law to novel and innovative products and services can carry significant ambiguities. Industry participants should consider seizing opportunities to make their voices heard ex ante and comment on proposed rules and regulations. The legal landscape is such that the SEC may be more receptive to industry’s views.
Key cases
SEC v. Jarkesy
Background
On June 27, 2024, the U.S. Supreme Court ruled in SEC v. Jarkesy that individuals accused of securities fraud with civil penalties on the line have a right to a jury trial via the Seventh Amendment rather than being subjected to an SEC proceeding with an in-house administrative law judge.
Pre-Jarkesy, the SEC had the option of adjudicating civil penalty actions in-house. This came with obvious advantages for the SEC. Post-Jarkesy, the playing field is now level. In a six-to-three decision, the Court held that civil penalty actions must be brought in federal court, where those accused of securities fraud may avail themselves of a jury trial.
Per the Seventh Amendment, “[i]n Suits at common law, where the value in controversy shall exceed twenty dollars, the right of trial by jury shall be preserved.” In determining whether this jury right applies, courts consider the cause of action and (more importantly) the remedy it provides. As to the cause of action, the Court reasoned that SEC fraud actions are rooted in the common law. Regarding the remedy, money damages aimed at punishment and deterrence trigger the right to a jury trial. Here, the Court determined that SEC penalties so qualify.
To be sure, under the so-called public rights exception, “Congress may assign the matter for decision to an agency without a jury, consistent with the Seventh Amendment.” However, the Court observed that the exception is a limited one, applying to a narrow subset of cases (e.g., those “involving the collection of revenue,” those involving “relations with Indian tribes,” and those involving immigration). The SEC’s claims did not so qualify.
Takeaways
The decision in Jarkesy eliminates the SEC’s ability to obtain penalties in administrative proceedings. That is surely a consequential ruling as far as it goes. But for years, the SEC has been increasingly pursuing penalties in federal court, so the immediate impact of this ruling will likely be on the margins.
The more consequential aspect of Jarkesy might be what it augurs for future challenges to SEC and other agency action. For example, Jarkesy did not address the Fifth Circuit’s alternative ruling that Congress had violated the nondelegation doctrine by authorizing the SEC, without intelligible guidance, to choose whether to litigate in federal court or to adjudicate the matter in-house. Especially in this post-Loper world, we expect increased judicial receptivity to such nondelegation arguments, and we encourage clients and others to explore regulatory challenges along these lines.
Nat’l Ass’n of Private Fund Mgrs. v. SEC
On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit vacated the private fund adviser rules adopted by the SEC on August 23, 2023. While the rules are no more, they provide insight into the SEC’s concerns, and going forward, we expect the SEC to proceed with regulation via enforcement in this important area. Thus, it would be prudent for private funds and their advisers to understand the private fund rules and the ways in which the SEC may enforce compliance despite the Fifth Circuit’s decision.
Private Fund Rules
Per the SEC, the private fund rules were adopted to protect those who invest in private funds and to prevent fraud by the investment advisers to those funds. Key highlights include:
- Preferential Treatment: Prohibits advisers from granting preferential redemption or information rights about portfolio holdings that would have a material, negative effect on other investors in the private fund or a similar pool of assets. For all types of preferential treatment, advisers must (a) provide advance written notice to prospective investors of preferential treatment related to any material economic terms; and (b) provide timely after-the-fact and annual written notices to current investors of all preferential treatment.
- Restricted Activities: Restricts advisers from engaging in certain activities, including (among others) charging or allocating certain fees and expenses to private funds, unless the adviser meets certain disclosure and, in some cases, consent-based exceptions.
- Quarterly Statements: Requires SEC-registered advisers to provide investors with quarterly information about private fund adviser compensation, fund fees and expenses, and performance.
- Annual Audits: Requires SEC-registered advisers to cause (a) each private fund they advise to undergo an annual audit as set forth in the custody rule (Advisers Act Rule 206(4)-2); and (b) audited financial statements to be delivered to investors.
- Adviser-led Secondaries: Requires SEC-registered advisers that engage in adviser-led secondary transactions to obtain and distribute a fairness or valuation opinion, and provide a summary of any material business relationships between the adviser or its related persons and the independent opinion provider.
- Books and Records: Requires SEC-registered advisers to retain books and records related to each of the above requirements.
- Compliance Policy Annual Review: Requires SEC-registered advisers to document in writing the annual review they conduct pursuant to the compliance rule (Advisers Act Rule 206(4)-7).
Fifth Circuit Decision
In a case brought by a group of private fund managers, the Fifth Circuit unanimously vacated the private fund rules, reasoning that the SEC exceeded the scope of its statutory authority in promulgating these rules. Nat’l Ass’n of Private Fund Mgrs. v. SEC, No. 23-60471, 2024 WL 2836655 (5th Cir. June 5, 2024).
The SEC’s asserted statutory authority for the private fund rules were sections 211(a) and 206(4) of the Investment Advisers Act of 1940. Section 211(a) authorizes the SEC to “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes” for any investment advisers that the Commission deems contrary to “the protection of investors.” The Fifth Circuit held that this section of the statute applies only to “retail customers” (i.e., a natural person who receives personalized investment advice about securities from a broker, dealer, or investment adviser for personal, family, or household purposes), not private fund investors. Because Congress explicitly chose not to impose such restrictions on private funds, the Fifth Circuit held that section 211(a) did not provide the SEC with the necessary statutory authority to formulate the private fund rules.
The court turned next to an analysis of the SEC’s claimed authority under section 206(4), which authorizes the SEC to “define, and prescribe means reasonably designed to prevent such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative” regarding “any investment adviser.” The Fifth Circuit held that the SEC failed to articulate a rational connection between the type of fraud it meant to address and any part of the private fund rules that it ultimately promulgated. Accordingly, section 206(4) did not provide the SEC with statutory authority to issue these rules, thereby vacating the private fund rules in their entirety.
Takeaways
Importantly, the SEC declined to request rehearing or rehearing en banc by the Fifth Circuit and did not file a petition for writ of certiorari to the U.S. Supreme Court. Based on our experience, the SEC will likely turn toward continuing to regulate private fund advisers through examinations and enforcement actions grounded in existing rules and regulatory practice. If anything, the now-defunct private fund rules demonstrate that the conduct of private fund advisers is a key SEC enforcement priority in 2024 and onward. Accordingly, businesses operating in this space should focus their efforts on compliance and risk mitigation in light of this new enforcement landscape.
SEC v. Ripple
Background
In 2020, the SEC commenced an action against Ripple Labs (Ripple), alleging that Ripple and several of its executives raised over $1.3 billion through the sale of XRP in an unregistered securities offering.
The Southern District of New York found that Ripple’s XRP token was a security for institutional buyers under the Howey test, which defines an investment contract as a scheme whereby a person (1) invests his money in a common enterprise, and (2) is led to expect profits solely from the efforts of others.
On July 13, 2023, the Southern District of New York issued a landmark ruling holding that programmatic, or open market, sales of XRP tokens do not constitute investment contracts and are thus not securities regulated by the SEC. The court found that the third prong of Howey was not satisfied when it came to programmatic sales. The court noted that “Ripple’s Programmatic Sales were not blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP.” Therefore, the programmatic buyer “stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.”
On August 7, 2024, the U.S. District Court for the Southern District of New York issued its judgment in SEC v. Ripple Labs, Inc., imposing a $125.04 million civil penalty on Ripple for securities law violations. The court rejected the SEC’s disgorgement theory as the SEC failed to show any “allegations of fraud, misappropriation, or more culpable conduct.” Instead, the court applied a “transaction specific” approach to calculate a civil penalty. This is far less than the $876.31 million penalty sought by the SEC.
Ripple is also permanently enjoined from violating section 5 of the Securities Act of 1933 (Securities Act) by selling a security in the absence of an exemption or an effective registration statement. The court granted the injunction based on its findings that Ripple’s institutional sales were not isolated events. While the court did not hold that Ripple's post-complaint sales violated the Securities Act, the court found that “Ripple's willingness to push the boundaries of the Order evinces a likelihood that it will eventually (if it has not already) cross the line,” and therefore, “there is a reasonable probability of future violations.”
Key Takeaways
The Ripple decision left the crypto regulatory landscape mostly unchanged, but the decision ostensibly has implications for the SEC’s efforts to regulate exchanges where blind bid/ask transactions occur.
Read in conjunction with the court’s 2023 decision, the injunction should not preclude Ripple from selling XRP through programmatic sales or paying XRP to third parties as compensation. Absent an appeal, Ripple Labs will go to trial on its remaining issues, including the SEC’s aiding and abetting claims against two Ripple executives. The SEC will likely appeal before the U.S. Court of Appeals for the Second Circuit. Ripple may also appeal the court’s ruling on institutional sales.
Prior to Ripple, the only fully litigated SEC enforcement action against a token issuer resulted in a remedies order: SEC v. LBRY, Inc. In that case, the SEC sought a smaller civil penalty ($111,614) and an injunction but did not seek disgorgement. The LBRY court granted the civil penalty and ordered an injunction barring LBRY from future section 5 violations “and from participating in unregistered offerings of crypto asset securities.” It is likely that courts will look to Ripple and LBRY for guidance when assessing possible remedies in other SEC digital asset enforcement cases.