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May 2, 2017 By ehansen

Stuck with Steckman: Why Item 303 Cannot be a Surrogate for Section 11

Aaron Jedidiah Benjamin^†

Item 303 of SEC Regulation S-K requires companies to disclose “known trends and uncertainties” in certain public filings. In securities class action litigation, plaintiffs increasingly allege the omission of such “known trends and uncertainties” as a basis for liability. But Item 303 provides no private right of action. A private plaintiff can bring an Item 303 action only if there is a separate violation of a securities law for which there is a private right of action. To state a claim under section 11 of the 33 Act, plaintiffs (and courts) rely on a decades-old Ninth Circuit decision, Steckman v. Hart Brewing Co. Steckman held that an Item 303 violation automatically states a claim under section 11, short-circuiting any separate consideration under the statute. This Article examines the Steckman decision and contends that it was wrongly decided. Analysis in recent decisions by the U.S. Courts of Appeal for the Second, Third, and Ninth Circuits contradict Steckman’s holding. These courts held that an Item 303 violation does not sufficiently state a claim for liability under section 10(b) of the 34 Act, for the simple reason that Item 303 sets a lower threshold for materiality than 10(b): Item 303 materiality is defined by a “reasonably likely” standard set by the SEC, but 10(b) materiality is subject to a heightened “substantial likelihood” standard set by the U.S. Supreme Court in Basic v. Levinson. This Article argues that this materiality distinction applies equally to section 11. Courts agree that an omission under section 11—like section 10(b)—must be material under the heightened Basic standard. Given that (i) an Item 303 violation cannot sufficiently establish Basic materiality, and (ii) Basic materiality is required under section 11, it follows that an Item 303 violation cannot be sufficient to state a claim for liability under Section 11. Steckman should be reconsidered.

I. Introduction

Nearly fifty years after Congress enacted the Securities Act of 1933 (33 Act) and the Securities Exchange Act of 1934 (34 Act) (collectively, the securities laws), the Securities and Exchange Commission (SEC) adopted Regulation S-K (Reg. S-K).^[1] Reg. S-K provides instructions for companies filing disclosure forms under the securities laws.^[2] However, Reg. S-K does not provide a private remedy.^[3] A company that omits a Reg. S-K disclosure is subject to liability in a private action only if that omission is actionable under the securities laws.^[4] Yet in initial public offering (IPO) litigation across the country, class action plaintiffs—and increasingly courts—view certain Reg. S-K omissions as sufficient to state a claim, without separately analyzing whether the omissions are actionable under the securities laws.^[5]

Plaintiffs typically focus on Reg. S-K Item 303’s requirement to disclose known trends and uncertainties.^[6] An Item 303 violation is easy to plead, for three reasons. First, a plaintiff need not allege that any disclosed fact was untrue, but simply that a trend or uncertainty was omitted.^[7] Second, an Item 303 allegation is inherently speculative—making it harder to dismiss at the pleadings stage before fact discovery—because it calls for hindsight analysis of forward-looking information.^[8] In light of negative results that have now come to pass, plaintiffs look back to the time of the offering and assert that the company had enough information then to identify a trend or uncertainty that would have predicted the current results. Finally, Item 303 has a lower materiality threshold than section 10b of the 34 Act.^[9]

In recent years, courts have begun paying close attention to attempts by plaintiffs to leverage Item 303 allegations to state a claim for liability under section 10(b) of the 34 Act.^[10]

Less attention has been paid to attempts to leverage Item 303 allegations to state a claim under section 11 of the 33 Act. Many courts assume, with little or no analysis, that an Item 303 violation is automatically sufficient to state a claim.^[11] This assumption can be traced to the Ninth Circuit’s “short and cryptic opinion”^[12] in Steckman v. Hart Brewing.^[13] The Steckman court concluded that “allegations which sufficiently state a claim under Item 303 also state a claim under section 11.”^[14]

This view of Item 303 as a surrogate^[15] for section 11 has dire consequences for companies and their officers and directors. Item 303’s lower materiality threshold and murky cause of action^[16] make it easier to survive dismissal. By viewing an Item 303 violation as actionable under section 11, Steckman opens companies up to costly discovery and “virtually absolute” liability even when the alleged materiality falls below the statutory threshold.^[17]

This Article contends that Steckman’s conclusion was wrong. To reach it, Steckman ignored statutory language and U.S. Supreme Court precedent.^[18] The conclusion was not necessary for its holding.^[19] Steckman ignored the parties’ reasoning and distorted their arguments. Its view of materiality is incoherent and unsupported.

Most important, Steckman is contradicted by recent analyses in the U.S. Courts of Appeals for the Ninth, Third, and Second Circuits. These courts hold that an Item 303 violation does not sufficiently state a claim under section 10(b). Their reasoning is straightforward: Item 303 sets a lower threshold for materiality than section 10(b).^[20] Under section 10(b), the alleged omission must be material under a heightened “substantial likelihood” standard followed by the Supreme Court in Basic v. Levinson.^[21] In contrast, Item 303 materiality is defined by a lower (and different) “reasonably likely” standard set by the SEC.^[22] An omission sufficiently material under the lower standard of Item 303 is not necessarily material under the higher standard of section 10(b). Thus, these courts conclude that an Item 303 violation cannot be a surrogate for section 10(b) liability.^[23]

By this logic, Item 303 cannot be a surrogate for section 11, either. Courts agree that an omission under section 11—like section 10(b)—must be material under the heightened Basic standard.^[24] Given that (i) an Item 303 violation cannot sufficiently establish Basic materiality and (ii) Basic materiality is required under section 11, it follows that an Item 303 violation cannot be sufficient to state a claim for liability under section 11.

The Article proceeds as follows: Part II outlines the statutory and regulatory framework. Part III analyzes the arguments and decision in Steckman. Part IV examines three Circuit Court of Appeals decisions rejecting Steckman’s analysis. Part V shows how their reasoning applies with equal force to 33 Act claims. Part VI shows how these courts have struggled to preserve Steckman’s distinction between 34 Act and 33 Act claims and contends that these attempts fail. The Article concludes by urging practitioners and courts to reconsider Steckman, following the lead of a 2011 federal district court decision.

II. Statutory and Regulatory Framework

A. Statutory Provisions

Sections 11 and 12 of the 33 Act provide a private remedy to the purchaser of a security in connection with a misleading offering. Section 11 provides a remedy if the security was issued pursuant to a registration statement that “omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading . . . .”^[25] Section 12(a)(2) provides a remedy if the security was offered or sold by means of a prospectus or communication that omitted “to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading . . . .”^[26]

Section 10(b) of the 34 Act makes it unlawful to sell securities using “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”^[27] The SEC implemented section 10(b) by promulgating Rule 10b-5. The rule makes it unlawful “to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading . . . .”^[28] Although neither section 10(b) nor Rule 10b-5 contains an express private remedy, courts have “implied a private cause of action from the text and purpose of [section] 10(b).”^[29]

B. Reg. S-K Item 303

Item 303 requires companies to include in certain public filings management’s discussion and analysis of their financial condition and results of operations (MD&A).^[30] Among numerous MD&A line item disclosures, one frequently asserted by plaintiffs is the requirement to “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.”^[31]

C. Contrasting Statutory Materiality with Item 303 Materiality

Both the securities laws and Item 303 contain a materiality requirement.^[32] However, the standard for materiality under these two varies.

1. Securities Laws

Materiality of an omission for purposes of liability under the securities laws is subject to a “substantial likelihood” standard set by the U.S. Supreme Court. In Basic v. Levinson,^[33] the Court “expressly adopt[ed]” the materiality standard defined in the Court’s 1976 decision TSC v. Northway^[34]:

An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important . . . . [To establish materiality,] there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor as having significantly altered the ‘total mix’ of information made available.^[35]

Basic noted that “with respect to contingent or speculative information or events, . . . materiality ‘will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’”^[36]

Though Basic involved 34 Act claims, courts have made clear that the Basic standard applies to 33 Act claims as well.^[37]

2. Item 303

By contrast, materiality under Item 303 is subject to a “reasonably likely” standard set by the SEC^[38]:

Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:

(1) Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.

(2) If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.^[39]

The SEC has expressly distinguished the Item 303 standard from the Basic standard:

[Item 303] mandates disclosure of specified forward-looking information, and specifies its own standard for disclosure, i.e., reasonably likely to have a material effect. This specific standard governs the circumstances in which Item 303 requires disclosure. The probability/magnitude test for materiality approved by the Supreme Court in Basic Inc. v. Levinson, 108 S. Ct. 978 (1986), is inapposite to Item 303 disclosure.^[40]

III. Steckman v. Hart Brewing

In Steckman, shareholder Jeffrey Steckman brought a class action on behalf of shareholders against Hart Brewing, a craft brewery, six months after it went public.^[41] The complaint alleged that Hart Brewing’s IPO registration statement contained omissions under sections 11 and 12(a)(2) of the 33 Act.^[42] According to the complaint, the company “knew that a plateau in sales and earnings had been reached” prior to the IPO, “and that subsequent quarters would experience declining sales.”^[43] Steckman contended that this was a known “adverse trend” required to be disclosed under Item 303.^[44] The district court found no Item 303 violation and dismissed the action.^[45]

On appeal, the defendants maintained that Item 303 had not been violated.^[46] In addition, the underwriter defendants raised a new argument in the alternative: even if, arguendo, Item 303 had been violated, that “would not be sufficient to state a cause of action under the [33] Act.”^[47]

A. The Underwriters’ New Argument

The underwriters noted that the Basic test governs materiality under section 11.^[48] They then distinguished the Basic test from the materiality test under Item 303.^[49] The underwriters concluded that, in light of Item 303’s different (and lower) threshold for materiality, it could not serve as a surrogate for liability under section 11: “[b]ecause the SEC and Section 11 employ different standards for determining when required information is ‘material[,]’ . . . it is inevitable that their disclosure obligations cannot be used interchangeably.”^[50]

The underwriters also quoted Alfus v. Pyramid, a federal district court decision.^[51] Alfus held that the “demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5[, which, like section 11, applies the Basic materiality standard]. Such a duty to disclose must be separately shown.”^[52]

B. Steckman’s Reply

In his reply, Steckman did not dispute the underwriters’ central argument. He did not contend that even if Item 303 materiality is subject to a lower threshold than section 11, it could nonetheless be a surrogate for section 11 liability. Instead, he objected to the premise; he argued that Item 303 materiality and statutory materiality are in fact interchangeable: “the general standards of materiality set forth in TSC, Basic [(section 10(b))], and Worlds of Wonder [section 11] do apply to Item 303.”^[53]

C. The Ninth Circuit’s Ruling

The Ninth Circuit affirmed the district court’s finding that Steckman “ha[d] failed to state a claim under Item 303.”^[54] It did not need to pass on the underwriters’ new argument in the alternative, had an Item 303 violation been established.^[55] Yet the court chose to address the “threshold issues” raised by the underwriters’ new argument.^[56]

In a “short and cryptic opinion,” the Steckman court held that Item 303 can be a surrogate for liability under the 33 Act, but not the 34 Act.^[57] This result was advocated by neither party. The court did not weigh in on the central question in dispute: whether Item 303 materiality is interchangeable with Basic materiality. Instead, it adopted a position presented by neither party, contrary to precedent and statute: neither Item 303 nor section 11 require Basic materiality. Steckman’s holding has three components: an Item 303 violation is (1) a surrogate for section 11 liability, (2) a surrogate for section 12(a)(2) liability, and (3) not a surrogate for section 10(b) liability. Each will be analyzed in turn.

1. Surrogate for Section 11 Liability

First, the court asserted that “allegations which sufficiently state a claim under Item 303[(a) of Regulation S-K] also state a claim under section 11”^[58]:

Form S-1, which [the company] used in its registration, requires the registrant to follow Item 303. There is liability under section 11 if a registrant ‘omit[s] to state a material fact required to be stated’ in the registration statement. See section 11(a). Therefore, any omission of facts ‘required to be stated’ under Item 303 will produce liability under Section 11.^[59]

The court here took the position—not taken by either party—that the mere omission of a fact that the company had a legal duty to disclose states a claim for liability under section 11.^[60] The court quotes the “material fact” language from section 11 and then reads it out of the statute, translating the statute as imposing liability for “any omission of facts required to be stated.”^[61] But the statute expressly requires the omission of a “material fact.” It is well-settled that section 11 liability is predicated on a material omission.^[62] Further, the lack of a materiality requirement leads to a strange result. Reg. S-K requires many line item disclosures of little or no significance to investors.^[63] Under this reading of Steckman, an omission of any of these trivialities would subject a company to strict liability under section 11 because the information was “required to be stated” by Reg. S-K.^[64] This runs counter to the U.S. Supreme Court’s repeated warnings against excessive disclosure.^[65]

2. Surrogate for Section 12(a)(2) Liability

The Steckman court then extended its conclusion to section 12(a)(2): “[a]llegations which would support a claim under Item 303[] are sufficient to support a claim under [s]ection 12(a)(2).”^[66]

This position—suggested by neither party—is even more problematic. The “required to be stated” language central to the court’s analysis of section 11 is absent from section 12(a)(2).^[67] With respect to section 12(a)(2), the court cannot claim that “any omission of facts” triggers liability. Instead, it apparently concedes that an omission must be material, but suggests a new standard for materiality. Quoting a Third Circuit case not involving Item 303 and cited by neither party, the court asserts that “disclosures mandated by law are presumably material.”^[68]

Steckman’s ultimate conclusion, then, is that materiality under the securities laws is presumed simply by the fact that the company omitted a disclosure “mandated by law,” including by SEC regulation. This is essentially the same result the court articulated under section 11, but now the court labels this as material. As discussed, such a result was advocated by neither party and leads to absurd results. Steckman’s presumption of materiality ignores Supreme Court jurisprudence defining heightened materiality under the securities laws.^[69]

3. Not a Surrogate for Section 10(b) Liability

The Steckman court limited its conclusion to 33 Act claims. With respect to 34 Act claims, however, the court conceded that Item 303 is not a surrogate for liability.^[70] The court offered one sentence of explanation: “Section 10(b) of the Exchange Act, which has only an implied right of action, differs significantly from Sections 11 and 12(a)(2) of the Securities Act, which have express rights of action.”^[71]

Why should that matter? As one commentator has pointed out, “none of the courts rejecting Item 303 as a basis for Rule 10b-5 liability mentioned the implied nature of the cause of action as being a factor.”^[72] The court’s distinction has no basis in case law or legislative history. Though the remedy for section 10(b) is implied, its standard for liability is defined in identical terms to section 12(a)(2), for which the court just held Item 303 is a surrogate.^[73] Further, the Ninth, Third, and Second Circuits all hold that the same materiality standard applies to both 33 Act and 34 Act claims.^[74] If materiality can be presumed, liability should follow, whether the cause of action is express or implied.^[75]

For all of these reasons, Steckman was wrongly decided.

IV. The Underwriters’ Argument is Adopted by the Third, Ninth, and Second Circuits

Since Steckman, at least three federal Courts of Appeal have come to endorse the underlying argument made by Hart Brewing’s underwriters distinguishing Item 303 materiality from Basic materiality.

A. Third Circuit

In Oran v. Stafford,^[76] shareholders brought a class action against a drug manufacturer, alleging 34 Act violations for not “disclos[ing] several studies linking the drugs to heart-valve damage.”^[77] The district court dismissed for failure to state a claim.^[78] On appeal, the plaintiffs argued that by not disclosing the alleged “link between its drugs and valvular heart disorder,”^[79] the company violated Item 303’s requirement to disclose “known trends and uncertainties,”^[80] and that “such a violation can support a claim under [the 34 Act].”^[81]

Then-Judge Alito explained that to prevail, plaintiffs had to show “either that [Item] 303 creates an independent private right of action, or that the regulation imposes an affirmative duty of disclosure on [the company] that, if violated, would constitute a material omission under Rule 10b-5.”^[82]

After holding that Item 303 does not create a private right of action,^[83] the court proceeded to analyze plaintiffs’ contention that a violation of Item 303 constitutes a material omission under the securities laws. In the court’s view, the critical question was the same question identified three years earlier by the Steckman underwriters (but ignored by the Steckman court): “whether the disclosure mandated by [Item] 303 is governed by standards consistent with those that the Supreme Court has imposed for private fraud actions under the federal securities laws.”^[84]

Oran began by quoting the SEC’s two-part “reasonably likely” materiality standard that “characterized a company’s disclosure obligations under [Item] 303.”^[85] It then contrasted that with the materiality standard under the securities laws:

[T]he general test for securities fraud materiality [was] set out by the Supreme Court in Basic, Inc. v. Levinson, which premised forward-looking disclosure ‘upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’^[86]

The Third Circuit concluded, like the Steckman underwriters, that the standards “var[y] considerably.”^[87] Specifically, “[Item] 303’s disclosure obligations extend considerably beyond those required by Rule 10b-5.”^[88] “Because the materiality standards for Rule 10b-5 and [Item] 303 differ significantly,” Item 303 cannot be a surrogate for section 10(b) or Rule 10b-5.^[89] Thus, “a violation of [Item] 303’s reporting requirements does not automatically give rise to a material omission under Rule 10b-5.”^[90]

B. Ninth Circuit

The question of Item 303 as a surrogate for federal securities claims did not again come before the Ninth Circuit until 2014, sixteen years after Steckman. Shareholders brought a securities class action under the 34 Act against semiconductor manufacturer NVIDIA for not disclosing alleged product defects.^[91] The district court dismissed the claims for failure to plead scienter.^[92] On appeal, plaintiffs contended that “the district court’s analysis should have focused on whether NVIDIA acted with scienter in failing to make the Item 303 disclosure.”^[93]

In its opinion, the Ninth Circuit noted that it had “never directly decided whether Item 303’s disclosure duty is actionable under Section 10(b) and Rule 10b-5. We now hold that it is not.”^[94] In reaching this holding, the court followed Oran: “In Oran v. Stafford, the Third Circuit decided this issue more directly. We are persuaded by its reasoning.”^[95]

After analyzing the materiality tests under Item 303 and Basic, NVIDIA determined, as did Oran and the Steckman underwriters, that “these two standards differ considerably”^[96]:

Management’s duty to disclose under Item 303 is much broader than what is required under the standards pronounced in Basic. . . . The SEC’s effort to distinguish Basic’s materiality test from Item 303’s disclosure requirement provides further support for the position that Item 303 requires more than Basic—what must be disclosed under Item 303 is not necessarily required under the standard in Basic. Therefore, . . . the ‘demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5.’^[97]

C. Second Circuit

In Stratte-McClure,^[98] shareholders brought a putative class action under the 34 Act against Morgan Stanley for alleged misstatements and omissions regarding its exposure to subprime mortgages.^[99] The plaintiffs alleged that Morgan Stanley should have disclosed its exposure earlier as a “known trend[] or uncertaint[y]” under Item 303 that had or was “reasonably expected to have an unfavorable material effect on revenue.”^[100] The district court “ruled that Morgan Stanley did have a duty [to disclose] under Item 303.”^[101] It found further that the “alleged disregard of Item 303 of Regulation S-K, constituted an actionable omission under Section 10(b) and Rule 10b-5.”^[102] But the district court dismissed the claim for failure “to plead ‘a strong inference of scienter.’”^[103] The Second Circuit affirmed:

We conclude, as a matter of first impression in this Court, that a failure to make a required Item 303 disclosure in a 10-Q filing is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim. However, such an omission is actionable only if it satisfies the materiality requirements outlined in Basic Inc. v. Levinson, and if all of the other requirements to sustain an action under Section 10(b) are fulfilled. Here, the district court properly dismissed Plaintiffs’ exposure claim predicated on Morgan Stanley’s failure to disclose under Item 303 because the second amended complaint did not sufficiently plead scienter.^[104]

The Second Circuit further broke down its analysis. It first acknowledged that “Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).”^[105] But then it clarified: “The failure to make a required disclosure under Item 303, however, is not by itself sufficient to state a claim for securities fraud under Section 10(b). Significantly, Rule 10b-5 makes only ‘material’ omissions actionable.”^[106]

The Second Circuit went on to draw the same contrast shown by the Steckman underwriters, the Third Circuit in Oran, and the Ninth Circuit in NVIDIA.^[107] It contrasted the Basic test with the SEC’s “two-part (and different) inquiry” that determines a “duty to report under Item 303.”^[108] It noted—as did the Steckman underwriters, Oran, and NVIDIA—that the SEC has itself stated that “this disclosure standard is unique to Item 303,” and “is inapposite” to Basic materiality.^[109] The court then adopted Oran’s conclusion that “Item 303’s disclosure obligations ‘extend considerably beyond those required by Rule 10b-5’”^[110]:

Since the Supreme Court’s interpretation of ‘material’ in Rule 10b-5 dictates whether a private plaintiff has properly stated a claim, we conclude that a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b-5 if the allegedly omitted information satisfies Basic’s test for materiality.^[111]

Thus, the Second Circuit joined the Third and Ninth in embracing the Steckman underwriters’ distinction of Item 303 materiality from Basic materiality. For this reason, these courts hold that Item 303 cannot be a surrogate for section 10(b) liability.

V. Because 33 Act Claims are Governed by Basic They Cannot Be Distinguished From 34 Act Claims

The position of the Steckman underwriters, Oran, NVIDIA, and Stratte-McClure cannot logically be contained to claims under the 34 Act. The reason is simple: these courts agree that Basic materiality—and not the SEC’s broader Item 303 test—governs 33 Act claims.^[112] Just as Item 303 is not sufficient to state a section 10(b) claim because it is subject to the heightened Basic standard, for the same reason Item 303 cannot be sufficient to state a claim under section 11.

This result is not only logical, but also supported by the Court’s reasoning in Basic. The Basic Court explained that it deliberately raised the materiality standard:

Acknowledging that certain information concerning corporate developments could well be of ‘dubious significance,’ the Court was careful not to set too low a standard of materiality; it was concerned that a minimal standard might bring an overabundance of information within its reach, and lead management ‘simply to bury the shareholders in an avalanche of trivial information—a result that is hardly conducive to informed decisionmaking.’^[113]

This rationale applies with equal (if not stronger) force to section 11.^[114] Disclosures pose the same risk of “burying the shareholders in an avalanche of trivial information” whether they are subject to challenge under section 11 or section 10(b).^[115] Moreover, the “interrorem nature”^[116] of section 11’s “virtually absolute” strict liability^[117] (which, unlike section 10(b), has no scienter requirement) makes it even more likely to spur excessive disclosure. Were Basic applied only to section 10(b) claims and not section 11, its purpose would be defeated: the specter of section 11’s strict liability would still induce issuers to bury investors in trivial information.

VI. Attempts to Distinguish 33 Act Claims Fail

Not wishing to overrule Steckman, the Oran and NVIDIA courts attempt to confine their holding to 34 Act claims. These attempts—which are mere dicta^[118]—fail.

A. Reliance on Steckman is Misplaced

Oran assumes in a footnote that section 11 claims are different simply because Steckman says so.^[119] It neither engages with Steckman’s rationale nor offers any basis for such distinction. Likewise, NVIDIA begins by noting that, “as we acknowledged in [Steckman], ‘section 10(b) of the Exchange Act . . . differs significantly from sections 11 and 12(a)(2) of the Securities Act.’”^[120]

These courts’ reliance on Steckman is misplaced (putting aside that Steckman was wrongly decided). Unlike these courts, Steckman never adopted the argument that Item 303 is not sufficient to state a claim requiring Basic materiality. Thus Steckman was able to hold that Item 303 could be interchangeable with, and a surrogate for, section 11. In contrast, these courts have all embraced the argument—ignored by Steckman—that Item 303 and Basic (which applies to section 11) are not interchangeable. Arguably, the Steckman court itself would never have distinguished 33 Act claims had it adopted the underwriters’ insufficiency argument as do these courts. These courts’ adoption of the underwriters’ argument effectively overrules Steckman’s conclusion.

B. Distinction Based on Statutory Language Fails

The NVIDIA court attempts to distinguish 33 Act claims based on purported differences in statutory language: “[l]iability under sections 11 and 12(a)(2) of the Securities Act may arise from ‘omit[ting] to state a material fact required to be stated.’ . . . There is no such requirement under section 10(b) or Rule 10b-5.”^[121] As the Second Circuit pointed out, however, this misreads the statute: “section 12(a)(2)’s prohibition on omissions is textually identical to that of Rule 10b-5 . . . .”^[122]

C. 33 Act Materiality is Set by Basic even after Matrixx

NVIDIA cites the Second Circuit’s decision in Panther Partners that “[33 Act] liability arises from ‘an omission in contravention of an affirmative legal disclosure obligation,’”^[123] and contrasts that with 34 Act liability as defined in Matrixx.^[124] If the court means, like Steckman, that there is no materiality requirement for 33 Act claims, this reads materiality out of the statute and suffers the same ills as Steckman.^[125] The more plausible reading is that 33 Act claims have a lower materiality standard than 34 Act claims. But this is contradicted by the Second Circuit’s statement in Blackstone that “the test for materiality is the same [under section 10(b) as] when claims are brought pursuant to sections 11 and 12(a)(2) . . . .”^[126] Further, neither Blackstone nor Panther Partners state that section 12(a)(2) has a lower materiality standard than section 10(b).

Moreover, even were it true that after Matrixx, materiality under the 34 Act is higher than under the 33 Act, that still does not reduce 33 Act claims from the Basic materiality threshold, which is itself a higher standard than under Item 303. Matrixx stated that under section 10(b), even “material information need not be disclosed unless omission of that information would cause other information that is disclosed to be misleading.”^[127] But Matrixx did not address section 11. Nothing in Matrixx overrules the well-settled appellate jurisprudence that Basic materiality applies equally to section 11 and section 10(b) claims. Indeed, Matrixx reaffirms Basic as the baseline standard for materiality. At most, Matrixx sets the bar for 34 Act omissions higher than the Basic standard. It does nothing to lower the standard for section 11.^[128] Section 11 remains subject to Basic materiality, which is not interchangeable with Item 303 materiality.

D. Differences Regarding Scienter and Pleading Requirements are Irrevelant

NVIDIA proffers a seemingly meaningless distinction: 33 Act claims are different because “scienter is not an element.”^[129] Scienter is not an element, but materiality is. And materiality is governed by Basic which is higher than Item 303 materiality, which makes it impossible for an Item 303 violation to automatically trigger section 11 liability. This same logic applies to NVIDIA’s purported distinction on the grounds that 33 Act claims are “not subject to the PSLRA’s heightened pleading standards.”^[130]

E. The Second Circuit’s “Two-Step” Approach

Recent Second Circuit decisions may reject surrogate liability with respect to both 33 Act and 34 Act claims.^[131]

The Second Circuit recognizes two discrete elements in establishing an omission under the securities laws: (1) a duty to disclose and (2) a material omission.^[132] An Item 303 violation “establishes that the defendant had a duty to disclose. A plaintiff must then allege that the omitted information was material under Basic’s probability/magnitude test.”^[133] An omission required under Item 303 may still not be actionable under the securities laws if not material under Basic.^[134] Although Stratte-McClure focuses on 34 Act claims, this two-step approach may apply to 33 Act claims as well.^[135] If so, Item 303 would not be sufficient to state a claim under section 11.^[136]

VII. Conclusion

Steckman’s conclusion that Item 303 is a surrogate for section 11 liability is worth reconsidering. Its conclusion was not necessary for its holding.^[137] Further, Steckman has been effectively overruled. The widespread rejection of Item 303 as a surrogate for Basic materiality makes clinging to Steckman indefensible.^[138] Misplaced reliance on Steckman end runs the Supreme Court’s carefully calibrated materiality standards. It promotes excessive disclosure and frivolous litigation.

Instead, courts should side with the Steckman underwriters and the reasoning in NVIDIA, Oran, and Stratte-McClure—and follow that reasoning to its inexorable conclusion: 33 Act claims, like 34 Act claims, cannot sufficiently be established by an Item 303 violation. Such an approach will restore the careful balance struck by the Supreme Court in Basic, benefiting both issuers and investors with more substantive disclosures and less meritless litigation.

The break with Steckman has already begun.^[139] In In re Thornburg Mortgage Securities Litigation, the federal district court left open the possibility that Item 303 is not a surrogate for section 11.^[140] Where plaintiffs did not “establish[] a violation of Item 303,” the court expressly declined to “decide whether every violation [of Item 303] is necessarily also a violation of section 11.”^[141]

Securities litigators and judges—that’s your cue.^[142]

† Associate, Wilson Sonsini Goodrich & Rosati. The Author is grateful to Boris Feldman, Jesse Fried, Ignacio Salceda, and Ben Tolman for helpful comments.

[1] 17 C.F.R. § 229 (1982); see also 2 Thomas Lee Hazen, Treatise on the Law of Securities Regulation § 9.4(1) (6th ed. 2009).

[2] 17 C.F.R. § 229.10 (2017).

[3] See, e.g., Oran v. Stafford, 226 F.3d 275, 287 (3rd Cir. 2000) (“Neither the language of the regulation nor the SEC’s interpretative releases construing it suggest that it was intended to establish a private cause of action, and courts construing the provision have unanimously held that it does not do so.”) (citations omitted).

[4] Id.; see also, e.g., id. at 288 (“[T]he demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5. Such a duty to disclose must be separately shown.”) (citation omitted); In re Sofamor Danek Group, 123 F.3d 394, 403 (6th Cir. 1997) (holding that there is no private action under Item 303 but acknowledging that “disclosure dut[ies] under [a statutory] claim may stem from Item 303”); Silverstein v. Globus Med., Inc., No. 15-5386, 2016 U.S. Dist. LEXIS 113740, at *32 (E.D. Pa. Aug. 24, 2016) (quoting Oran, 226 F.3d); In re Quintel Entertainment Inc. Secs. Litig., 72 F. Supp. 2d 283, 293 (S.D.N.Y. 1999) (“Violations of Item 303 may be relevant to determining when a false or misleading omission has been made [under the securities laws.]”).

[5] E.g., Steckman v. Hart Brewing, Inc., 143 F.3d 1293, 1296 (9th Cir. 1998) (“[A]ny omission of facts ‘required to be stated’ under Item 303 will produce liability under Section 11.”); Welgus v. Trinet Grp., Inc., No. 15-cv-03625-BLF, 2017 U.S. Dist. LEXIS 6347, at *51 (N.D. Cal. Jan. 17, 2017) (order granting in part and denying in part motions to dismiss with leave to amend in part and without leave to amend in part) (“Allegations which state a claim under Item 303(a) of Regulation S-K also sufficiently state a claim under Sections 11 and 12(a)(2).”) (quoting Steckman, 143 F.3d); In re Initial Pub. Offering Secs. Litig., 358 F. Supp. 2d 189, 211 (S.D.N.Y. 2004) (“An omission of fact ‘required to be stated’ under Item 303 will generally produce liability under section 11.”) (citing Steckman, 143 F.3d); Simon v. American Power Conversion Corp., 945 F. Supp. 416, 431 (D.R.I. 1996) (“[B]ecause [the company] was under an affirmative duty to disclose [under Item 303] and did not, the Court finds this omission to be actionable [under section 10(b).]”); Lead Plaintiff’s Opposition to Defendant Trinet’s, The Individual and Director Defendants’ and General Atlantic’s Motions to Dismiss First Amended Complaint, Welgus v. Trinet Grp., Inc., No. 5:15-cv-03625-BLF, 2016 WL 4501063 (N.D. Cal. Aug. 19, 2016); cf. In re SAIC, Inc., No. 12 Civ. 1353 (DAB), 2013 U.S. Dist. LEXIS 142606, at *33 (S.D.N.Y. Sept. 30, 2013) (citing Steckman, 143 F.3d) (analyzing only Item 303, not the Exchange Act); Mallen v. Alphatec Holdings, Inc., No. 10-cv-1673 – BEN (MDD), 2013 U.S. Dist. LEXIS 46159, at *40 (S.D. Cal. Mar. 28, 2013) (citing Steckman, 143 F.3d) (focusing analysis on whether the complaint “allege[d] that defendants violated a disclosure duty under Regulation S-K”, without considering the statutory standards for materiality); O’Donnell v. Coupons, No. 1-15-cv-278399, 2016 Cal. Super. LEXIS 1097 (Cal. Super. Ct., Santa Clara Cty. May 24, 2016) (dismissing plaintiffs’ section 11 claim because the omitted information was “not required by item 303”).

[6] See 17 C.F.R. § 229.303(a) (2017).

[7] Item 303 requires issuers to “[d]escribe any known trends or uncertainties.” 17 C.F.R. § 229.303(a)(3)(ii) (2017). Item 303 is therefore violated if such known trends or uncertainties are omitted. E.g., Steckman, 143 F.3d at 1296 (“[A]ny omission of facts required to be stated under Item 303 will produce liability under Section 11.”) (quotations omitted).

[8] Unlike the securities laws, Item 303 expressly requires the disclosure of certain forward-looking information. See Management’s Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures, Securities Act Release No. 6835, Exchange Act Release No. 26831, Investment Company Act Release No. 16961, 54 Fed. Reg. 22427 (May 18, 1989) [hereinafter SEC May 18, 1989 Release], https://www.sec.gov/rules/interp/33-6835.htm (“Several specific provisions in Item 303 require disclosure of forward-looking information.”).

[9] See infra Part II.C.

[10] Compare In re NVIDIA Corp. Secs. Litig., 768 F.3d 1046, 1056 (9th Cir. 2014) (“Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5. Such a duty to disclose must be separately shown . . . .”), cert. denied, 135 S. Ct. 2349 (2015), with Stratte-McClure v. Stanley, 776 F.3d 94, 102 (2d Cir. 2015) (“Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).”), and Ind. Pub. Ret. Sys. v. SAIC, Inc., 818 F.3d 85, 94 (2d Cir. 2016) (quoting Stratte-McClure, 776 F.3d at 101 n. 7), cert. granted, Leidos, Inc. v. Ind. Pub. Sys., 2017 WL 1114966 (U.S. Mar. 27, 2017) (No. 16-581). See also Petition for Writ of Certiorari, SAIC, 818 F.3d 85 (No. 16-581), 2016 WL 6472615 (asking the Supreme Court to resolve the circuit split). This Article’s core argument against Steckman’s conclusion that an Item 303 violation is sufficient to state a claim under section 11 is not likely to be resolved by Leidos.

[11] See sources cited supra note 5.

[12] Jared L. Kopel, Ignacio E. Salceda & Scott L. Adkins, United States: The Duty to Disclose Intra-Quarter Financial Results, Mondaq (May 6, 1999), www.mondaq.com/unitedsta tes/x/7306/The+Dutythe+duty+to+‌Disc‌l‌o‌se‌‌‌+‌Intra‌Qua‌rte‌r+‌Financial+Results‌disc‌l‌o‌se‌‌‌+‌intra‌qua‌rte‌r+‌financial+results.

[13] See 143 F.3d 1293 (9th Cir. 1998).

[14] Id. at 1296. To this day, Steckman remains the only Ninth Circuit Court of Appeals decision in a section 11 case holding that an Item 303 violation is a surrogate for section 11 liability. Arguably, it is the only such federal appellate decision in any circuit. See infra note 112 (discussing recent Second Circuit decisions).

[15] Leveraging a rule violation to state a claim construes the rule as a “surrogate” for the statute. See In re VeriFone Secs. Litig., 11 F.3d 865, 870 (9th Cir. 1993); In re NVIDIA Corp. Secs. Litig., No. 08-CV-04260-RS, 2010 U.S. Dist. LEXIS 114230, at *33–34 (N.D. Cal. Oct. 19, 2010) (applying VeriFone to Item 303).

[16] E.g., In re Canandaigua Secs. Litig., 944 F. Supp. 1202, 1210 (S.D.N.Y. 1996) (“The difficulty in interpreting S-K 303 is compounded by the broad and ambiguous language of the item and the S.E.C’s decision to leave the standard of disclosure ‘intentionally general . . . .’”) (quoting SEC May 18, 1989 Release, supra note 8); Brief for the Securities Industry and Financial Markets Association and the Chamber of Commerce of the United States of America as Amici Curiae Supporting Petitioner, Leidos, Inc. v. Ind. Pub. Ret. Sys., No. 16-581, 2016 WL 7011426 at *3 (March 27, 2017) (“[T]he breadth and amorphousness of Item 303’s reporting standards make it almost impossible in many instances to determine when management is obligated to make a disclosure.”).

[17] Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983) (“Liability [under section 11] against the issuer of a security is virtually absolute, even for innocent misstatements.”) (footnote omitted).

[18] See Brian Neach, Item 303’s Role in Private Causes of Action Under the Federal Securities Laws, 76 Notre Dame L. Rev. 741, 770–72 (2001).

[19] See id.

[20] See Stratte-McClure v. Stanley, 776 F.3d 94, 103–34 (2d Cir. 2015); In re NVIDIA Corp. Secs. Litig., 768 F.3d 1046, 1054 (9th Cir. 2014); Oran v. Stafford, 226 F.3d 275, 288 (3rd Cir. 2000); see also infra Part III.

[21] See Basic Inc. v. Levinson, 485 U.S. 224, 231–32 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).

[22] See SEC May 18, 1989 Release, supra note 8.

[23] See cases cited supra note 5.

[24] See infra note 112.

[25] 15 U.S.C. § 77k(a) (2012). The securities laws impose liability for false or misleading statements as well as omissions. This Article focuses on omissions, as that is where Item 303 allegations typically arise.

[26] 15 U.S.C. § 77q(a)(2) (2012).

[27] 15 U.S.C. § 78j(b) (2012).

[28] 17 C.F.R. § 240.10b-5(b) (2017).

[29] See Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 37 (2011).

[30] 17 C.F.R. § 229.303 (2017).

[31] 17 C.F.R. § 229.303(a)(3)(ii).

[32] The securities laws refer to “material fact.” Supra Part II.A. Item 303 refers to “material favorable or unfavorable impact.” Supra Part II.B.

[33] See Basic v. Levinson, 485 U.S. 224, 232 (1988). The Basic test was reaffirmed in 2011. See Matrixx, 563 U.S. at 38–45.

[34] See Basic, 485 U.S. at 232, 249 (“We specifically adopt, for the § 10(b) and Rule 10b-5 context, the standard of materiality set forth in [TSC Indus., v. Northway, Inc., 426 U.S. 438 (1976)].”).

[35] Id. at 231 (emphasis added) (quoting TSC Indus., 426 U.S. at 449); see also Matrixx, 563 U.S. at 38 (emphasis added) (quoting Basic, 485 U.S. at 231–32).

[36] Basic, 485 U.S. at 238 (quoting SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968)).

[37] See infra note 112.

[38] See SEC May 18, 1989 Release, supra note 8.

[39] Id. (emphasis added).

[40] Id. at n. 27. Commentators offer various ways to measure the difference between these two tests. See Neach, supra note 18, at 752–55 (“[A] simple comparison of the literal language of the SEC’s two-step analysis in the 1989 Release to the Supreme Court’s language in Basic reveals a marked difference between the two standards . . . . [T]he Supreme Court uses the term ‘substantial likelihood;’ this language connotes a higher standard for materiality than does the ‘reasonably likely’ language of the 1989 Release . . . . Item 303’s threshold for disclosure is lower than the Basic standard because management can no longer discount the magnitude of the uncertainty with a probability factor.”); Suzanne J. Romajas, The Duty to Disclose Forward-Looking Information: A Look at the Future of MD&A, 61 Fordham L. Rev. S245, S256 n.83 (1993) (“It is helpful to visualize the difference between the tests in mathematical terms. With respect to the first step of Item 303’s test, Former SEC Commissioner Fleischman has suggested that ‘reasonably likely’ may be in the 40% probability range. With respect to the second step, one commentator has noted that ‘the MD&A [test] requires the probability [of occurrence] to be assumed at 100% unless it can be determined to be close to zero, whereas Basic allows the probability of occurrence to be estimated at any point from zero to 100%.’”) (citations omitted).

[41] Steckman v. Hart Brewing, Inc., 143 F.3d 1293, 1294–95 (9th Cir. 1998).

[42] Class Action Complaint Violations of the Securities Laws at 12–13, Steckman, 143 F.3d 1293 (No. 396CV01077), 1996 WL 34446326.

[43] Steckman, 143 F.3d at 1296.

[44] Id.

[45] Steckman v. Hart Brewing, Inc., No. 96-1077-K (RBB), 1996 U.S. Dist. LEXIS 22424, at *14–16 (S.D. Cal. Dec. 24, 1996).

[46] Brief of Defendants/Appellees, Steckman, 143 F.3d 1293 (9th Cir. 1998) (No. 97-55199), 1997 WL 33555008 [hereinafter Appellees’ Brief].

[47] Steckman, 143 F.3d at 1296; see also Brief of the Underwriter Defendants/Appellees, Steckman, 143 F.3d 1293 (No. 97-55199), 1997 WL 33555009 [hereinafter Underwriters’ Brief]; Appellees’ Brief, supra note 46.

[48] The Underwriters’ Brief notes that “[b]y its terms, Section 11 addresses only ‘material’ misstatements or omissions. As this Court has held, . . . the definition of materiality that governs any such [33] Act claim is set forth in Basic, Inc. v. Levinson[.]” Underwriters’ Brief, supra note 47, at 17 (citing In re Worlds of Wonder Secs. Litig., 35 F.3d 1407, 1413 n.2 (9th Cir. 1994)) (noting that Worlds of Wonder “confirm[s] that the Basic standard governs [33] Act claims”); see also In re Worlds of Wonder, 814 F. Supp. 850, 859 (N.D. Cal. 1993) (applying the Basic test to section 11 claims).

[49] Underwriters’ Brief, supra note 47, at 17 (“By contrast, the SEC has expressly rejected the Basic test for the purposes of determining whether there has been an omission under Item 303.”).

[50] Id. at 18 (“Contrary to Alfus, Caere and the SEC’s own interpretation, plaintiff assumes that the requirements of Item 303 are interchangeable with those of section 11. Because, in fact, there are fundamental differences between the standards governing a private claim under the Securities Act and an SEC enforcement action—and because plaintiff has not attempted to ‘separately show’ any section 11 violation—this action was properly dismissed with prejudice.”). The underwriters erred, however, in citing In re VeriFone Securities Litigation. 784 F. Supp. 1471 (N.D. Cal. 1992), aff’d 11 F.3d 865 (9th Cir. 1993). That case did not consider whether Item 303 was sufficient for a section 11 violation, but whether 303 was violated in the first instance. See Neach, supra note 18, at 769 n.169.

[51] Alfus v. Pyramid Tech. Corp., 764 F. Supp. 598 (N.D. Cal. 1991); see also Feldman v. Motorola, Civ. A. No. 90-C-5887, 1993 U.S. Dist. LEXIS 14631 (N.D. Ill. Oct. 14, 1993) (quoting Alfus, 764 F. Supp.).

[52] Underwriters’ Brief, supra note 47, at 18 (quoting Alfus, 764 F. Supp.).

[53] Plaintiff’s/Appellant’s Joint Reply Brief, Steckman v. Hart Brewing, Inc., 143 F.3d 1293 (9th Cir. 1998) (No. 97-55199), 1997 WL 33555006 [hereinafter Plaintiff’s Reply] (emphasis added). Steckman submitted that Basic contains two tests: the “probability/magnitude” test and the “substantial likelihood/total mix” test. He contended that the “probability/magnitude” test is limited to the preliminary merger context of the Basic case. Before Basic, a company was not required to disclose merger negotiations until an “agreement-in-principle” had been reached: “Basic rejected this bright line test, and held that materiality in the merger context should [be] viewed by assessing the probability the merger would occur.” Id. (citing Basic v. Levinson, 485 U.S. 224, 239 (1988)). Outside the merger context, however, materiality is governed by Basic’s “substantial likelihood/total mix” test, which is a “general materiality standard[]” that governs materiality for omissions under the 33 Act, 34 Act, and Item 303. Id.; see also Romajas, supra note 40, at 257 (“In Basic, the Court was concerned with the disclosure of one very specific type of forward-looking information—preliminary merger negotiations. In determining whether there was a duty to disclose such information, the Court applied the probability/magnitude test. It limited its decision to the merger context, however, expressly stating that it was not addressing the applicability of its test to the disclosure of projections or other forward-looking information. In practice, most courts have dispensed with the probability/magnitude test when determining whether disclosure of projections is required. Therefore, it is not surprising that Item 303 also dispenses with that test.”). This view however has not been widely followed. Courts apply the “probability/magnitude” test beyond the merger context. See, e.g., Stratte-McClure v. Stanley, 776 F.3d 94, 103 (2d Cir. 2015) (noting that plaintiffs must “allege that the omitted information was material under Basic’s probability/magnitude test”); In re Alliance Pharm. Secs. Litig., 1995 U.S. Dist. LEXIS 11351, *10, *19 (S.D. Cal. May 23, 1995) (applying the “probability/magnitude” test to “securities violations involving nondisclosure relat[ing] to information suggesting that something might happen in the future”); see also SEC May 18, 1989 Release, supra note 8 (applying “probability/magnitude” test to securities violations in general, not limited to the merger context).

[54] Steckman v. Hart Brewing, 143 F.3d 1293, 1298 (9th Cir. 1998).

[55] See Neach, supra note 18, at 771. The court “declined to pass” on other issues it did not need to address in light of Steckman’s failure to state an Item 303 violation. Steckman, 143 F.3d at 1298.

[56] Steckman, 143 F.3d at 1296.

[57] Kopel, et al., supra note 8 (noting that “Steckman is also very hard to harmonize with Worlds of Wonder, which was also issued by the Ninth Circuit Court of Appeals” and that “in light of this, it is not surprising that other courts have largely ignored Steckman’s holding,” and focusing on whether Steckman imposed a duty to report intra-quarter results).

[58] Steckman, 143 F.3d at 1296. Steckman is not consistent with the Ninth Circuit’s VeriFone decision (cited by Steckman) as VeriFone has been understood by other courts. See In re VeriFone Secs. Litig., 11 F.3d 865, 870 (9th Cir. 1993) (“We decline to hold that a violation of exchange rules governing disclosure may be imported as a surrogate for straight materiality analysis under § 10(b) and Rule 10b–5.”); In re NVIDIA Corp. Secs. Litig., No. 08-CV-04260–RS, 2010 U.S. Dist. LEXIS 114230, at *33–34 (N.D. Ca. Oct. 19, 2010) (applying VeriFone to an Item 303 violation); Kriendler v. Chemical Waste Management, 877 F. Supp. 1140, 1157 (N.D. Ill. 1995) (similar).

[59] Steckman, 143 F.3d at 1296.

[60] Cf. Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1204 (1st Cir. 1996) (“The information ‘required to be stated’ in a registration statement is spelled out . . . in various regulations promulgated by the SEC . . . .”) (quoting section 11).

[61] Id. (emphasis added). The court may have been drawing from the following language in Steckman’s brief: “Item 303 establishes a ‘duty’ to disclose. Item 303 is relevant to cases arising under section 11 of [the 33] Act where plaintiff alleges [that] an issuer[] ‘omitted to state a material fact required to be stated [in the registration statement].’ The question ‘what is required to be stated’, is answered by reference to Item 303.” Plaintiff’s Reply, supra note 53, at 19. But Steckman’s focus was never that such an omission would automatically impose liability. He stated merely that Item 303 creates a “duty to disclose,” rendering a violation an omission. However, such omission may still need to be separately established as material. See infra Part VI.E (discussing the Second Circuit’s “two-step” approach); see also Plaintiff’s Reply, supra note 53, at 3 (stating that “[t]he omission of material facts, which [defendants] had a duty to disclose, establishes a violation of Section 11 and Section 12(2) of the [33 Act],” thereby implying that the duty to disclose and materiality are separate elements).

[62] See infra note 112, at 102.

[63] E.g., 17 C.F.R. § 229.102 (2017) (“[S]tate briefly the location and general character of the . . . physical properties of the registrant and its subsidiaries.”); 17 C.F.R. § 229.502 (2017) (explaining that the registrant must “include the table of contents immediately following the cover page in any prospectus you deliver electronically”); 17 C.F.R. §§ 229.510, 229.702 (2017) (indemnification of officers and directors); see also Neach, supra note 18, at 773 (“[M]andatory Item 303 disclosures encompass a broad spectrum of both material and immaterial information. The unfairness of the Steckman court’s holding becomes evident when applied to a reporting company that complies fully with all Item 303 disclosures that are material (in the Basic sense), yet could still be liable for seemingly minor omissions.”).

[64] Reductio ad absurdum is further grounds for rejecting Steckman’s reading. See, e.g., Corley v. United States, 556 U.S. 303, 316 (2009) (rejecting a statutory reading where taking it to its logical extreme would lead to “absurdities”). Moreover, legislative history supports a narrower reading of the “required to be stated” language. See H.R. Rep. No. 73-152, at 26 (1933) (“[U]nless the [A]ct expressly requires such a fact to be stated”) (emphasis added) (implying that the “required to be stated” language refers only to a disclosure required by the Act itself, and not one required merely by regulation such as Reg. S-K).

[65] See Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 38 (2011) (“We were ‘careful not to set too low a standard of materiality,’ for fear that management would ‘bury the shareholders in an avalanche of trivial information.’”) (quoting Basic v. Levinson, 485 U.S. 224, 231 (1988)); see also infra Part VI.

[66] Steckman v. Hart Brewing, 143 F.3d 1293, 1296 (9th Cir. 1998).

[67] Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1204 (1st Cir. 1996) (“That predicate is unique to Section 11; neither Section 12(2) of the Securities Act nor Section 10(b) or Rule 10b-5 under the Exchange Act contains comparable language.”); see also Stratte-McClure v. Stanley, 776 F.3d 94, 104 (2d Cir. 2015) (noting that “Section 12(a)(2)’s prohibition on omissions is textually identical to that of Rule 10b-5”).

[68] Steckman, 143 F.3d at 1296 (quoting Craftmatic Secs. Litig. v. Kraftsow, 890 F.2d 628, 641 n.17 (3d Cir. 1990)). Craftmatic does not discuss Item 303 or specify what it meant by “mandated by law.” In a subsequent decision, the Third Circuit noted that it is “far from certain that the requirement that there be a duty to disclose under Rule 10b-5 may be satisfied by importing the disclosure duties from S-K 303.” In re Burlington Coat Factory Secs. Litig., 114 F.3d 1410, 1419 (3d Cir. 1997) (internal quotation marks omitted) (quoting In re Canandaigua Secs. Litig., 944 F. Supp. 1202, 1209 n.4 (S.D.N.Y. 1996)); see also Neach, supra note 18, at 771 (arguing that the “presumably material” language is sourced in an unsupported phrase in a law review article that “does not provide any source for this proposition; thus indicating that the Steckman court’s decision rested on a rather fragile foundation”).

[69] See Neach, supra note 18, at 771 (“[I]ntertwining a presumption of materiality with SEC-required disclosures completely undercuts the Supreme Court’s decisions regarding materiality.”) (citing Basic, 485 U.S. 231–32; TSC Indus., Inc. v. Northway, Inc. 426 U.S. 438, 449 (1976)); see also infra note 112 (discussing Worlds of Wonder, an earlier Ninth Circuit decision that applied Basic/TSC materiality to section 11).

[70] This distinction was advocated by neither party. Steckman may have been trying to distinguish VeriFone, a case cited by the underwriters that declined to find section 11 liability where Item 303 violations were alleged. See In re VeriFone Securities Litigation, 784 F. Supp. 1471, 1483 (N.D. Cal. 1992), aff’d 11 F.3d 865 (9th Cir. 1993). But VeriFone was misconstrued by the underwriters. It concerned whether Item 303 had been violated in the first instance, not whether an Item 303 violation is sufficient to state a securities claim. See Neach, supra note 18, at 769 n.169.

[71] Steckman, 143 F.3d at 1296.

[72] Neach, supra note 18, at 770.

[73] See Stratte-McClure v. Stanley, 776 F.3d 94, 104 (2d Cir. 2015) (explaining, “[b]ut Section 12(a)(2)’s prohibition on omissions is textually identical to that of Rule 10b-5: both make unlawful omission of ‘material fact[s] . . . necessary to make . . . statements, in light of the circumstances under which they were made, not misleading’” and holding that Item 303 requirements establish a duty to disclose under both 33 Act and 34 Act claims) (citations omitted) (quoting 15 U.S.C.A. §77l (West 2000)).

[74] See infra note 112. One such case is Craftmatic Secs. Litig. v. Kraftsow, 890 F.2d 628, 640–41 (3d Cir. 1990), which Steckman itself cites, 143 F.3d at 1296.

[75] After the 2011 Matrixx decision, there may be grounds to distinguish 34 Act materiality as requiring something more than Basic. See infra Part VI. However, such grounds did not exist in 1993 when Steckman was decided.

[76] 226 F.3d 275 (3d Cir. 2000).

[77] Id. at 279.

[78] See id.

[79] Id. at 287.

[80] Id. at 281.

[81] Id.

[82] Id. at 287.

[83] See id. at 288.

[84] Id. at 287.

[85] Id. (citing SEC May 18, 1989 Release, supra note 8).

[86] Id. at 288 (citation omitted); see also Underwriters’ Brief, supra note 47, at 17.

[87] 226 F.3d at 288 (“[T]he materiality standards for Rule 10b-5 and [Item] 303 differ significantly.”) (quoting SEC May 18, 1989 Release, supra note 8); see also Underwriters’ Brief, supra note 47, at 17.

[88] Oran, 226 F.3d at 288 (emphasis added); see also Underwriters’ Brief, supra note 47, at 18.

[89] Oran, 226 F.3d at 228 (quoting Alfus v. Pyramid Tech. Corp., 764 F. Supp. 598 (N.D. Cal. 1991).

[90] Id.

[91] In re NVIDIA Corp. Secs. Litig., 768 F.3d 1046, 1048 (9th Cir. 2014).

[92] Id.

[93] Id. at 1054.

[94] Id.

[95] Id. (citation omitted).

[96] Id. at 1055.

[97] Id. at 1054 (quoting Oran v. Stafford, 226 F.3d 275 (3rd Cir. 2000)) (quoting the Alfus language cited by the Steckman underwriters).

[98] Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 94 (2d Cir. 2015).

[99] Id. at 96.

[100] Id. at 98.

[101] Id. at 99.

[102] Id. at 100.

[103] Id. at 99 (quoting Stratte-McClure v. Morgan Stanley, No. 09 Civ.2017(DAB), 2013 WL 297954, at *9 (S.D.N.Y. Jan. 18, 2013)).

[104] Id. at 100 (emphasis added) (citation omitted).

[105] See id. at 102.

[106] See id.; see also infra part VI.E (discussing the Second Circuit’s “two-step” approach).

[107] See Stratte-McClure, 776 F.3d at 103–04.

[108] Id. at 103.

[109] See id. (quoting SEC May 18, 1989 Release, supra note 8).

[110] See id.

[111] Id.

[112] Ninth Circuit. In Worlds of Wonder, a case involving section 11 claims, the Ninth Circuit confirmed that the Basic test for materiality applies to omissions challenged under section 11. In re Worlds of Wonder Secs. Litig., 35 F.3d 1407, 1413 n.2 (9th Cir. 1994) (“[F]or nondisclosure to be actionable ‘there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.’”) (citation omitted). The court rejected the Worlds of Wonder plaintiffs’ argument that bespeaks caution applied only to section 10(b) claims, reasoning that the “[bespeaks caution] doctrine is primarily an application of the materiality concept, which applies equally to both statutory provisions.” Id. at 1415 n.3 (emphasis added).

That section 11 materiality is governed by the heightened Basic standard is oft-repeated in the Ninth Circuit. See, e.g., Hemmer Grp. v. Southwest Water Co., 527 Fed. Appx. 623, 626 (9th Cir. 2013) (“A fact is material [under section 11] if there is ‘a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.’”) (quoting Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 38 (2011)); Sherman v. Network Commerce, Inc., 346 Fed. Appx. 211, 213 (9th Cir. 2009) (“To establish materiality, plaintiffs must demonstrate a ‘substantial likelihood that a reasonable investor would have acted differently if the misrepresentation had not been made or the truth had been disclosed.’”) (quoting Livid Holdings Ltd. v. Salomon Smith Barney, Inc., 416 F.3d 940, 946 (9th Cir. 2005)); Aaron v. Empresas La Moderna, 46 F. App’x 452, 454 (9th Cir. 2002) (discussing that under section 11, an “omission is material if there is ‘a substantial likelihood that the disclosure of the omitted [or misrepresented] fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available’”) (quoting TSC Indus., Inc. v. Northway, Inc. 426 U.S. 438, 449 (1976)).

Second Circuit. See In re Morgan Stanley Info. Fund Secs. Litig., 592 F.3d 347, 360 (2d Cir. 2010) (“The definition of materiality is the same for these provisions [sections 11 and 12(a)(2)] as it is under section 10(b) of the Exchange Act.”); Kronfeld v. Trans World Airlines, Inc., 832 F.2d 726, 731 (2d Cir. 1987) (“The materiality standard of Northway has been applied in this circuit under Section 11 of the 1933 Act.”) (citing, inter alia, Akerman v. Oryx Commc’ns, Inc., 609 F.Supp. 363, 367 (S.D.N.Y. 1984), aff’d, 810 F.2d 336 (2d Cir. 1987) (applying Basic’s “substantial likelihood” and “probability/magnitude” test to section 11 claims)).

Third Circuit. In Craftmatic, the Third Circuit reviewed allegations under sections 11, 12(a)(2), and 10(b) for a company’s alleged failure to predict certain results. Craftmatic Secs. Litig. v. Kraftsow, 890 F. 2d 628, 640–41 (3rd Cir. 1989). Judge Scirica equated all three claims, and analyzed them uniformly under the Basic/TSC “substantial likelihood/total mix” materiality standard: “In Basic, the Supreme Court expressly adopted the TSC standard of materiality for § 10(b) and Rule 10b-5. Other courts have held that the definition of materiality from TSC applies to actions under both § 11 and § 12(2).” Id. at 641 n.18 (citations omitted); see also id. at 638 n.14 (“[U]nder all three sections [11, 12(a)(2), and 10(b)], liability flows from material misrepresentations or omissions.”); see also In re Ressler Hardwoods & Flooring, Inc., 427 B.R. 312, 325 (Bankr. M.D. Pa. 2010) (“The TSC Industries definition has been extended to apply to ‘materiality’ in the context of a sale of securities under § 12(2) of the Securities Act of 1933.”).

[113] Basic Inc. v. Levinson, 485 U.S. 224, 231 (1988) (quoting TSC, 426 U.S. at 448–49); see also Matrixx, 563 U.S. at 38 (first quoting Basic, 485 U.S. at 238; then quoting TSC, 426 U.S. at 449).

[114] See Kaplan v. Rose, 49 F.3d 1363, 1374 (9th Cir. 1994) (acknowledging that for purposes of a section 11 claim, a “prospectus should not ‘bury the shareholders in an avalanche of trivial information’”) (quoting Basic, 485 U.S. at 231).

[115] Item 303, in contrast, does not impose a private right of action. The mere prospect of regulatory enforcement would not have the same “interrorem” effect as strict private liability under section 11. Panther Partners Inc. v. Ikanos Communs., Inc., 681 F.3d 114, 119–20 (2d Cir. 2012) (quoting In re Morgan Stanley, 592 F.3d at 359).

[116] Id.

[117] Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983).

[118] These cases did not involve section 11 claims—that they uphold Item 303 as a surrogate for section 11 liability is dicta.

[119] Oran v. Stafford, 226 F.3d 275, 288 n.9 (3rd Cir. 2000) (“[The Steckman] court carefully limited its holding, however, making clear that it did not extend to claims under Section 10(b) or Rule 10b-5.”).

[120] In re NVIDIA Corp. Secs. Litig., 768 F.3d 1046, 1055 (9th Cir. 2014) (quoting Steckman v. Hart Brewing, Inc., 143 F.3d 1293, 1296 (9th Cir. 1998)).

[121] Id. at 1055–56 (citation omitted). The Ninth Circuit here may have mistakenly quoted from section 12(b) regarding loss causation, which contains the “required to be stated” language. 15 U.S.C. § 77l(b) (2012).

[122] Stratte-McClure v. Stanley, 776 F.3d 94, 104 (2d Cir. 2015) (quoting 15 U.S.C. § 77l (2012)).

[123] NVIDIA, 768 F.3d at 1055–56 (quoting Panther Partners v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2nd Cir. 2012)).

[124] Id. at 1056 (citing Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 43–44 (2011)).

[125] See supra Part III.C.

[126] See Litwin v. Blackstone Group, L.P., 634 F.3d 706, 716 n.10 (2d Cir. 2011). There is one line in Blackstone that suggests that Item 303’s “reasonably likely” materiality would apply to sections 11 and 12(a)(2). Id. at 716. However, the decision thereafter makes clear that the heightened Basic “substantial likelihood” materiality governs these claims. Id.

[127] NVIDIA, 768 F.3d at 1056 (citing Matrixx, 563 U.S. at 45–46) (emphasis added).

[128] At one point Stratte-McClure suggests that the reason a 34 Act plaintiff must “allege that the omitted information was material under Basic’s probability/magnitude test” is “because 10b-5 only makes unlawful an omission of ‘material information’ that is ‘necessary to make . . . statements made’ . . . ‘not misleading.’” Stratte-McClure v. Stanley, 776 F.3d 94, 103 (2d Cir. 2015) (quoting Matrixx, 563 U.S. at 36). That is not the reason. The reason is that the 34 Act—like the 33 Act—requires an omission of “material” information which courts have repeatedly recognized is governed by Basic. See supra note 112. The “necessary to make statements made not misleading” language quoted from and discussed by Matrixx relates to why even information that is material may not need to be disclosed. Stratte-McClure itself describes “the Supreme Court’s interpretation of ‘material’” as the Basic test. Stratte-McClure, 776 F.3d at 103.

[129] NVIDIA, 768 F.3d at 1056.

[130] Id.

[131] Neither Panther, Panther Partners v. Ikanos Communications, Inc., 681 F.3d 114 (2nd Cir. 2012), nor Blackstone, 634 F.3d, state that section 10(b) claims are different from 33 Act claims with respect to an Item 303 violation.

[132] Stratte-McClure, 776 F.3d at 103; see also supra note 61 (discussing that the duty to disclose and materiality are separate elements).

[133] Stratte-McClure, 776 F.3d at 103.

[134] Id. at 107–08.

[135] See Blackstone, 634 F.3d at 716 (reasoning that after finding Item 303 required certain trends to be stated, the “remaining issue” to find section 11 liability was whether the effect of the omitted information was material).

[136] Stratte-McClure states that the Ninth Circuit in Steckman “also adopted th[e] position” established in Panther and Blackstone “that Item 303 creates a duty to disclose for the purposes of liability under section 12(a)(2).” 776 F.3d at 104; see also id. at 101 (“We have already held [in Panther and Blackstone] that failing to comply with Item 303 by omitting known trends or uncertainties from a registration statement or prospectus is actionable under sections 11 and 12(a)(2).”). However, this may mean simply that Item 303’s “affirmative duty to disclose in Form 10-Qs can serve as the basis for a securities fraud claim” by providing step one—a duty to disclose. See id. at 99 (“[Panther and Blackstone] held that Item 303 may provide a basis for disclosure obligations under sections 11 and 12(a)(2) of the Securities Act of 1933.”) (emphasis added). Neither Panther nor Blackstone mention Steckman, let alone state that they follow it. Those cases can be read as stating merely that the omissions in those cases both (1) violated Item 303 and (2) were material under Basic, but not that every Item 303 violation necessarily is material under Basic to trigger section 11 liability, as Steckman held.

[137] See Neach, supra note 18, at 770–72.

[138] See supra Part V.

[139] See supra Part VI (discussing that the Second Circuit may reject Steckman).

[140] In re Thornburg Mortg., Inc. Secs. Litig., 824 F. Supp. 2d 1214, 1256 (D.N.M. 2011).

[141] Id. (emphasis added); see also id. at 1267 (“[If] the omission was not material, it is of no moment whether Item 303 required disclosure.”).

[142] This Article’s argument may be readily deployed in litigation of section 11 class actions in state courts not bound by the federal Steckman decision. E.g., Marshall v. County of San Diego, 238 Cal. App. 4th 1095, 1115 (2015) (“Decisions of the lower federal courts interpreting federal law, though persuasive, are not binding on state courts.”) (internal quotation marks omitted) (quoting Raven v. Deukmejian, 52 Cal.3d 336 (1990)).

April 4, 2017 By ehansen

Age Before Equity? Federal Regulatory Agency Disgorgement Actions and the Statute of Limitations

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Michael Columbo and Allison Davis¹

I. Introduction

At what point may a person rest assured that the government will not confiscate her money due to a past alleged regulatory infraction? In Kokesh v. SEC, the Supreme Court is poised to resolve a three-way split among the federal circuit courts of appeals over whether the statute of limitations in 28 U.S.C. § 2462 applies to federal regulatory actions seeking disgorgement of a person’s funds for long-past alleged regulatory infractions.² Congress enacted the statute of limitations in § 2462 to prohibit federal courts from entertaining an action for the enforcement of “any civil fine, penalty, or forfeiture, pecuniary or otherwise,” unless the case is commenced within five years of the alleged violation.³ Federal regulatory enforcement agencies such as the Securities and Exchange Commission (SEC) nonetheless bring actions to confiscate a person’s funds for alleged violations beyond that limitations period by seeking “disgorgement” of the defendant’s funds.⁴

The claimed difference between the terms “forfeiture” and “disgorgement” is not apparent from their common legal definitions. “Forfeiture” is defined as “the loss of a right, privilege, or property because of a crime, breach of obligation, or neglect of duty,”⁵ while “disgorgement” is defined as “the act of giving up something (such as profits illegally obtained) on demand or by legal compulsion.”⁶

Federal courts in various circuits have three distinct and inconsistent responses to agency efforts to confiscate a defendant’s funds for infractions beyond the limitations period. Some courts accept that the government may obtain disgorgement of a person’s funds beyond the limitations period even though it may not seek forfeiture of those funds after that period has expired.⁷ Others resolve the issue through a fact-intensive inquiry into, among other things, the government’s motivation for seeking the defendant’s funds and the financial circumstances of the particular defendant.⁸ Yet another response is that disgorgement is simply one form of forfeiture, and thus disgorgement is categorically limited by the statute of limitations.⁹ The first and last of these approaches are simple, predictable, and cost little for practitioners to ascertain, though they produce opposite outcomes. The fact-intensive middle option is, by contrast, unpredictable, costly, and time-consuming, thus effectively depriving the public of repose even after the limitations period has run, unless and until the issue is litigated and the defendant prevails.

Moreover, as to the argument that such actions call for courts to invoke equitable powers unconstrained by the statute of limitations, well-founded equitable principles similarly support precluding agency actions for disgorgement after the expiration of the limitations period. Those principles deny circumvention of the statute of limitations due to the availability of a legal remedy had the government diligently acted within the five-year limitations period. Indeed, many state legislatures have barred courts’ use of equity to circumvent statutes of limitations.¹⁰

Part II of this Article summarizes the statute of limitations and catalogues the courts’ three divergent approaches to federal agency attempts to confiscate funds after the expiration of the limitations period. Part III analyzes these approaches in light of the Supreme Court’s interpretation of the statute of limitations and considers the weaknesses in each approach. Part IV applies the relevant maxims of equity to these various approaches. Finally, this Article concludes that the plain text of the statute of limitations applies to all actions seeking confiscation of a defendant’s funds for deposit into the U.S. Treasury due to a regulatory infraction regardless of whether the remedy is pleaded as forfeiture or disgorgement. To distinguish between actions based on whether the remedy sought is pleaded as forfeiture or disgorgement would nullify the statute of limitations and the important purposes it serves: providing repose for the potentially liable, precluding the government from unjustly launching surprise actions based on stale claims, and saving the courts from engaging in fact-finding using incomplete evidence.

This conclusion is consistent with the logic and tenor of the Supreme Court’s holding in Gabelli v. SEC in 2013.¹¹ Although the Court did not then address whether injunctive relief and disgorgement are subject to § 2462, its holding reflects a reluctance on the part of the Court to nullify § 2462 with judicially-legislated exceptions.¹² It is also consistent with the recent decision of the Eleventh Circuit in SEC v. Graham, in which the court held that “forfeiture” is synonymous with, or includes, “disgorgement,” therefore making disgorgement subject to the statute of limitations.¹³ Accordingly, in Kokesh v. SEC, the Supreme Court should reverse the Tenth Circuit’s decision and hold that the statute of limitations categorically applies to actions seeking confiscation of funds for past regulatory infractions, regardless of whether the government seeks the funds through forfeiture or disgorgement.

II. Circuit Split on the Application of Statutes of Limitations to Regulatory Enforcement Suits Seeking Disgorgement

A. The Statute of Limitations

Section 2462 provides that claims the government seeks to bring against a party for the enforcement of a civil “fine, penalty, or forfeiture, pecuniary or otherwise” must be commenced within five years of the date of the claim’s accrual.¹⁴ For the purposes of § 2462, the weight of authority holds that the date when the claim first accrues is the date of the underlying violation, not the date of the final administrative order assessing a penalty.¹⁵

In 2013, the Supreme Court had occasion to survey the history of § 2462 in Gabelli v. SEC.¹⁶ The Court noted that § 2462, alongside its predecessor from the 1830s, “sets a fixed date when exposure to the specified [g]overnment enforcement efforts ends, advancing ‘the basic policies of all limitations provisions: repose, elimination of stale claims, and certainty about a plaintiff’s opportunity for recovery and a defendant’s potential liabilities.’”¹⁷ Such statutes “are intended to ‘promote justice by preventing surprises through the revival of claims that have been allowed to slumber until evidence has been lost, memories have faded, and witnesses have disappeared.’”¹⁸ This provides “security and stability to human affairs,” and such statutes are “vital to the welfare of society.”¹⁹ As the Court observed in Gabelli, “even wrongdoers are entitled to assume that their sins may be forgotten.”²⁰

Several key principles appear in this exposition. First, the purpose of statutes of limitations includes fixing a date after which the potential defendants in government enforcement actions may obtain “repose,” that is, certain knowledge that their “exposure to the specified [g]overnment enforcement effort ends.”²¹ Second, such statutes “promote justice” by preventing “surprises through the revival of claims that have been allowed to slumber.”²² The particular focus of this Article is the potentially unjust surprise of the revival of stale claims by the government. Third, statutes of limitations recognize that claims brought beyond the limitations period pose a practical obstacle to the courts’ fact-finding function due to lost evidence, faded memories, and missing witnesses. A court’s inability to accurately determine the facts necessarily interferes with its ability to reach the correct and just result. Fourth, the Court in Gabelli emphasized the importance of this interest in certainty and justice, holding that statutes of limitations provide “security and stability to human affairs”²³ and that they are “vital to the welfare of society”²⁴ notwithstanding that in some cases they may benefit those who may have violated a law.

All the justifications identified by the Court apply with full force to any cause of action and not less so depending on how the government characterizes the remedy sought. The Court gave no indication that any of these justifications would be diminished based on the historical origin of the remedy, the theoretical government motivation, or the severity of the impact on the particular defendant.

The importance of statutes of limitations to the American system of laws was recognized early in our country’s jurisprudence, and remains vital to this day. The D.C. Circuit recently responded to a federal agency’s assertion that its enforcement power was unconstrained by any statutes of limitations:

The general working presumption in federal civil and criminal cases is that a federal civil cause of action or criminal offense must have some statute of limitations and must not allow suits to be brought forever and ever after the acts in question. . . . As Chief Justice Marshall stated, allowing parties to sue ‘at any distance of time’ would be ‘utterly repugnant to the genius of our laws. In a country where not even treason can be prosecuted after a lapse of three years, it could scarcely be supposed that an individual would remain forever liable to a pecuniary forfeiture.’²⁵

B. Federal Agency Actions for Disgorgement for Time-Barred Claims in Federal Courts

Federal agencies routinely seek disgorgement of ill-gotten gains by characterizing it as an equitable remedy in civil enforcement cases filed in district courts.²⁶ Although the U.S. Federal Trade Commission,²⁷ the Commodity Futures Trading Commission,²⁸ the Federal Election Commission,²⁹ and the SEC all have pursued disgorgement in enforcing the laws and regulations under their charge, the SEC avails itself of the remedy especially frequently and has aggressively litigated the issue.³⁰

Federal agencies, such as the SEC, have pursued disgorgement after the expiration of the statute of limitations on the theory that disgorgement is inherently equitable and thus not subject to § 2462.³¹ The jurisprudence and outcomes of several such cases are far from consistent.

C. Inconsistent Judicial Approaches to Disgorgement and § 2462 Statute of Limitations

1. Courts Holding That Disgorgement is Categorically Exempted from the Statute of Limitations

In the past, courts and administrative tribunals have tended to agree with agencies’ contentions that disgorgement may be characterized as an equitable remedy in circumvention of the statute of limitations.³² Several courts accept the agencies’ argument that if the government simply requests confiscation of the defendant’s funds by pleading the remedy of disgorgement rather than the remedy of forfeiture, the court’s jurisdiction is not bound by the statute of limitations. This interpretation relies on the premise that the statute of limitations is itself categorically limited to “punitive” remedies rather than “remedial” remedies and that by pleading the requested confiscation as disgorgement rather than forfeiture, the requested remedy is not punitive and thus not subject to the statute of limitations.³³

For example, in SEC v. Kokesh, the appeal of which is currently pending before the Supreme Court, the Tenth Circuit held that “disgorgement is not a penalty because it is remedial,” in reliance on its prior conclusion that disgorgement belongs to those equitable remedies that “sanction past conduct.”³⁴ Interestingly, the plain meaning of “sanction” is to penalize when used in that context.³⁵ Further, although the Tenth Circuit noted that disgorgement must be “properly applied” so as not to “inflict punishment” and “[leave] the wrongdoer in the position he would have occupied had there been no misconduct,” it also paradoxically concluded that “there is nothing punitive about requiring a wrongdoer to pay for all the funds he caused to be improperly diverted to others as well as to himself.”³⁶ This is true even if he never controlled those funds, and the Court analogized such disgorgement (to the U.S. Treasury) to compensation paid to a victim by a tortfeasor.³⁷ And although the Tenth Circuit stated that under the non-punitive theory of disgorgement, it “just leaves the wrongdoer ‘in the position he would have occupied had there been no misconduct,’” it held that the disgorgement order in Kokesh could nonetheless be imposed on an insolvent elderly person with “no prospect of his restoring the gains he received.”³⁸

Similarly, in SEC v. Jones, the district court concluded that the primary purpose of the SEC’s request to have $109,004,551 of the defendants’ funds transferred to the U.S. Treasury was to deter them from continued violations by depriving them of their gains from the alleged violations.³⁹ The court concluded that because, in the Second Circuit, this asserted public protection purpose was considered remedial rather than punitive, the statute of limitations did not apply.⁴⁰ The Ninth Circuit also has held that SEC claims for disgorgement are not subject to any statute of limitations.⁴¹

The D.C. Circuit, which plays a significant role in informing federal agencies’ understanding of their authority, has employed a similar rationale to that of the Second Circuit but has not yet resolved this precise issue. Generally, the D.C. Circuit does not interpret disgorgement as a penalty so long as it is causally related to the alleged violation. In theory, disgorgement restores the status quo by depriving violators of ill-gotten gains and is thus remedial rather than punitive.⁴² In Riordan v. SEC, however, the court found the application of this doctrine to be questionable in cases where the disgorgement is to the government acting purely in its role as law enforcer, noting “it could be argued that disgorgement is a kind of forfeiture covered by § 2462, at least where the sanctioned party is disgorging profits not to make the wronged party whole, but to fill the federal government’s coffers.”⁴³ Significantly, the panel concluded that the D.C. Circuit has never expressly considered that scenario in any matter where it found that there was no statute of limitations for disgorgement actions.⁴⁴

The Riordan panel’s comment suggests that the D.C. Circuit could distinguish disgorgement to the government as the wronged party in a transaction from disgorgement to the U.S. Treasury in the course of an agency law enforcement action. The latter case is difficult to distinguish factually and doctrinally from a government penalty or forfeiture, which is subject to the statute of limitations.

2. Exception to the Statute of Limitations Depending on the Individual Defendant’s Circumstances

Another approach to determining whether disgorgement is legal or equitable, and thus whether to apply or avoid the statute of limitations, is to analyze the factual circumstances unique to the individual defendant and the government’s intent in seeking the remedy. The object of the analysis is to determine whether the remedy sought, including disgorgement, is remedial in nature and not punitive—and thus not subject to the statute of limitations.

For example, in SEC v. Wyly, the District Court for the Southern District of New York concluded that if the government seeks disgorgement after the expiration of the statute of limitations, it has the burden of proving “a realistic likelihood of recurrence.”⁴⁵ The factors in the analysis include whether the defendant has been found liable for illegal conduct, the degree of the defendant’s intent, whether the defendant’s violation was an isolated occurrence, whether the defendant maintains that he or she was blameless, and whether future violations by the defendant could be anticipated.⁴⁶ The analysis in Wyly is also consistent with the fact-based analysis in Johnson v. SEC, which sought to determine whether the requested injunctive relief was punitive (and therefore barred by the statute of limitations) or remedial (and thus not barred by the statute of limitations). The court did this by examining whether the remedy was “backward-looking” and thus punitive, or “forward-looking” and thus remedial.⁴⁷ According to this theory, a confiscation arising from an action in response to a violation and intended as a consequence for that past violation (and thus “backward-looking”) is by nature penal and thereby limited by the statute. In contrast, a confiscation intended to prevent the defendant’s future violations (and thus “forward-looking”) is by nature remedial and thereby not limited by the statute. In one such case, the court noted the risk that, under this doctrine, the government would evade the statute of limitations simply by strategically pleading the remedy sought.⁴⁸

3. Disgorgement Categorically Subject to the Statute of Limitations

In response to the government’s argument that the statute of limitations does not bar a claim if the remedy sought is pleaded as disgorgement rather than forfeiture, parties have begun to argue that disgorgement is in fact one type of “forfeiture,” and thus barred by the plain language of § 2462.

In SEC v. Graham, the SEC filed a civil enforcement action alleging that a real estate development company sold investments that were in fact unregistered securities using marketing that contained false and misleading statements.⁴⁹ The SEC sought, among other things, disgorgement of the profits from the allegedly noncompliant transactions that occurred beyond the statute of limitations. The district court held that the text of § 2462 applies to disgorgement because “requiring defendants to relinquish money and property . . . can truly be regarded as nothing other than a forfeiture (both pecuniary and otherwise), which remedy is expressly covered by § 2462.”⁵⁰ The Court explained that “[t]o hold otherwise would be to open the door to [g]overnment plaintiffs’ ingenuity in creating new terms for the precise forms of relief expressly covered by the statute in order to avoid its application,” and this “would make the [g]overnment’s reach to enforce such claims akin to its unlimited ability to prosecute murderers and rapists.”⁵¹

The SEC appealed the district court’s order, “arguing that § 2462 is nonjurisdictional and that the injunctive and declaratory relief and disgorgement it sought were not subject to § 2462’s time bar.”⁵² In a published opinion, the Eleventh Circuit rejected the SEC’s argument and agreed with the district court that “for the purposes of § 2462[,] forfeiture and disgorgement are effectively synonyms; § 2462’s statute of limitations applies to disgorgement.”⁵³ Comparing the dictionary definitions, the court found “no meaningful difference in the definitions of disgorgement and forfeiture.”⁵⁴ The court also quoted a Supreme Court decision to support this interpretation: “Forfeitures serve a variety of purposes, but are designed primarily to confiscate property used in violation of the law, and to require disgorgement of the fruits of illegal conduct.”⁵⁵ The Eleventh Circuit in Graham thus held “that for the purposes of § 2462 the remedy of disgorgement is a ‘forfeiture,’ and § 2462’s statute of limitations applies.”⁵⁶ The SEC argued that the words held different meanings because the scope of the definition of forfeiture encompassed more than just disgorgement, but the court rejected this contention:

[E]ven under the definitions the SEC puts forth, disgorgement is imposed as redress for wrongdoing and can be considered a subset of forfeiture. . . . We find no indication that in enacting § 2462’s widely applicable statute of limitations, Congress meant to adopt the technical definitions of forfeiture and disgorgement the SEC urges over the words’ ordinary meanings. ‘Had Congress wished unique or specialized meanings to attach to any of these terms, it readily could have taken the obvious and usual step either of including a specialized meaning in the definitions section of the statute or by using clear modifying language in the text of the statute.’ . . . Particularly because § 2462 applies to a wide variety of agency actions and contexts, we are loath to adopt the technical definition that the SEC promotes.⁵⁷

Consequently, the court held that claims for disgorgement are subject to, and may be barred by, the statute of limitations in § 2462.⁵⁸

III. Critical Analysis of the Three Paradigms

A. Defects in a Doctrine Categorically Exempting Disgorgement from the Statute of Limitations

A bright-line categorical exemption has the virtue of simplicity and predictability, which would minimize the time and effort required by government counsel, defense counsel, and the courts to find and apply the law. There are several deficiencies in this theory, however.

An interpretation that actions for disgorgement are not bound by the statute of limitations is premised on an assumption that, when the government uses the civil judicial system to enforce alleged violations of federal regulations, it should be treated like any private plaintiff in a common civil suit and thus enjoy the full range of the courts’ equitable powers—including the court’s potential discretion to circumvent the statute of limitations.

The Supreme Court in Gabelli v. SEC rejected this equivalence argument.⁵⁹ The Court distinguished government agencies from private parties, noting that regulatory agencies have powers to proactively monitor and investigate matters within their jurisdiction, unlike private citizens.⁶⁰ Accordingly, the Court held that the government, unlike private parties, may not rely on a passive discovery rule to evade the five-year statute of limitations.⁶¹

Because Congress may use statutes to both supersede the common law and delineate the jurisdiction of the courts, courts adopting a categorical exemption from the statute of limitations for actions pleaded as disgorgement may conflict with the prerogative of the legislative branch. And this categorical interpretation would allow federal agencies acting in the government’s executive branch law enforcement capacity to invoke equity—created to provide a refuge for the people from strict applications of the king’s law—to evade a limitation on the executive branch’s power duly imposed by the people’s elected representatives in the legislative branch. Accordingly, there may be constitutional infirmities in this interpretation. This danger has not escaped the Supreme Court’s notice. In Gabelli, the Court was concerned about exceeding its constitutional mandate even though it was merely interpreting the statute of limitations to determine when a claim accrues to start the five-year clock: “As we held long ago, the cases in which ‘a statute of limitation may be suspended by causes not mentioned in the statute itself . . . are very limited in character, and are to be admitted with great caution; otherwise the court would [be] mak[ing] the law instead of administering it.’”⁶²

Furthermore, the theory that actions seeking disgorgement are categorically excluded from the statute of limitations is either tautological (disgorgement is not forfeiture because it is disgorgement), formalistic (a government confiscation pleaded as a forfeiture claim is time-barred but one pleaded as a disgorgement claim is not), or it depends on an academic supposition about the government’s intent (that it pursues disgorgement to restore the status quo or to protect the public rather than to punish the defendant) that is potentially inaccurate and unascertainable. This claimed per se distinction from a punitive action without regard to the allegations or the defendant’s circumstances is difficult to rationalize. It presumes that a government confiscation as a consequence of a law enforcement action is always equitable rather than punitive regardless of the nature of the violation, the government’s actual purpose, and the impact on the defendant.

This categorical interpretation also suggests that, notwithstanding the five-year statute of limitations applicable to federal agency actions seeking to confiscate a person’s funds for an alleged regulatory violation through a forfeiture action, a court can permit an executive agency to confiscate those same funds at any time for the same violation if the remedy is characterized as disgorgement. This remedy does not compensate the government for an injury and is otherwise indistinguishable in both genesis and effect from a punitive law enforcement remedy. It is thus difficult to reconcile such an interpretation with the recent holdings of the Supreme Court and the D.C. Circuit, both of which emphasized the admonishment of Chief Justice Marshall that the absence of a statute of limitations would be “utterly repugnant to the genius of our laws.”⁶³

The government may also not be acting consistently when it asserts that disgorgement is an equitable remedy. The Internal Revenue Service (IRS) has taken an approach to disgorgement that largely aligns with the views of the Graham court and contradicts the SEC’s characterization of disgorgement actions as purely equitable: Generally speaking, taxpayers may not deduct forfeitures or penalties imposed as a result of a legal determination of liability.⁶⁴ Under certain circumstances, however, a taxpayer may deduct payments if their purpose is compensatory or remedial.⁶⁵ In a chief counsel advice document released in May 2016, the IRS stated that disgorgement payments to the SEC in a corporate Foreign Corrupt Practices Act enforcement action were not tax-deductible, as the taxpayer could not prove that the disgorgement was intended to compensate the SEC for actual losses suffered.⁶⁶ This notion—that the government deems disgorgement to be penal to allow it to tax disgorgement payments but deems disgorgement equitable to allow it to circumvent the statute of limitations—creates additional doctrinal tension.

In Kokesh v. SEC, the Tenth Circuit disagreed with the Eleventh Circuit’s holding in Graham, summarized above, that § 2462 limits actions for disgorgement. The Tenth Circuit reasoned that “[w]hen the term forfeiture is linked in [§] 2462 to the undoubtedly punitive actions for a civil fine or penalty, it seems apparent that Congress was contemplating the meaning of forfeiture in [a] historical sense.”⁶⁷ The Tenth Circuit concluded that by “forfeiture,” Congress meant a procedure to seize a person’s property due to the property’s involvement in an offense, even if “[t]he owner of the seized property” was “completely innocent of any wrongdoing” and regardless of the property’s value in “relation to any . . . gain to the owner.”⁶⁸ As the court held, “[t]he nonpunitive remedy of disgorgement does not fit in that company”—particularly given that “[the court is] to construe [§] 2462 in the government’s favor to avoid a limitations bar.”⁶⁹

Three aspects of the Tenth Circuit’s response to Graham bear scrutiny. First, the Tenth Circuit’s view of “forfeiture” as something imposed regardless of guilt or innocence conflicts with the paradigmatic understanding of § 2462 as applying solely to punitive remedies for a person’s violations and, therefore, the lengths to which the government and courts—including the Tenth Circuit—have gone (as summarized in this Article) to analyze whether disgorgement is or is not punitive. If § 2462 applies to non-punitive actions such as in rem proceedings, as the Tenth Circuit concluded,⁷⁰ then the case for also applying it to assertedly non-punitive disgorgement remedies is arguably stronger. Second, the Tenth Circuit’s acknowledgement that it was consciously favoring the government in the manner it construed § 2462 undercuts the objectivity and reasonableness of its analysis as a whole.⁷¹

Finally, the interpretation categorically exempting disgorgement from the statute of limitations provides no answers to those interests that the statute of limitations was created by Congress to protect. The Court in Gabelli focused on the interest in “justice” for potential “wrongdoers,” the evidentiary concerns complicating the judicial fact-finding function in stale claims, and the importance of the statute to societal welfare.⁷² Accordingly, it is not clear how courts may, consistent with Gabelli, permit the government to circumvent the statute of limitations for regulatory violations in an otherwise stale claim by strategically pleading the particular remedy sought to vindicate that claim. This is even more true where, as here, the disgorgement remedy is materially indistinguishable from a remedy—forfeiture—plainly listed in the statute of limitations.⁷³

B. Defects in Fact-Intensive Examinations of Government Intent and a Remedy’s Impact on Particular Defendants to Determine the Application of the Statute of Limitations

An approach that requires courts to engage in a case-by-case examination of the government’s intent in pursuing an action for disgorgement, as well as the particular impact on an individual defendant, offers little comfort to either the government or prospective defendants because each must suffer the burdens of contested litigation after the five-year statute of limitations has run before learning whether or not disgorgement is possible. Individuals who cannot afford to litigate against an expert federal agency with a virtually unlimited litigation budget necessarily are tempted to capitulate—hardly an outcome consistent with equity. And because the test turns on defendant-specific circumstances (and may produce a different settlement calculus in each case), there is the real possibility that the application or non-application of the statute of limitations, and thus the regulatory consequences for the same violation, will differ from defendant to defendant. Accordingly, this is a costly and time-consuming approach, and a potentially inequitable one, which may not produce predictable outcomes. Like the per se approach analyzed above, it also thwarts the benefits—to courts, defendants, and society—that compelled Congress to enact the statute of limitations.⁷⁴

In addition to the burdens this imposes on the government, defendants, courts, and society, this interpretation—like the categorical exception discussed above—reserves for the courts the power to exempt executive agency actions from the protections created by the democratically enacted statute of limitations.

C. Disgorgement Actions Categorically Subject to the Statute of Limitations

This interpretation has the benefit of clarity and simplicity, like the categorical exemption from the statute of limitations described above. Accordingly, it allows potential litigants to be certain of the statute’s application and the outcome of the analysis. Unlike the first two approaches, the third approach does not reserve for judges the right to disregard the elected legislature’s judgment—one that balances many interests on a subject squarely within the legislature’s province. And it avoids the spectacle of courts—under the guise of equity—allowing the executive to pursue members of the public despite a statute specifically designed to protect people from the injustice of extended liability for stale allegations. Finally, it protects courts from having to resolve stale claims based on faded memories and incomplete evidence.

The substantive argument for this interpretation is also compelling. As stated above, “forfeiture”—expressly barred by § 2462 for claims beyond the statute of limitations—is defined as “the loss of a right, privilege, or property because of a crime, breach of obligation, or neglect of duty.”⁷⁵ In the regulatory enforcement actions at issue here, the government is undeniably seeking to deprive the defendant of property “because of a crime, breach of obligations, or neglect of duty.” The logic of the Graham courts⁷⁶ is forceful: calling a functionally identical remedy “disgorgement” does not change the fact that the defendant is being deprived of property because of a breach of the law—that is, suffering a “forfeiture” subject to the statute of limitations. In other words, how one defines “disgorgement” does not alter the applicable definition of “forfeiture,” which would encompass any such action and therefore subject it to § 2462.

The main cost of the Eleventh Circuit’s interpretation that disgorgement is categorically subject to § 2462 is the possibility that a lawbreaker whom an agency has failed to pursue within five years of an alleged violation will not face one possible claim. But the Supreme Court in Gabelli explained that this is an acknowledged cost of a statute of limitations. Government agencies acting in their law enforcement capacities have investigatory powers that private litigants do not.⁷⁷ This provides a diligent agency with the enhanced ability to avoid the loss of claims to the statute.⁷⁸

IV. Application of Relevant Maxims of Equity

Courts considering government agency requests to invoke the court’s equitable powers to compel a defendant’s disgorgement for violations otherwise barred by the statute of limitations may evaluate such requests using equitable maxims. To a limited extent, courts in jurisdictions that consider the totality of the circumstances to determine whether the disgorgement is punitive already do so sub silentio. Courts not employing either of the categorical approaches could certainly use the maxims summarized below to evaluate the government’s request.

As terms of art, the words “equity” and “equitable” elude precise definition. In the lay sense, “equitable” is commonly understood to mean “fair” or “proportionate.”⁷⁹ In the legal sense, however, “equitable” generally means a court’s ability to use its own discretion to further justice on a case-by-case basis, rather than adhering to strict legal rules.⁸⁰

Historically, “equity” refers to the system of doctrines, rules, and remedies initially developed by the English Court of Chancery and currently applied by American courts sitting in equity (as opposed to in law, where a court cannot furnish legal relief if the law does not allow it to do so).⁸¹ In essence, equity’s guiding conviction is that where there is a right, there is a remedy,⁸² and hence the principles of equity can be used to ensure justice for a wronged party where the law fails to specify the form of relief.

The more discretionary nature of equitable remedies lies in contrast to that of legal remedies, which are set by statute. Legal remedies take effect ex post, and seek to provide the plaintiff with compensatory relief that puts her in the “rightful position” that she would have been in absent the wrong suffered.⁸³ Legal remedies generally provide for substitutionary relief, with the valuation of the judgment based on the fact finder’s assessment of the plaintiff’s loss. In contrast, equitable remedies can act ex ante (as with injunctions and declaratory judgments), and may provide the plaintiff with restitutionary relief, which is measured by the wrongdoing defendant’s gain rather than the plaintiff’s loss.⁸⁴ Equitable remedies may also provide for specific performance, which is extraordinary rather than ordinary. Equitable judgment is a matter of reasonable judicial discretion, rather than a matter of right or of law.⁸⁵

Equity jurisprudence, although tailored to individual cases, is not completely open ended. Courts sitting in equity are assumed to be acting in good conscience, but they may not grant equitable relief in the absence of a statute or clear precedent that establishes the right to the remedy requested.⁸⁶ Thus, when judges seek to determine the appropriate form of equitable relief, they must first consult precedent, determine the principles applicable to the case at bar, and then tailor these principles to the facts at hand in order to provide the ideal form of relief. Professor Karl Llewellyn summarized this process in his observation that the decisions of equity judges should have “reasonable regularity.”⁸⁷ In exercising judicial discretion, courts should apply general maxims of equity to the facts presented by the particular case.

The maxims of equity, developed over centuries of jurisprudence, offer a great deal of insight into the equitable discretion of modern courts and provide general parameters for judges sitting in equity. Although this Article does not endeavor to provide a comprehensive overview of the maxims of equity, it will address the applicability of three key equitable principles to the current tension inherent in the federal courts’ treatment of the remedy of disgorgement: first, equitable remedies are not punitive; second, equity is a form of “extraordinary” relief; and third, equity aids the vigilant, not those that slumber on their rights. These maxims should inform a court’s consideration of government requests for courts to exercise their equitable powers for claims otherwise barred by the statute of limitations.

A. Equitable Remedies are not Punitive

Although the disgorgement of ill-gotten gains was traditionally considered an equitable remedy (rooted in restitution and measured by the defendant’s profit, rather than the plaintiff’s losses), disgorgement only maintains its equitable status to the extent that it attends an unjust enrichment claim.⁸⁸ Otherwise, disgorgement can effectively operate as a penalty and is a legal, punitive remedy rather than an equitable one.⁸⁹ Additionally, in the context of securities law enforcement actions (wherein many claims for disgorgement arise), courts are compelled to evaluate the economic circumstances of the defendant to determine if there are any losses that should be applied to offset the gains or profits the defendant incurred as a result of the wrongful act.⁹⁰ If such losses exist, the amount disgorged may be reduced or eliminated because the defendant’s wrongdoing did not improve her economic position.⁹¹ In such cases, unjust enrichment is absent, and equity requires the elimination or reduction of disgorgement.⁹²

1. Equity is Extraordinary Relief Available Only Where Legal Remedies are Inadequate

It is axiomatic that a court’s equitable powers apply only when a plaintiff needs “extraordinary” relief; in other words, a court sitting in equity will not provide a remedy when the plaintiff already has an adequate remedy at law. Adequate legal remedies are available to regulatory agencies because they have the power to impose extensive penalties.⁹³ Accordingly, disgorgement to the U.S. Treasury may be a mere substitute for the plaintiff agency’s legal remedies and, therefore, denied.

Historically, equity foreclosed plaintiffs from bringing claims after the legal statute of limitations had run. Various state legislatures have codified this traditional rule by providing that the same limitations period applies to both legal and equitable actions, thus eliminating a court’s equitable discretion to entertain a claim after the applicable statute of limitations has expired.⁹⁴ In states where the legislature has taken this view, prejudice to the defendant is thus presumed if the plaintiff brings an action for equitable relief beyond the limitations period.

2. Equity Aids the Vigilant

The maxims of equity also provide that “equity aids the vigilant, not those who slumber on their rights.”⁹⁵ This maxim embodies the equitable doctrine of laches, which provides that an individual seeking equitable relief must not delay in asserting her rights.⁹⁶ Laches is analogous to the legal rule embodied in various statutes of limitations, but differs in that statutes of limitations are concerned with the fact of delay, while “laches are concerned with the effects of delay.”⁹⁷

As a defense to an action in equity, laches seeks to avoid undue prejudice to the defendant due to the plaintiff’s failure to bring a claim in a timely manner.⁹⁸ The consequences to the defendant when a plaintiff sleeps on its rights are myriad: relevant evidence can disappear or be destroyed, witnesses can pass away, and memories can fade. McClintock aptly summarizes the equitable defense of laches as valid “[w]here a party has unreasonably delayed the assertion of an equitable claim until the other party has acted, or the circumstances have changed, so as to result in prejudice because of the delay, equity will hold the party claiming the right to be guilty of laches, and will deny relief to him.”⁹⁹

3. The Use of Equity to Strengthen the Government’s Prosecutorial Powers

It exacerbates the potential doctrinal incoherency for the judiciary to use its equity power, which was intended to protect the public from the unjust application of the law, to enable the executive to circumvent Congress’s statutory limitation on the executive’s power. As discussed previously in Part II, the Supreme Court in Gabelli reasoned that courts should refrain from rescuing the government from its failure to initiate suit within the statute of limitations through exceptions not found in the statute itself. The Court in Gabelli thus recognized that the government was not entitled to the benefit of the judicially created “discovery rule,” which operated “to preserve the claims of victims who do not know they are injured and who reasonably do not inquire as to any injury.”¹⁰⁰ Such a rule is intended to protect private litigants, who should not be expected to be on constant alert regarding whether they have been defrauded by another party. In contrast, the mission of the SEC and other federal agencies is the enforcement of laws under their purview, which they fulfill using the government’s deep coffers and vast prosecutorial powers to investigate violations of these laws.

V. Conclusion

Consistent with the holding of the Eleventh Circuit in Graham, the rationale of the Supreme Court’s decision in Gabelli, and the decision of the D.C. Circuit in PHH, there are several significant problems with courts’ and agencies’ interpretation that the statute of limitations does not apply to federal agency law enforcement actions seeking disgorgement of funds from a defendant to the U.S. Treasury, or that its application can only be resolved after a fact-intensive judicial inquiry. The plain text of the statute applies to forfeitures, which are indistinguishable from disgorgement in all material aspects. Furthermore, every purpose of the statute of limitations applies with equal force to actions for disgorgement. Regardless, insofar as circumvention of the statute depends on deeming disgorgement to be an equitable remedy, established maxims of equity also should operate to support the application of the statute of limitations to actions for disgorgement.

Moreover, the constitutional prerogatives of Congress include the creation of laws for the executive branch to enforce and for the judicial branch to interpret. As the Supreme Court recognized in Gabelli, it is problematic for courts to risk making their own law by allowing executive agencies to evade the statute of limitations. This potential error is compounded by the potential use of a court’s equitable powers—originally designed to protect people from the consequences of a strict application of the law—to enable the government to circumvent a statutory limit on its prosecutorial powers. With respect to the statute of limitations contained in § 2462, Congress explicitly recognized the importance of promoting justice by preventing stale claims and providing repose.

When the Supreme Court addresses the circuit split discussed in this Article in the course of deciding Kokesh v. SEC, there are several potential modes of analysis to resolve the issue. The Court should use the authorities described here to fulfill the line of reasoning that extends from its holding over two hundred years ago in Adams v. Woods through its most recent expression in Gabelli. Ultimately, whether the Court relies on the plain text of § 2642, congressional intent, or the maxims of equity, it should fulfill this line of reasoning by applying the statute of limitations to all agency civil law enforcement actions seeking to confiscate funds for disgorgement to the U.S. Treasury.

December 6, 2016 By ehansen

A Federal Fiduciary Standard Under the Investment Advisers Act of 1940: A Refinement for the Protection of Private Funds

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Tyler Kirk^†

Introductory Note

The appropriate role of the fiduciary standard in the financial industry has garnered a lot of attention of late. Lawmakers, investors, and industry are all adding their voices to the chorus that will eventually become the regulatory response to the call to harmonize standards of professional conduct within the U.S. financial sector. The debate has pitted investors against industry, brokers against investment advisers, Congress against the President, and the Department of Labor against the Securities and Exchange Commission. However, what has gotten lost in the debate is the astonishing fact that Article III courts have barely begun to interpret one of the oldest federally established fiduciary relationships, that of the investment adviser and its client. More specifically, the judiciary has had scant opportunity to interpret section 206 of the Investment Advisers Act of 1940 beyond the seminal conclusion in SEC v. Capital Gains Research Bureau, which has been interpreted as holding that Congress intended to establish a federal fiduciary duty for investment advisers. However, a quick thumb-through of any treatise on agency law would illuminate the highly nuanced reality of the fiduciary relationship. Nowhere is this nuanced reality brought into sharper relief than when an investment adviser’s client is a private fund, such as a hedge fund. There, the client has no eyes with which to see, ears with which to hear, or a mind with which to comprehend. When faced with such an impaired principal, the law has taken care to develop doctrines to appropriately allocate benefits and burdens of conduct. This Article identifies such doctrines that have boiled up out of the cauldrons of state common law, and, through their application, addresses how the antifraud provisions of the federal securities laws should be applied to investment advisers advising private funds.

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I. Introduction

From time to time, the U.S. Securities and Exchange Commission (Commission) conducts investigations of, or brings enforcement actions against, investment advisers to private funds. Where these matters involve conflicts of interest between the adviser and its client, the private fund, the Commission^[1] must craft its legal theory under sections 206(1)–(3) of the Investment Advisers Act of 1940 (Advisers Act),^[2] taking into consideration the unique agency law doctrines that apply when an adviser acts as an agent for a client that is not a natural person.^[3] In such a circumstance, the adviser’s client has no eyes with which to see, ears with which to hear, or a mind with which to comprehend. In the usual course where the client is a natural person, the adviser can call up its client, disclose its conflict of interest, and obtain the client’s consent. However, when the client is a private fund, the adviser finds itself in the perverse position of providing disclosure of its conflict of interest to itself as the client’s agent. The Commission has historically taken the position that such disclosure is insufficient under the Advisers Act.^[4] Accordingly, the Advisers Act embodies the notion that imposing legally enforceable fiduciary duties on investment advisers serves as a crucial counterpoint to the informational asymmetries that exist between advisers and their clients.

As this Article progresses, it may be helpful to keep in mind the different standards to which various investment professionals are held. For example, security brokers must recommend “suitable” securities,^[5] whereas investment advisers must act in their clients’ best interest.^[6] The existence of a financial benefit flowing to an investment adviser as a result of acting on behalf of a client or making a recommendation to a client raises the rebuttable presumption that the investment adviser is not acting in its client’s best interest.^[7] If an agent has a conflict of interest in connection with a decision it must make on behalf of its principal, fiduciary law requires the agent to disclose the conflict to its principal and obtain the principal’s consent before proceeding.^[8] However, if the principal is a mere legal personality, such as a trust or a limited liability company with no board of trustees or board of directors, the agent is generally the principal’s first-line decision maker. To handle the various liability issues arising in this circumstance, state law has developed three important doctrines: (1) the doctrine of imputation;^[9] (2) the adverse interest doctrine;^[10] and (3) the sole actor doctrine.^[11]

However, looking to state law on a case-by-case basis to determine liability under the Advisers Act creates an unworkable legal framework, in part because inconsistent application of these doctrines leads to inconsistent liability for similar actions.^[12] This Article argues that an investment adviser’s liability under section 206—when acting as the agent for a private fund— should be determined under a federally established uniform framework, and should not be contingent upon the application of state fiduciary law.^[13] Accordingly, this Article will briefly address: (1) the structure of the private fund industry; (2) the historical source of fiduciary duty; (3) the source of fiduciary duty for “investment advisers” as that term is defined by the Advisers Act; (4) whether there is a federal fiduciary duty or, instead, a state-by-state application of agency law; and (5) whether and to what extent the state common law adverse interest and sole actor doctrines should be incorporated into the federal fiduciary standard under the Advisers Act.

II. Background: A Primer on the Private Fund Industry and Brief History of Fiduciary Duty

A. Structure of the Private Fund Industry

A unique problem in fiduciary law arises when the principal exists only as a legal entity and with no one other than its agent on which to rely for decision making. The problem under these circumstances is how the principal and agent resolve conflicts of interest, especially in the context of business and investment transactions. Under the Advisers Act, this problem arises out of the relationship between an investment adviser and a private pooled investment vehicle, such as a hedge fund or private equity fund (fund or private fund).^[14]

Such funds are typically organized as a limited partnership (LP) or as a limited liability company (LLC).^[15] LPs are managed by a general partner (GP), and the investors in the fund receive securities in the form of limited partnership interests.^[16] Similarly, LLCs are managed by a managing member (manager), and the investors in the fund receive securities in the form of membership interests.^[17] Typically, the investment adviser to the fund acts as the fund’s GP or manager.^[18] The investors, as limited partners or members, are mere passive investors in the fund, with little to no operational control.^[19]

Managing a private fund places investment advisers in a fiduciary relationship—owing duties of loyalty and care to the fund—under both state and federal law. State law imposes these duties based on the adviser’s role as the fund’s GP or manager,^[20] while the Advisers Act imposes this fiduciary relationship between all investment advisers^[21] and their clients,^[22] funds included.^[23] Since the investors in a fund are passive, the investment adviser, as GP or manager, is the only person operationally in control of the fund. Thus, if the investment adviser wants to enter the fund into a transaction that would confer a substantial benefit on the adviser, then the adviser is faced with a conflict of interest that must be resolved lest the investment adviser, the agent, breach its fiduciary duty to the fund, its principal.

As a final piece of background material, it is useful to point out the major distinctions between private funds and publicly traded investment companies, such as mutual funds. Registered funds and private funds are similar in that both issue and hold pools of securities. Investors are able to obtain both professional investment management and diversification through investing in these funds. The two types of funds may even engage in the same type of investment strategies and therefore hold similar types of investments.^[24] However, the similarities in these vehicles rapidly taper off at this point.

Registered funds, more precisely categorized as registered investment companies, are heavily regulated by the Investment Company Act of 1940 (’40 Act).^[25] In large part, the ’40 Act is a federal corporate governance statute, regulating such things as the independence of a registered investment company’s board of directors, shareholder votes, and affiliated transactions.^[26] Furthermore, investment companies must register with the Commission as such under the ’40 Act, register their publicly offered securities, and comply with the disclosure and reporting requirements of the federal securities laws.^[27] Private funds, because they are excluded from the definition of “investment company” by virtue of sections 3(c)(1) and (7), essentially avoid all regulation under the ’40 Act.^[28]

B. The Historical Sources of Fiduciary Duty

Before exploring the contours of fiduciary law, it is worth noting what several legal luminaries have said on the topic. The venerable Professor Stanley A. Kaplan, formerly of the University of Chicago Law School, once expressed that “fiduciary duty” was “a concept in search of content.”^[29] Earlier, and only three years after the passage of the Advisers Act, Justice Frankfurter stated that, “[t]o say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge those obligations? And what are the consequences of his deviation from duty?”^[30] This section will explore these questions.

State common law is the historical source of the fiduciary duty in the United States.^[31] In general, the common law of the states has and continues to recognize three relationships as giving rise to fiduciary duties: (1) expert relationships; (2) agency relationships; and (3) trustee relationships.^[32] Each has considerable utility and serves a vital role in society. Primarily, these relationships are an efficient solution for information asymmetries that arise in different ways depending on the relationship in question. However, relying on experts, agents, or trustees places laypersons, third parties,^[33] and beneficiaries, respectively, at risk of being abused by those serving in such positions of trust and influence. Legally enforceable fiduciary duties serve as a crucial check on this power. Thus, society benefits from an efficient solution to information asymmetries without the cost of abuse being intolerably high.

Significantly, fiduciaries are distinguished from most other business practitioners in two ways. The typical business practitioner is only subject to a commercial standard of conduct.^[34] Fiduciaries, however, possess the technical expertise, experience, and specialized knowledge that equip them to render advice with the care of a prudent person vested with such skills. In addition, they are bound by an undivided loyalty to their client. In short, fiduciaries owe their clients a duty of care^[35] and a duty of loyalty,^[36] which exceed the typical business practitioner’s commercial standard of conduct.

C. The Historical Source of an Investment Adviser’s Fiduciary Duty

Prior to the passage of the Advisers Act, investment advisers^[37] were fiduciaries under state common law. As investment experts, investment advisers conferred a benefit on society by bridging the knowledge gap between themselves and the average American over wealth generation and capital formation. Because society viewed generating wealth and forming capital to be vital to the economy, while recognizing the potential for abuse by unscrupulous investment advisers, state law determined that it was in the public interest to impose fiduciary duties on investment advisers as experts.^[38]

Additionally, it was common for investment advisers to find themselves acting as agents or trustees. When investment advisers were given discretionary authority over an investor’s assets, investment advisers entered into a principal-agent relationship with their clients. As agents, investment advisers were then bound by the fiduciary duties developed under state agency law. Furthermore, investment advisers were sought out for their investment expertise to manage trust assets as trustees. There again, investment advisers were bound by the fiduciary duties developed under state trust law. Thus, prior to the passage of the Advisers Act, investment advisers were commonly recognized by the states to be fiduciaries.^[39]

III. The Federal Fiduciary Standard

The Supreme Court has said that when interpreting an act of Congress, it must assume Congress drafts legislation aware of developments in the common law.^[40] Therefore, without reference to legislative history, it can be assumed that Congress was aware of the common law developments that declared investment advisers fiduciaries when it passed the Advisers Act. Since the enactment of the Advisers Act, the Supreme Court has repeatedly held that investment advisers, as defined by section 202(a)(11) of the Advisers Act, are fiduciaries, and that Congress intended to codify this fiduciary duty through section 206 of the Act.^[41]

While there is no substantive federal common law outlining the scope of this fiduciary duty,^[42] its contours may be informed by state common law. Moreover, a desire to promulgate a broadly applicable fiduciary standard likely precluded Congress from providing specifically for the numerous situations that might arise between an investment adviser and its client. Therefore, the Advisers Act should be interpreted to synchronize section 206 with state and common law rules and maxims^[43] that are consistent with the purposes of the Act.^[44]

There is scant case law on whether the federal fiduciary duty codified in section 206 can be interpreted to synchronize the well-developed state law doctrines regulating fiduciaries, such as those found in the law of agency.^[45] To fill the void, one approach may be to argue that whether an investment adviser is liable under section 206 turns upon the applicable state law for fiduciaries. Accordingly, there are several ways in which federal courts may apply state law. First, a federal court may invoke the internal affairs doctrine,^[46] reasoning that whether or not a particular doctrine applies depends on the state law under which an investment adviser is organized.^[47] Alternatively, when state law claims are heard in federal court under the court’s diversity or supplemental jurisdiction, a federal court may apply the appropriate state law according to the choice-of-law rules of the forum state.^[48] However, as explained below, it is untenable to apply state law to a purely federal claim unavailable to private litigants, but instead, available only to a federal agency serving in its law enforcement capacity.

None of the foregoing reasons for applying state law is appropriate when determining liability under section 206. As an initial matter, a violation of section 206 is a federal claim, which can be brought only by the Commission.^[49] Furthermore, it would be manifestly against the express purposes of the Advisers Act for liability under section 206 to be dependent upon state law, as this would yield inconsistent outcomes.^[50] Rather, Congress recognized the important role investment advisers played in the economy, and intended the Advisers Act to apply uniformly to all investment advisers engaged in their profession through interstate commerce, wherever they may be organized.^[51] Concluding otherwise would lead to the perverse result that an investment adviser may avoid liability under section 206 by organizing in a state that does not recognize a particular doctrine of fiduciary law, while other investment advisers who engage in the identical conduct would be liable because their state of organization does recognize the doctrine at issue. In other words, Congress could not have intended to allow for investment advisers to engage in regulatory arbitrage. Therefore, a federal court should interpret the federal fiduciary duty under section 206 consistent with the purposes of the Advisers Act, and in so doing, synchronize this fiduciary standard with the appropriate common law rules and maxims developed in the states.^[52]

A. Synchronizing the Federal Fiduciary Standard with the Law of Agency

An issue ripe for interpretation under the fiduciary standard codified in section 206 is whether and to what extent the fiduciary standard under the Advisers Act should be synchronized with state law doctrines of agency law. Resolving conflicts of interest between investment advisers and their clients is especially challenging when their clients are private funds.^[53] The challenge exists for two key reasons: (1) the investment adviser serves as the agent for the private fund; and (2) there are crucial differences in the management structure of private funds and investment companies.^[54] Unlike investment companies, private funds almost never have boards comprised of independent directors,^[55] nor are they required to obtain shareholder approval of for certain actions.^[56] Instead, as the agent for a private fund, an investment adviser serves as the fund’s eyes, ears, and mind. Thus, when an investment adviser has a conflict of interest with a private fund it manages, it is in the perverse position of disclosing its own conflict of interest to itself as the fund’s agent. Accordingly, there should be a uniform framework of federal fiduciary law under the Advisers Act to address conflicts of interest between investment advisers and private funds.

Synchronizing the fiduciary standard with the appropriate common law rules and maxims developed in the states is the best way to achieve this goal. When an investment adviser to a private fund has a conflict of interest, the investment adviser is a conflicted fiduciary.^[57] In the states, decades of doctrinal development in agency law have addressed the liability of agents and their principals when the agents act adversely to the interests of their principals.

Agency law addresses a tripartite dynamic.^[58] It is developed around the need to fairly assign liability between principals, agents, and third parties.^[59] As the agent for a private fund, an investment adviser’s conduct is either aimed at its principal or third parties. For purposes of the Advisers Act, the agency doctrines that apply when determining liability for an investment adviser’s conduct depend on which remaining member of the tripartite the agent is defrauding—the third party or the investment adviser’s principal, the private fund.

When an investment adviser is a conflicted fiduciary, there are three relevant doctrines of agency law: (1) the doctrine of imputation; (2) the adverse interest doctrine; and (3) the sole actor doctrine. Under agency law, the default rule is the doctrine of imputation, which states that the knowledge of an agent is imputed to its principal.^[60] Typically, the principal possesses deeper pockets than its agent, thus the doctrine of imputation is asserted against a principal by a third party seeking to be made whole where it has been defrauded or otherwise harmed by the principal’s agent. The adverse interest doctrine is an exception to the default rule of imputation and blocks the imputation of an agent’s knowledge to its principal where the agent in the particular transaction acts adversely or antagonistically to its principal.^[61] The adverse interest doctrine is typically asserted by a principal seeking to avoid liability for its agent’s conduct towards third parties by disclaiming its agent’s knowledge.^[62] Lastly, the sole actor doctrine treats principal and agent as one if the agent controls the principal’s decision-making or is its sole representative, thus reinstating the default rule of imputation where the principal is charged with notice of the agent’s conduct.^[63] Here, the sole actor doctrine would be asserted to collapse the silos of knowledge between a principal and its agent in order to establish notice on the part of the principal.^[64]

B. The Law of Agency in Securities Enforcement

An investment adviser becomes a conflicted fiduciary in several ways. For example, an investment adviser faces a conflict of interest when it engages in principal securities transactions with a client.^[65] A principal transaction of this type occurs when the investment adviser directly or indirectly^[66] enters into a securities transaction with a client for its own proprietary account.^[67] To avoid violating section 206 of the Advisers Act, an investment adviser must: (1) disclose to its client that it is entering into the transaction on a principal basis and (2) obtain consent from the client to execute the transaction despite the investment adviser’s conflict.^[68] Furthermore, the investment adviser must provide such disclosure and obtain such consent on a transaction-by-transaction basis.^[69]

Significantly, resolving conflicts of interest, such as principal transactions, presents the Commission with a unique enforcement challenge under section 206. Few federal courts have had the opportunity to synchronize the federal fiduciary standard with the appropriate agency law doctrines.^[70] Since not every jurisdiction’s agency law doctrines are the same,^[71] it is still unsettled which doctrines the federal court would interpret section 206 to include.^[72]

As a consequence, a principal transaction between an investment adviser and a private fund exposes a critical doctrinal gap under the federal fiduciary standard.^[73] In the securities enforcement context, the Commission brings unlawful principal transaction charges based on the investment adviser’s failure to: (1) provide meaningful disclosure to, and (2) obtain effective consent from, the private fund. In response to the Commission’s charges, the investment adviser would likely argue that, as an agent, its knowledge is imputed to its principal, the private fund. Therefore, the doctrine of imputation would hold that the private fund is presumed to be aware of the investment adviser’s conflict of interest.^[74] Nevertheless, and at least one court agrees,^[75] the Commission would argue that the investment adviser’s conflict places its interests adverse to those of the private fund, and therefore the adverse interest doctrine would block the imputation of the investment adviser’s knowledge to the private fund.

In this scenario, the remaining hurdle for the Commission to overcome is the sole actor doctrine. As noted above, when the agent is the principal’s sole decision-maker or representative in a transaction, the sole actor doctrine revives the general rule of imputation. Accordingly, the best argument for the investment adviser to avoid liability under section 206 is to invoke the sole actor doctrine, arguing that as the sole decision-maker and representative of the private fund, knowledge of its conflict is imputed to the private fund. While this argument under section 206 has not been squarely addressed in the federal courts, it is clearly inconsistent with the purposes of the Advisers Act “to eliminate, or at least to expose, all conflicts of interest which might incline [an] investment adviser—consciously or unconsciously—to render advice which was not disinterested.”^[76] Therefore, in order to synchronize the federal fiduciary standard under the Advisers Act with common law rules and maxims in light of this purpose, federal courts should interpret section 206 to bar the application of the sole actor doctrine when the private fund is the investment adviser’s intended victim.^[77]

The maxim that an agent’s knowledge is not imputed to its principal when the principal is its agent’s victim harmonizes the federal fiduciary standard under the Advisers Act with the purposes of agency law and the management structure of private funds. It is important to keep in mind that agency law doctrines were generally developed to protect innocent third parties.^[78] Courts reasoned that, as between a third party and a principal, the principal was in the better position to monitor the conduct of its agent and therefore should bear the burdens flowing therefrom. However, by virtue of a private fund’s structure, the presumption that the principal is in the best position to monitor the conduct of its agent is invalid.^[79] As noted, a private fund does not typically have independent directors to serve as its eyes, ears, and mind. Hence, a private fund does not typically have the means to carry out such a monitoring function or create incentives for the investment adviser to act in its best interest. Thus, imputation to the private fund through the sole actor doctrine should not apply where the private fund is the intended victim.^[80]

IV. Conclusion

Experts like investment advisers serve a critical role in our society. Through great effort and sacrifice, these professionals have acquired skills, which, when deployed appropriately, command respect and remuneration. However, information asymmetries beget opportunities for abuse. A well-developed legal framework of fiduciary law is the panacea for private fund clients. As the Commission continues to pursue investment advisers to private funds for failing to disclose their conflicts of interest and obtain effective consent, the Commission ought to bring such cases before an Article III court. And when faced with such a controversy, the courts should recognize the unique structure of private funds and their relationships with their investment advisers, cutting off the application of the sole actor doctrine regardless of the jurisdiction in which the fund was organized.^[81]

† Associate in the Investment Management, Hedge Funds, and Alternative Investments practice group at K&L Gates, LLP in Washington, DC. Prior to joining K&L Gates, the Author was Senior Counsel at the U.S. Securities and Exchange Commission. The Author earned his J.D. magna cum laude from the University of Miami School of Law, M.A. of Economics from North Carolina State University College of Management, and B.A. in economics cum laude from Georgia State University Andrew Young School of Policy Studies. The views and opinions expressed herein are solely those of the Author and do not reflect those of his employer or past employers. This Article is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. The Author would like to express his deepest appreciation to Fatima Sulaiman, Esq. for her thoughtful review and guidance on this Article.

[1] Generally, there is no private right of action under the Investment Advisers Act of 1940. See Transamerica Mortg. Advisors v. Lewis, 444 U.S. 11 (1979). In large part, this explains the relative dearth of case law deeply exploring the fiduciary duty of investment advisers under the statute. Therefore, it is left to the Commission to decide in which forum to bring their section 206 cases, administratively or before an Article III judge.

[2] Investment Advisers Act of 1940 § 206(1)–(3), 15 U.S.C. § 80b-6 (2012).

[3] See, e.g., In re Paradigm Capital Mgmt., Inc., Investment Advisers Act Release No. 3857, 109 S.E.C. Docket 430 (June 16, 2014) (discussing an adviser’s failure to use sufficiently independent conflicts committees where the adverse interest doctrine prevented the investment adviser, as a conflicted fiduciary, from acting on behalf of its client, a hedge fund).

[4] See, e.g., id; In re Eric David Wanger, Investment Advisers Act Release No. 3427, 104 S.E.C. Docket 3 (July 2, 2012); SEC v. DiBella, 587 F.3d 553 (2d Cir. 2009). But see SEC v. Northshore, No. 05 Civ. 2192(WHP), 2008 WL 1968299 (S.D.N.Y. 2008).

[5] See Duties of Brokers, Dealers, and Investment Advisers, Investment Advisers Act Release No. 3558, 105 S.E.C. Docket 3092 at n.50 (Mar. 1, 2013) (stating the minimum standard of care owed customers by brokers is suitability).

[6] See Transamerica, 444 U.S. at 17 (“[); SEC v. Capital Gains Researching

ETF) to use swing pricing–shirgint atin market factors

e); proposed transaction fits registSection] 206 establishes ‘federal fiduciary standards’ to govern the conduct of investment advisers . . . .”) (citing Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 472 n.11 (1977) (“Congress intended the Investment Advisers Act to establish federal fiduciary standards for investment advisers.”)); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191–92 (1963) (“[The Advisers Act] reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline as investment adviser-consciously or unconsciously-to render advice which was not disinterested.”); see also In re Arlene W. Hughes, 27 S.E.C. 629 (1948), aff’d sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949) (setting out the Commission’s views on essential aspects of fiduciary responsibility, focusing on the burdens of investment advisers when conflicts are present).

[7] See Securities Act Release No. 3043, Exchange Act Release No. 3653, Investment Advisors Act Release No. 40 (Feb. 5, 1945) (Opinion of Director of Trading and Exchange Division).

[8] See Restatement (Third) of Agency § 5.04 cmt. c (Am. Law Inst. 2006).

[9] See, e.g., Martin Marietta Corp. v. Gould, Inc., 70 F.3d 768 (4th Cir. 1995) (applying Maryland law).

[10] See Restatement (Third) of Agency § 5.04 (Am. Law Inst. 2006).

[11] See National Turners Bldg. & Loan Ass’n v. Schreitmueller, 285 N.W. 497, 586 (Mich. 1939).

[12] There are two instances where this is problematic. First, consider the scenario where two advisers act adversely to their clients, two separate private funds, by engaging in conflicted transactions. One adviser organized its fund in a jurisdiction that does not recognize the sole actor doctrine while the other adviser organizes its fund in a jurisdiction that does recognize the sole actor doctrine. In this scenario, as explained in greater detail below, the former adviser would be liable under the Advisers Act while the latter adviser would not, even though they engaged in the same misconduct. Second, if an adviser advised two funds, one organized in a jurisdiction that does not recognize the sole actor doctrine and one organized in a state that does, and the adviser acted adversely to both funds, applying state law would lead to the perverse result that the adviser could be on the hook for conduct directed to one fund and not the other, despite engaging in the same conduct.

[13] As will be explained below, state fiduciary law could be applied in this circumstance through the operation of state choice-of-law rules or the internal affairs doctrine.

[14] “Private fund” means “an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. § 80a-3), but for section 3(c)(1) or 3(c)(7) of that Act.” Investment Advisers Act of 1940 § 206, 15 U.S.C. § 80b-2a(29) (2012); see also 17 C.F.R. § 275.206(4)-8 (2016) (defining “pooled investment vehicle”).

[15] See SEC Staff, Implications of the Growth of Hedge Funds 9 & n.27 (2003).

[16] See id. at 49.

[17] See id. at 9 & n.27.

[18] See id.

[19] See, e.g., R. Franklin Balotti & Jesse A. Finkelstein, Delaware Law of Corporations and Business Organizations § 21.1 (2015); see also Tamar Frankel et al., Regulation of Money Managers: Mutual Funds and Advisers § 21.01 & n.99 (2015).

[20] See, e.g., Balotti & Finkelstein, supra note 19, at §§ 19.7, 20.9, 21.6.

[21] Cases have held that GPs and managers meet the definition of “investment adviser.” See, e.g., Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977); SEC v. Saltzman, 127 F. Supp. 2d 660 (E.D. Pa. 2000); SEC v. Spyglass Equity Sys., Inc., Litig. Release No. 21892 (Mar. 22, 2011) (charging the manager of an LLC primarily under the Advisers Act); see also Frankel, supra note 19, §§ 3.03, 21.01. It is worth clarifying, however, that the adviser breaches its fiduciary duty as the investment adviser to the fund, not as a GP or manager of the fund. Further, it is under this federally-imposed fiduciary relationship that the doctrines of imputed knowledge, adverse interest, and sole actor should be developed, and not under state fiduciary law. Further still, some jurisdictions allow parties to abdicate such duties through freedom of contract. See Balotti & Finkelstein, supra note 19, §§ 19.7, 20.9, 21.6. However, the Advisers Act expressly prohibits such abdication through contract. See Investment Advisers Act of 1940 § 215, 15 U.S.C. § 80b-15 (2012).

[22] See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963); see also Frankel et al., supra note 19, § 13.01. See generally Arlene W. Hughes, 27 S.E.C. 629 (1948) (setting out the Commission’s views on essential aspects of fiduciary responsibility, focusing on the burdens of investment advisers when conflicts are present), aff’d sub nom., Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949).

[23] Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006) (vacating Rule 203(b)(3)-2 under the Advisers Act and allowing an adviser to treat a single fund, rather than the individual investors, as its client).

[24] See SEC Staff, supra note 15, at 5–7.

[25] Investment Company Act of 1940, 15 U.S.C. § 80a (2012).

[26] See, e.g., id. §§ 10, 16, 12(d), 17, 56.

[27] See SEC Staff, supra note 15, at 5–7.

[28] See §§ 3(c)(1), (7).

[29] See A. A. Sommer, Jr., Foreword: Fiduciary Duties—The Search for Content, 9 Loy. U. Chi. L. J. 525, 525 (2015).

[30] SEC v. Chenery Corp., 318 U.S. 80, 85–86 (1943).

[31] See e.g., Quinn v. Phipps, 113 So. 419, 421 (Fla. 1927) (“[T]he relation and duties involved need not be legal; they may be moral, social, domestic, or personal. If a relation of trust and confidence exists between the parties (that is to say, where confidence is reposed by one party and a trust accepted by the other, or where confidence has been acquired and abused), that is sufficient as a predicate for relief.”); see also Tibble v. Edison Int’l, 135 S.Ct. 1823, 1828 (2015) (noting that the fiduciary duty created by the federal Employee Retirement Income Security Act is “derived from the common law of trusts”) (citation omitted).

[32] See Knut A. Rostad, Six Core Fiduciary Duties for Financial Advisors, Inst. For Fiduciary Standard (2013); Lorna A. Schnase, Investment Adviser’s Fiduciary Duty, Inst. For Fiduciary Standard (2010); Andrew J. Donohue, Director, SEC Div. of Inv. Mgmt., Keynote Address at IAA/ACA Insight’s Investment Adviser Compliance Forum 2010 (Feb. 25, 2010), https://www.sec.gov/news/speech/2010/spch022510ajd.htm.

[33] Later, this Article will discuss that agents may also wield considerable power over their principals when their principals are not natural persons.

[34] See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963) (stating that a fundamental purpose of the federal securities laws was to replace the default business standard of caveat emptor with higher standards of conduct designed to achieve a high standard of business ethics in the securities industry).

[35] See, e.g., Fla. Stat. § 518.11(1)(a) (2016) (“The fiduciary has a duty to invest and manage investment assets as a prudent investor would considering the purposes, terms, distribution requirements, and other circumstances of the trust.”); see also United States v. White Mountain Apache Tribe, 537 U.S. 465, 475 (2003) (“[The] standard of responsibility is ‘such care and skill as a man of ordinary prudence would exercise in dealing with his own property.’”) (citation omitted).

[36] See Restatement (Third) of Agency § 8.01 (Am. Law Inst. 2006); see also Capital Bank v. MVB, Inc., 644 So. 2d 515, 520 (Fla. Dist. Ct. App. 1994); Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928) (“Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”).

[37] When discussing the term “investment adviser” prior to the passage of the Advisers Act, this Article is referring to the most inclusive categorization of the term and so includes all of the enumerated professions excluded from the Advisers Act’s definition. Investment Advisers Act of 1940 § 202(a)(11), 15 U.S.C. 80b-2(a)(11) (2012).

[38] See Rostad, supra note 32; Schnase, supra note 32; Donohue, supra note 32. See generally Capital Gains Research Bureau, 375 U.S. at 187–90 (discussing the history of the investment advisory industry).

[39] See Rostad, supra note 32; Schnase, supra note 32; Donohue, supra note 32.

[40] See Norman Singer & Shambie Singer, 2B Sutherland Statutes and Statutory Construction § 50:1 (7th ed. 2015) (“Legislatures are presumed to know the common law before a statute was enacted.”); id. § 50:4 (“[It is useful] to examine a federal statute with reference to the common law of the various states as it existed when the statute was enacted.”). See generally Miles v. Apex Marine Corp., 498 U.S. 19, 32 (1990) (“We assume that Congress is aware of existing law when it passes legislation.”); Capital Gains Research Bureau, 375 U.S. at 195.

[41] See Transamerica Mortg. Advisors v. Lewis, 444 U.S. 11, 17 (1979) (“[Section] 206 establishes ‘federal fiduciary standards’ to govern the conduct of investment advisers . . . .”) (citing Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 472 n.11 (1977) (“Congress intended the Investment Advisers Act to establish federal fiduciary standards for investment advisers.”)); Capital Gains Research Bureau, 375 U.S. at 191–92 (“[The Advisers Act] reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline as investment adviser—consciously or unconsciously—to render advice which was not disinterested.”); see also Arlene W. Hughes, 27 S.E.C. 629 (1948) (setting out the Commission’s views on essential aspects of fiduciary responsibility, focusing on the burdens of investment advisers when conflicts are present), aff’d sub nom. Hughes, 174 F.2d. But see Arthur B. Laby, SEC v. Capital Gains Research Bureau and the Investment Advisers Act of 1940, 91 B.U. L. Rev. 1051 (2011) (arguing Capital Gains Research Bureau did not establish a federal fiduciary duty).

[42] See Erie R. Co. v. Tompkins, 304 U.S. 64, 78 (1938) (holding that there is no substantive federal common law).

[43] See Singer & Singer, supra note 40, § 50:2; see also Info-Hold, Inc. v. Sound Merchandising, Inc., 538 F.3d 448, 455–56 (6th Cir. 2008) (quoting Carter v. United States, 530 U.S. 255, 266 (2000) (“[W]e have not hesitated to turn to the common law for guidance when the relevant statutory text does contain a term with an established meaning at common law.”)).

[44] See Capital Gains Research Bureau, 375 U.S. at 191–92 (“[The Advisers Act reflects] a congressional recognition of the delicate fiduciary nature of an investment advisory relationship, as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline [an] investment adviser—consciously or unconsciously—to render advice which was not disinterested.”).

[45] See SEC v. DiBella, 587 F.3d 553, 568 (2d Cir. 2009) (addressing consent by a conflicted fiduciary under section 206(2), stating that “[t]hird party disclosure to an agent is not imputed to the principal when the agent is acting adversely to the principal’s interest and the third party has notice of this”) (citing Arlinghaus v. Ritenhour, 622 F.2d 629, 636 (2d Cir. 1980)).

[46] See Mark H. Alcott & Marc Falcone, Business and Commercial Litigation in Federal Courts § 102:6 (Robert I. Haig ed., 3d ed. 2015) (indicating the internal affairs doctrine, lex incorporationis, “holds that the relationships within a corporation—those among the corporation, its officers, directors, and shareholders—are governed by the law of the state of incorporation”).

[47] See, e.g., Bank of China v. NBM LLC, 359 F.3d 171, 179 (2d Cir. 2004) (applying New York common law); Ruberoid Co. v. Roy, 240 F. Supp. 7, 9 (E.D. La. 1965) (applying the Florida fiduciary law).

[48] See Alcott & Falcone, supra note 46.

[49] See Transamerica Mortg. Advisors, Inc. v. Lewis, 444 U.S. 11, 24–25 (1979) (holding that there is only one private right of action under the Advisers Act for rescinding a contract); see also id. at 24 n.14 (“Such relief could provide by indirection the equivalent of a private damages remedy that we have concluded Congress did not confer.”).

[50] See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191–92 (1963) (“[The Advisers Act reflects] a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline [an] investment adviser—consciously or unconsciously—to render advice which was not disinterested.”); see also Investment Advisers Act of 1940 § 222, 15 U.S.C. § 80b-18a (2012).

[51] See § 201.

[52] On this point, the Commission’s choice of forum should be criticized. So long as the Commission proceeds administratively, it continues to rob our beloved jurisprudence of doctrinal development by preventing Article III courts from interpreting the Advisers Act.

[53] See Goldstein v. SEC, 451 F.3d 871, 882–83 (D.C. Cir. 2006) (vacating Rule 203(b)(3)-2 under the Advisers Act).

[54] Investment companies are regulated by the ’40 Act and the rules promulgated thereunder. Investment companies are defined in section 3(a) of that Act. Private funds are typically organized and operated in a manner to be excluded from the definition of “investment company” pursuant to section 3(c)(1) or section 3(c)(7) of the ’40 Act. 15 U.S.C. §§ 80a-3(c)(1), (7) (2012). Consequently, private funds can avoid the jurisdiction of the ’40 Act as long as they comply with the exclusion upon which they rely.

[55] Cf. § 10.

[56] Cf. § 13.

[57] See SEC v. DiBella, 587 F.3d 553, 568 (2d Cir. 2009) (addressing consent by a conflicted fiduciary under section 206(2), stating that “[t]hird party disclosure to an agent is not imputed to the principal when the agent is acting adversely to the principal’s interest and the third party has notice of this”) (citing Arlinghaus v. Ritenhour, 622 F.2d 629, 636 (2d Cir. 1980)).

[58] Restatement (Third) Of Agency § 1.01 cmt. c (Am. Law Inst. 2006) (“It has been said that a relationship of agency always contemplates three parties—the principal, the agent, and the third party with whom the agent is to deal.”) (quoting 1 Floyd R. Mechem, A Treatise on the Law of Agency § 27 (2d ed. 1914)).

[59] See, e.g., In re Sunpoint Sec., Inc., 377 B.R. 513, 567 (Bankr. E.D. Tex. 2007) (citing Janvey v. Thompson & Knight, LLP, No. 3:03-CV-158-M, 2003 WL 21640573, at *6 (N.D. Tex. July 8, 2003)) (“The imputation rule is designed to protect innocent third parties with whom a dishonest agent deals on a principal’s behalf.”).

[60] See 3 C.J.S. Agency § 547 (2015).

[61] See 3 Am. Jur. 2d Agency § 250 (2016); see also Restatement (Third) of Agency § 5.04 (Am. Law Inst. 2006).

[62] Restatement (Third) of Agency § 5.04 (Am. Law Inst. 2006).

[63] See id. cmt. d., illust. 10.

[64] See, e.g., Grassmueck v. Am. Shorthorn Ass’n, 402 F.3d 833, 838–42 (8th Cir. 2005) (determining that the sole actor doctrine could apply as an exception to the adverse interest doctrine under the law of California, Oregon, Nevada, and Nebraska).

[65] See Paradigm Capital Mgmt., Inc., Exchange Act Release No. 3857, 2014 WL 2704311 (June 16, 2014); see also SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 189 (1963) (“One activity specifically mentioned and condemned by investment advisers who testified before the Commission was trading by investment counselors for their own account in securities in which their clients were interested.”) (internal quotes omitted); Interpretation of § 206(3) of the Investment Advisers Act of 1940, Exchange Act Release No. IA-1732, 1998 WL 400409 at *2 (July 17, 1998).

[66] See Interpretation of § 206(3), supra note 65, at n.3; see also Paradigm Capital Mgmt., 2014 WL 2704311.

[67] See Investment Advisors Act of 1940 § 206, 15 U.S.C. § 80b-6 (2012).

[68] See Interpretation of § 206(3), supra note 65.

[69] See Securities Act Release No. 3043, supra note 7.

[70] See SEC v. DiBella, 587 F.3d 553, 568 (2d Cir. 2009) (addressing consent by a conflicted fiduciary under section 206(2), stating that “[t]hird party disclosure to an agent is not imputed to the principal when the agent is acting adversely to the principal’s interest and the third party has notice of this”) (citing Arlinghaus v. Ritenhour, 622 F.2d 629, 636 (2d Cir. 1980)). One court, however, has held that section 206(1) and 206(2) charges are not available in cases alleging that a conflicted adviser failed to disclose information to fund investors. See SEC v. Northshore Asset Mgmt., No. 05 Civ. 2192(WHP), 2008 WL 1968299 at *6 (S.D.N.Y. May 5, 2008) (applying Goldstein v. SEC, 451 F.3d 871 (D.C. Cir. 2006), and concluding that, with regard to section 206(1) and 206(2) claims, “failure to disclose information or misrepresentations to the [fund entities’] investors cannot form the basis for a claim that [the adviser] breached his fiduciary duties to the [fund entities]”). The staff clearly believes that the Northshore decision does not preclude the Commission from charging violations of section 206(1) and 206(2) on these facts because the court never addressed (or even noted) the adverse interest argument in its opinion. See, e.g., In re Paradigm Capital Mgmt., Inc., Investment Advisers Act Release No. 3857, 109 S.E.C. Docket 430 (June 16, 2014).

[71] The presumption of imputed knowledge from agent to principal is generally regarded as a strong presumption. See, e.g., In re Pitt Penn Holding Co., 484 B.R. 25 (Bankr. D. Del. 2012) (applying Delaware law). Further, the presumption of imputed knowledge from agent to principal is generally regarded as conclusive in some jurisdictions. See, e.g., Freeman v. Super. Ct., San Diego Cty., 282 P.2d 857 (Cal. 1955); see also Neb. Pub. Emps. Local Union 251 v. Otoe Cty., 257 N.W.2d 237 (Neb. 1999). The presumption of imputed knowledge from agent to principal is not rebuttable in some jurisdictions. See, e.g., Kramer-Tolson Motors, Inc. v. Horowitz, 157 A.2d 625 (D.C. 1960). Yet, the presumption of imputed knowledge from agent to principal is rebuttable in other jurisdictions. See, e.g., BancInsure, Inc. v. U.K. Bancorporation Inc., 830 F. Supp. 2d 294 (E.D. Ky. 2011) (applying Kentucky law); Mancuso v. Douglas Elliman LLC, 808 F. Supp. 2d 606 (S.D.N.Y. 2011) (applying New York law); Kirschner v. KPMG LLP, 938 N.E.2d 941 (N.Y. 2010). Finally, the presumption of imputed knowledge from agent to principal is generally regarded as subject to the adverse interest exception. See Restatement (Third) Of Agency § 5.04 note c (Am. Law Inst. 2006) (discussing the application of the adverse interest doctrine across several jurisdictions).

[72] For evidence of a judicial willingness to apply common law fiduciary duty principles in cases arising under the ’40 Act, see Rosenfeld v. Black, 445 F.2d 1337, 1342–43 (2d Cir. 1971), cert. denied, 409 U.S. 802 (1972).

[73] The same would be true for many other undisclosed conflicts of interest.

[74] See, e.g., Grassmueck v. Am. Shorthorn Ass’n, 402 F.3d 833, 838–42 (8th Cir. 2005) (invoking the sole actor doctrine and imputing knowledge of fund’s GP to the fund despite the GP acting adversely to the fund).

[75] See SEC v. DiBella, 587 F.3d 553, 568 (2d Cir. 2009) (addressing consent by a conflicted fiduciary under section 206(2), stating that “[t]hird party disclosure to an agent is not imputed to the principal when the agent is acting adversely to the principal’s interest and the third party has notice of this”) (citing Arlinghaus v. Ritenhour, 622 F.2d 629, 636 (2d Cir. 1980)).

[76] SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191–92 (1963).

[77] The law of agency presumes imputation even where an agent acts less than admirably, exhibits poor business judgment, or commits fraud against a third party, but not when an agent commits fraud against the principal. See, e.g., Sec. Inv’r. Protect. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 476 B.R. 715 (S.D.N.Y. 2012), supplemented (May 15, 2012), aff’d sub nom. In re Bernard L. Madoff Inv. Sec. LLC, 773 F.3d 411 (2d Cir. 2014) (applying New York law); Kirschner v. KPMG LLP, 938 N.E.2d 941, 952 (N.Y. 2010) (“The presumption that agents communicate information to their principals does not depend on a case-by-case assessment of whether this is likely to happen. Instead, it is a legal presumption that governs in every case, except where the principal is actually the agent’s intended victim.”); Nerbonne, N.V. v. Lake Bryan Int’l Props., 685 So. 2d 1029, 1032 (Fla. Dist. Ct. App. 1997) (holding that an agent who defrauded its principal may not benefit from imputation of knowledge of fraud to its principal, and in dicta, discussing that the doctrine imputing an agent’s knowledge to its principal when the agent is the sole actor in a transaction with a third party is applicable only to a controversy between the principal and an innocent third party); see also Restatement (Third) of Agency § 5.04 note c (Am. Law Inst. 2006).

[78] This article does not attempt to explore the propriety of the sole actor doctrine outside of the fiduciary relationship between an investment adviser and its client. Indeed, the sole actor doctrine seems to exist to protect innocent third parties from unscrupulous principals seeking to avoid liability for their agent’s conduct. Thus, the sole actor doctrine acquires a different gloss when asserted by a third party as opposed to here, where it is being asserted by an agent taking advantage of its principal.

[79] Cf. Restatement (Third) of Agency § 5.04 cmt. b (Am. Law Inst. 2006).

[80] It is important to keep in mind that the jurisdiction in which a fund is organized may still affect an investment adviser’s liability from the perspective of standing in the shoes of a GP or manager of a private fund. In this context, the GP or manager may owe fiduciary duties to the partnership or LLC depending on applicable state law. However, such claims would be adjudicated against the investment adviser under state law and not under the Advisers Act. Notably, as mentioned above, some jurisdictions allow parties to waive fiduciary duties.

[81] The remaining question is whether the federal fiduciary standard explicated by the federal courts under the Advisers Act should apply across the entire universe of federal law, wherever fiduciaries are found, or just confined to a particular federal statute whereby Congress created a fiduciary standard.

December 5, 2016 By ehansen

Increased Antitrust Merger Enforcement: Considerations for Your Next Deal

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Michael B. Bernstein, Justin P. Hedge, and Francesca Pisano^†

I. Introduction

Antitrust merger enforcement has become increasingly aggressive in recent years with the Federal Trade Commission (FTC) and Antitrust Division of the Department of Justice (DOJ) (collectively, the U.S. antitrust authorities) demonstrating that they are ready to litigate to block deals they believe will harm competition. Political figures, from President Barack Obama and President-Elect Donald J. Trump to senators, have called for government action to protect and promote competition.^[1] Indeed, a recent speech by the head of the Antitrust Division made clear that the government will not shy away from bringing cases even when enforcers might lack “particularized and quantified proof of consumer harm” or a precise “measur[e] [of] the effect on price and output”—instead, “experience” and other evidence such as “company documents and customer testimony” can be sufficient.[2] This suggests that robust agency scrutiny of potential mergers and acquisitions is likely to continue in the future.

While an increasing number of mergers have been challenged and blocked in federal court,^[3] some are prevailing at trial or managing to find a path to clearance without litigation.^[4] This Article reviews the trends that have emerged in federal merger enforcement and discusses some key differences between deals that have been cleared and those that have faced government opposition. In particular, the antitrust authorities are focusing on (1) the use of narrow price-discrimination markets to analyze competition, (2) the credibility of future competition, and (3) the complexity of any remedy package. Understanding how the antitrust authorities analyzed and reached different conclusions in these areas is critical for assessing the antitrust risks of future transactions and forming the best strategy to obtain antitrust clearance.

II. Standards Applied in Federal Merger Investigations

Mergers and acquisitions are governed by section 7 of the Clayton Act, 15 U.S.C. § 18. This provision prohibits acquisitions of “the whole or any part of the stock in any line of commerce . . . [where] the effect of such acquisition may be substantially to lessen competition, or tend to create a monopoly.”^[5] The DOJ and FTC are the primary government enforcers of section 7.^[6] Their review of acquisitions is facilitated by the Hart-Scott-Rodino Act (HSR Act), which requires merging parties to give notice of their merger to the DOJ and FTC, if valued above certain thresholds, and to observe a waiting period before closing.^[7] The HSR Act also allows the U.S. antitrust authorities to request additional information from the parties and extend the waiting period to evaluate whether or not to challenge the transaction.^[8]

The DOJ and FTC also have published the Horizontal Merger Guidelines (Guidelines), which set forth the government’s framework for analyzing acquisitions.^[9] According to the Guidelines, the U.S. antitrust authorities undertake a fact-specific inquiry into each merger that considers all evidence relevant to potential competitive harms, including market shares, head-to-head competition between the merging parties, whether the merger is eliminating a “maverick” that has been driving competition (including through innovation), the presence of actual anticompetitive effects, and the ability of the merged entity to price discriminate against “certain targeted customers.”^[10]

III. Key Enforcement Trends

A. Narrow Price-Discrimination Markets

Recent merger cases demonstrate that the U.S. antitrust authorities are willing not just to investigate, but also to litigate market definition issues centered around a narrow set of customers subject to price discrimination. U.S. antitrust authorities typically define markets narrowly and are more likely to engage in an extended investigation if they believe a particular class of customers might be harmed by a merger—that is, if there is a group of customers for whom the merged firm can raise prices.^[11] Price-discrimination markets are not new—the 2010 Guidelines specifically discussed such markets and noted that the anticompetitive effects from a merger might vary significantly for different customers if there are some for whom the merged firm can profitably raise prices because of the customers’ particular needs.^[12] In recent cases, district courts have accepted such narrow markets, validating the U.S. antitrust authorities’ analysis and putting future merging parties on notice to carefully examine a deal’s potential impact on all types of customers in assessing its risks.

Three recent cases, in particular, highlight the increased importance regulators are placing on price-discrimination market definitions. First, in its 2015 challenge to Sysco’s acquisition of US Foods, the two largest food distribution companies, the FTC focused on the acquisition’s impact on national customers (for example, large chain restaurants).^[13] Given the specific purchasing needs of such customers—a supplier with a national distribution footprint, private-label products, a system to ensure consistency of ordering, pricing, and products, and a “high level[] of customer service”^[14]—the FTC found that Sysco and US Foods were the only two “broadline” competitors who could serve as a “one stop shop” for these national customers.^[15]

The court accepted the FTC’s national market definition, relying on the long-standing Supreme Court case Brown Shoe, which provides a set of indicia or factors to test and define the boundaries of markets.^[16] As the court summarized, application of this test frequently includes an analysis of “the product’s peculiar characteristics and uses, unique production facilities, distinct customers, distinct prices, the existence of special classes of customers who desire particular products and services, ‘industry or public recognition’ of a separate market, and how the defendants’ own materials portray the ‘business reality’ of the market.”^[17] The court was persuaded by the FTC’s market definition, in large part, based on broadline customers’ testimony.^[18]

Second, in its case against Staples’ acquisition of Office Depot, two of the largest office-supply companies, the FTC also staked out a narrow customer-specific market definition, alleging the merger would harm “business-to-business” customers, rather than the more common concerns related to “direct-to-consumer” customers.^[19] In doing so, the FTC similarly emphasized such customers’ “distinct” needs,^[20] including, again, a national distribution footprint, private-label product offerings, product consistency, and a “high level[] of customer service.”^[21] The FTC alleged that the combined firm would have accounted for 70% of the narrow business-to-business office supply market, giving rise to a presumption of anticompetitive effects from the merger under the Guidelines.^[22] The court found in favor of the FTC, also relying on the Brown Shoe standard.^[23] And in reaching its decision, the court relied on the merging parties’ internal documents that recognized a category of large, business-to-business customers as a distinct group.^[24]

Lastly, the 2015 acquisition of Trulia by Zillow,^[25] two online real estate portals, demonstrates that although the U.S. antitrust authorities may investigate whether a proposed deal might harm a particular class of customers, narrow price-discrimination markets are not always present. After a six-month review, the FTC cleared the Zillow/Trulia acquisition without requiring divestitures. In its closing statement, the FTC noted that it did scrutinize the deal for potential impact on price-discrimination markets.^[26] The FTC specifically considered whether real estate portals were a relevant market to certain groups of real estate agents willing to pay to list on the merging parties’ websites.^[27] The FTC ultimately concluded that while there was some evidence supporting narrow price-discrimination markets, it was “inconclusive,” in part, because there was no evidence of actual price discrimination prior to the merger.^[28] While this transaction was able to close, the FTC’s statement clearly identified that price-discrimination markets were top of mind in the agency’s analysis.^[29]

As these recent cases indicate, courts have been receptive to the government’s arguments that mergers might harm certain classes of customers. However, as the Zillow/Trulia investigation demonstrates, if parties can show that there is no evidence of price discrimination before the merger, there is a better chance that the U.S. antitrust authorities will close the investigation and clear the deal.

Given the U.S. antitrust authorities’ success in Staples and Sysco, the enforcers are likely to continue to closely investigate narrow market definitions in future mergers. As such, there are several issues counsel and merging parties should consider heading into a new deal.

First, anticipate that the DOJ or FTC will define narrow customer segments, even if they represent a relatively small portion of a company’s business. The Staples court noted that “[a]ntitrust laws exist to protect competition, even for a targeted group that represents a relatively small part of an overall market.”^[30] The FTC was not only willing to bring a case where the alleged market represented only 1.4% of the parties’ overall sales, but also successful in blocking the transaction based on that narrow market definition.^[31]

Second, determine if there is evidence that either party is pricing differently to specific segments of customers. Counsel and merging parties should seek to understand as early as possible in the merger process whether there is any particular business channel or subsegment of customers who may be especially vulnerable to post-merger price increases, even if those customers or lines of business are ancillary to the deal rationale.

Third, do not assume that the U.S. antitrust authorities will discount harms to sophisticated customers. The U.S. antitrust authorities have recognized that the strength and sophistication of merging parties’ buyers can mitigate a merger’s potential anticompetitive effects.^[32] But, as demonstrated in Sysco and Staples, even where customers are large corporations and arguably can protect themselves, the FTC successfully has blocked mergers by defining the relevant market around the provision of products and services to such customers and focusing on price-discrimination markets.

B. Future Competition

Another trend in recent merger enforcement is the high level of proof expected by the U.S. antitrust authorities, as well as courts, for any party asserting claims of future competition.^[33] Arguments without evidence of concrete steps to enter or minimal foothold entry in the relevant market are more likely to be rejected as mere speculation.

In Staples’ proposed acquisition of Office Depot, the parties argued that regional competitor W.B. Mason and recent entrant Amazon would be able to expand their business-to-business sales and replace any competition lost as a result of the merger.^[34] The FTC, however, argued that entry would not be successful, and the court agreed. It found particularly persuasive the testimony of regional competitor W.B. Mason that it was not interested in expanding into the national market.^[35] With respect to Amazon, the court was troubled that it had an online sales model that had never actually won a bid in response to a business-to-business customer’s Request for Proposal (RFP).^[36] The court concluded that it would be “sheer speculation” to expect Amazon to compete with Staples/Office Depot within three years.^[37] The court also expressed concern that the structure of Amazon—a marketplace with third-party vendors who each controlled their own product price—would make it difficult for the retailer to bid for large corporate contracts; the court concluded that Amazon’s model was “at odds” with the RFP method business customers used.^[38]

In contrast, the FTC in 2013 cleared Office Depot’s acquisition of Office Max without divestitures because the “explosive growth of online commerce . . . had a major impact on this market.”^[39] In that investigation, the FTC’s focus was on retail customers, and the FTC found that stores were losing sales to online retailers and frequently were forced to match their lower prices.^[40] The key distinction between the two cases is that in Office Depot/Office Max, online competitors already enjoyed some success as competitors in the retail office supply market, so their future competition was given significant weight.

The U.S. antitrust authorities’ treatment of online competition in other contexts further illustrates how the similarity of offerings will be key in determining whether to credit future online competition arguments. For example, in the 2015 Dollar Tree/Family Dollar merger, the FTC rejected arguments that online retailers were competitively significant.^[41] The FTC determined that the “primary appeal” of dollar stores was a “combination of value and convenience,” which could not be met by internet-based retailers given the time required to process and ship online orders.^[42] Similarly, in the 2015 merger between two subprime consumer loan companies, Springleaf and OneMain, the DOJ concluded that online banks were unlikely to act as a significant competitive constraint post-merger.^[43] Although the DOJ noted that online lenders had successfully entered the market for loans made to prime borrowers, the online lenders “face[d] challenges in meeting the needs of and mitigating the credit risk posed by subprime borrowers.”^[44] The DOJ focused on three main reasons that online lenders were unlikely to compete directly with Springleaf or OneMain: (1) lack of close customer relationships, (2) inability to conduct in-person meetings that may reduce fraud or risk, and (3) a slower loan application, processing, and distribution speed.^[45]

The need for substantial evidence in support of future competition arguments extends to the government as well, in particular when it alleges a transaction will eliminate such future competition. In 2015, the FTC filed a complaint to block the merger between Steris and Synergy—two medical sterilization providers—but ultimately lost its challenge.[46] The FTC argued that Synergy was an “actual potential entrant” into the x-ray sterilization industry, which the FTC alleged would have competed directly with Steris’ gamma radiation sterilization method.^[47] The FTC cited internal Synergy documents, dating back to 2012, in an effort to prove that the business had moved from “planning to implementation,” obtained a number of customer letters of interest, and was poised to have a “large and lasting competitive impact” on the sterilization market.^[48] The merging parties disagreed that entry was likely, in part relying on Synergy documents reflecting a lack of customer support for expansion into x-ray sterilization and a low projected rate of return—3%, rather than the targeted 15%—and the court agreed.^[49] Indeed, Synergy discontinued its x-ray sterilization project in early 2015, which the court found was unrelated to the merger.^[50] After failing to block this transaction, the FTC acknowledged “just how difficult a potential competition case is to win.”^[51] But it made clear it would still consider bringing them where there is strong evidence entry would occur but for the merger, such as approved capital investment plans as opposed to mere evidence of the capability to enter.^[52]

Given these cases, it is important to consider the extent to which the merger’s success relies on arguments of future competition and the quality of evidence supporting such claims.

First, it is clear the U.S. antitrust authorities (and courts) require a significant amount of evidence that the future competitor has plans to enter and that it is likely to be successful upon entry. Even when merging parties point to large, successful companies like Amazon as competitive constraints, if those companies have neither expressed an interest in competing for the business at issue nor had any success on recent entry, the U.S. antitrust authorities (and the courts) are likely to give less weight to entry and expansion arguments.

Second, it should not be assumed that internet-based competitors offering the same products and services as the merging parties are necessarily competitive constraints. In both Staples and Springleaf, the regulators were not convinced that internet-based companies could adequately compete with brick-and-mortar stores, whether because of how pricing is set (for example, Amazon’s marketplace allows third-party vendors to set individual prices)^[53] or how features of the market might disadvantage online companies (for example, online subprime lenders unable to meet customers face-to-face).^[54] Accordingly, merging parties who seek to rely on arguments of internet-based competition should ensure that there are no market realities that might prevent online businesses from fully competing in the relevant market.

Finally, it is important to consider whether the U.S. antitrust authorities or the courts will consider the merging parties as competitors, even if the parties are not currently competing today. The FTC’s recent loss in Steris illustrates that a merger challenge based on potential competition between the two businesses faces high evidentiary hurdles. FTC Commissioner Maureen Ohlhausen noted the Steris/Synergy case “ought to give the agency pause in pursuing potential competition cases in the future.”^[55] However, the U.S. antitrust authorities routinely have required divestitures where products are likely to be in future competition with each other, and such a position is likely to continue. As a result, it is important to consider future product innovation and product pipelines when advising on a transaction.

C. Preference for Simple Remedies and Divestiture Packages with a Proven Track Record of Success

As a final consideration, U.S. antitrust authorities have become increasingly critical of remedy settlement packages that are complex and would not create competitors of the same scale. Yet, where the parties have crafted comprehensive remedy proposals, the U.S. antitrust authorities still are willing to accept them to resolve competition concerns if the divestiture creates a player ready to compete on “day one” post-merger.

During the DOJ’s investigation of the merger of Halliburton and Baker Hughes, two of the largest oil-field services providers, the parties offered a divestiture package to address the DOJ’s concerns. Though the package represented up to $7.5 billion in sales, the DOJ rejected it as “wholly inadequate” and filed suit to block the transaction in April 2016.^[56] Indeed, the DOJ characterized the proposed fix as “among the most complex and riskiest remedies ever contemplated in an antitrust case” as it was a “collection of assets selected from various . . . business lines,” rather than a stand-alone business unit.^[57] The DOJ also was concerned that the divestiture structure would leave the buyer dependent on Halliburton for “crucial” services and thus, unable to compete independently.^[58] And there were gaps in the package’s scope and scale such that the DOJ felt it would not “replicate the [lost] competition.”[59] Not only did the proposed divestiture not cover several key product areas, but the DOJ also had concerns that the divested business would “be less efficient, have less research and development . . . and be less able to offer integrated solutions” than the pre-merger parties.^[60]

Similarly, in July 2016 when the DOJ challenged the merger of Aetna and Humana, two of the largest health insurance companies, it expressed concerns regarding the parties’ proposed divestiture. The companies offered to divest Humana’s Medicare Advantage business, which the DOJ criticized as merely pieces of contracts rather than a stand-alone business.^[61] The DOJ also highlighted that the divestiture buyer would remain “dependent on Aetna—potentially for years—for providing basic services.”^[62] Ultimately, the DOJ concluded that no buyer of the proposed package would be able to compete as effectively or be as well positioned to expand as the two merging parties.^[63]

In contrast, the day before suing Aetna and Humana, the DOJ approved the merger of two of the largest beer manufacturers in the world, AB InBev and SABMiller, with a remedy package that included not just divestitures but also conduct conditions.^[64] From the outset, the parties committed to divesting SABMiller’s equity and ownership stake in MillerCoors, a joint venture through which SABMiller operated in the United States, as well as other assets.^[65] In the end, the parties further agreed to give MillerCoors international rights to the Miller brands of beer and perpetual, royalty-free licenses for certain products. The parties also committed to non-discriminatory practices in their distribution arrangements, which were aimed at protecting the distribution of independent craft beer brands.^[66]

Similarly, in the merger of cigarette manufacturers Reynolds and Lorillard that closed in 2015, Reynolds negotiated a remedy up front.^[67] Contingent on Reynolds’ acquisition of Lorillard, Reynolds committed to sell a number of Reynolds and Lorillard brands and a manufacturing plant to a third cigarette manufacturer, ITG.^[68] The FTC ultimately concluded that the divestiture not only addressed the competitive concerns raised by the merger, but also provided ITG “a robust opportunity . . . to grow its market share.”^[69] In particular, the FTC noted that the divested cigarette brands—Winston, Kool, Salem, and Maverick—were already accepted brands in the U.S. market and had a collective established market share of about 7%.^[70] The FTC also noted that ITG had greater incentive to promote the growth of the divested brands than Reynolds because “incremental sales of these brands are unlikely to cannibalize sales from more profitable cigarette brands in its portfolio.”^[71]

Close agency scrutiny of any proposed divestiture is likely to continue in the future. While arguments on the merits may be strong, companies considering mergers may ultimately decide to settle for various reasons, including timing. In preparation for a potential investigation, companies should carefully evaluate a number of facets related to potential divestiture remedies in order to have a proposal be as effective as possible.

Parties should consider remedies early. As the approval in Reynolds/Lorillard demonstrates, negotiating a remedy concurrently with the original transaction can pay dividends. Such fix-it-first remedies are worth considering, particularly to ease agency review of a complicated merger. And even if a fix-it-first remedy is impractical, it is important to begin thinking about structural remedies early in the merger process.

Also, remedies need to be structured so the divested entity resolves the U.S. antitrust authorities’ competition concerns and can effectively compete on day one. The U.S. antitrust authorities will look closely at any proposed remedy to ensure the competition lost from the transaction is replaced by a proposed divestiture. This will include scrutiny of both the size and the scope of the divestiture as well as the buyer’s ability to effectively replace the lost competition. Where a divestiture package would not create a competitor able to compete in product scope and service offerings for the particular product and geographic markets at issue, the U.S. antitrust authorities are unlikely to accept that divestiture as a fix for any competitive concerns. Moreover, where assets are cobbled together and the divestiture does not position the proposed divestiture buyer to compete on day one and beyond, the U.S. antitrust authorities are unlikely to accept the proposed remedy.

IV. Conclusion

Merger review has been, and will continue to be, fact-specific. However, the recent cases that the DOJ and FTC have brought and won in federal court are informative on what it takes to get a deal done in today’s regulatory environment.

As a result, parties should consider the antitrust issues up front, including narrow customer-centric product markets and the way in which future competition will affect the merger. By doing this, parties will understand these issues early and be better equipped to consider what remedies are workable from a business perspective as well as from an antitrust perspective.

† Michael B. Bernstein is a Partner in the Washington, D.C. office of Arnold & Porter LLP, where he concentrates his practice on obtaining antitrust clearance for transactions, representing corporations in government investigations and civil litigation, as well as counseling on antitrust implications of business practices.

Justin P. Hedge is an Associate in the Washington, D.C. office of Arnold & Porter LLP, where his practice focuses on representing companies before the federal antitrust authorities in the review of mergers and other investigations, antitrust litigation, and day-to-day counseling on antitrust compliance and training.

Francesca M. Pisano is an Associate in the Washington, D.C. office of Arnold & Porter LLP. Her practice focuses on government review of mergers and acquisitions, complex civil antitrust litigation, and counseling clients in relation to antitrust issues.

[1] In April 2016, President Obama issued an executive order for federal agencies to “identify specific actions” to detect abuses, enhance competition, and reduce burdens on competition. Exec. Order No. 13,725, 81 Fed. Reg. 23,417, 23,417–18 (Apr. 15, 2016), https://www.whitehouse.gov/the-press-office/2016/04/15/executive-order-steps-increase-competition-and-better-inform-consumers. Some politicians have sharply criticized consolidation in various sectors of the economy. See, e.g., Senator Elizabeth Warren, Reigniting Competition in the American Economy, Keynote Remarks at New America’s Open Markets Program Event (June 29, 2016), http://www.warren.senate.gov/ files/documents/2016-6-29_Warren_Antitrust_Speech.pdf; Letter from Senator Al Franken et al. to Tom Weeler, Fed. Commc’n Comm’n Chairman, and Eric Holder, Att’y Gen., Dep’t of Justice (April 21, 2015), http://www.franken.senate.gov/files/documents/150421ComcastTWC.pdf.

[2] Renata Hesse, Acting Assistant Att’y Gen., Dep’t of Justice Antitrust Div., And Never the Two Shall Meet? Connecting Popular and Professional Visions for Antitrust Enforcement, Remarks at the 2016 Global Antitrust Enforcement Symposium (Sept. 20, 2016), https://www.justice.gov/opa/speech/acting-assistant-attorney-general-renata-hesse-antitrust-division-delivers-opening.

[3] Complaint at 4–5, FTC v. Sysco Corp., 83 F. Supp. 3d 271 (D.D.C. 2015) (No. 1:15-cv-00256(APM)); Complaint at 3, 12, FTC v. Staples, Inc., 2016 WL 2899222 (D.D.C. Dec. 9, 2015) (No. 15-2115(EGS)).

[4] FTC v. Steris Corp., 133 F. Supp. 3d 962, 971–72, 982 (N.D. Ohio 2015); Fed. Trade Comm’n, FTC File No. 141-0168, Analysis of Agreement Containing Consent Order to Aid Public Comment, In re Reynolds American Inc. and Lorillard Inc. 3 (2015), https://www.ftc.gov/system/files/documents/cases/ 150526reynoldsanalysis.pdf.

[5] Clayton Act § 7, 15 U.S.C. § 18 (2012).

[6] See 15 U.S.C. § 26 (2012). Other federal agencies, such as the Surface Transportation Board and the Federal Communications Commission, have jurisdiction to enforce section 7 in their respective areas of expertise. See 15 U.S.C. § 21(a) (2012).

[7] See 15 U.S.C. § 18a (2012).

[8] Id.

[9] U.S. Dep’t of Justice & Fed. Trade Comm’n, Horizontal Merger Guidelines (Aug. 19, 2010), https://www.ftc.gov/sites/default/files/attachments/merger-review/100819hmg.pdf.

[10] Id. at §§ 2.1, 3.

[11] Id. at § 3.

[12] Id.

[13] Complaint at 4–5, FTC v. Sysco Corp., 83 F. Supp. 3d 271 (D.D.C. 2015) (No. 1:15-cv-00256(APM)).

[14] Id. at 3.

[15] Id. at 4–5.

[16] FTC v. Sysco Corp., 113 F.Supp.3d 1, 23 (D.D.C. June 26, 2015) (citing Brown Shoe Co. v. United States, 370 U.S. 294 (1962)).

[17] Id. at 23–33 (emphasis added).

[18] Id. at *28.

[19] Complaint at 3, 12, FTC v. Staples, Inc., 2016 WL 2899222 (D.D.C. Dec. 9, 2015) (No. 15-2115(EGS)) [hereinafter Staples/Office Depot Complaint].

[20] FTC v. Staples, Inc., No. 15-2115(EGS), 2016 WL 2899222, at *10–11 (D.D.C. May 17, 2016).

[21] Staples/Office Depot Complaint, supra note 19, at 13.

[22] Id. at 16–17.

[23] Staples, 2016 WL 2899222, at *25–26.

[24] See id. at *9–10.

[25] See Press Release, Zillow Announces Acquisition of Trulia for $3.5 Billion in Stock (July 28, 2014), http://investors.zillowgroup.com/releasedetail.cfm?releaseid=862266.

[26] See Fed. Trade Comm’n, FTC File No. 141-0214, In the Matter of Zillow, Inc. and Trulia, Inc. (2015), https://www.ftc.gov/system/files/documents/public_statements/625671/150219zillowmko-jdw-tmstmt.pdf.

[27] See id.

[28] See id.

[29] See id.

[30] FTC v. Staples, Inc., No. 15-02115 (EGS), 2016 WL 2899222, at *16 (D.D.C. May 17, 2016).

[31] Defendants’ Brief in Opposition to Plaintiffs’ Motion for a Preliminary Injunction at 14, FTC v. Staples, Inc., 2016 WL 2899222 (D.D.C. May 17, 2016) (No. 15-02115 (EGS)), http://www.appliedantitrust.com/ 14_merger_litigation/cases_ftc/staples2015/1_ddc/staples_ddc_pi_opp3_16_2016redacted.pdf.

[32] U.S. Dep’t of Justice & Fed. Trade Comm’n, Horizontal Merger Guidelines (Aug. 19, 2010), https://www.ftc.gov/sites/default/files/attachments/merger-review/100819hmg.pdf (“Powerful buyers are often able to negotiate favorable terms with their suppliers . . . . The [a]gencies consider the possibility that powerful buyers may constrain the ability of the merging parties to raise prices.”).

[33] Consideration of future competition is always relevant to merger analysis, though it can take many forms. In the past, the antitrust agencies have challenged deals where one company seeks to acquire another company that is poised to enter a relevant market as a new competitor. See, e.g., Press Release, Fed. Trade Comm’n, FTC Issues Administrative Challenge to Polypore International, Inc.’s Consummated Acquisition of Microporous Products L.P. and Other Anticompetitive Conduct (Sept. 10, 2008), https://www.ftc.gov/news-events/press-releases/2008/09/ftc-issues-administrative-challenge-polypore-international-incs (announcing the FTC’s decision to challenge Polypore International’s acquisition of Microporous Products, which had been “preparing to enter” the relevant market).

[34] FTC v. Staples, Inc., No. 15-02115 (EGS), 2016 WL 2899222, at *2, *24–25 (D.D.C. May 17, 2016).

[35] See id. at *24–25. The determination that a regional competitor was insufficient to replace the lost competition is similar to the conclusion in the Sysco/US Foods litigation. See FTC v. Sysco Corp., 113 F.Supp.3d 1, 40–41 (D.D.C. 2015). In Sysco/US Foods, the FTC alleged, and the court agreed, that regional competitors were insufficient to constrain national competition on their own. Id. And while there was an organization through which regional competitors could jointly bid for national contracts, the court found it to be an ineffective alternative to the merging parties because of inherently higher costs and logistical complexities. Id.

[36] Staples, 2016 WL 2899222, at *22–24.

[37] Id. at *24.

[38] Id. at *23.

[39] Fed. Trade Comm’n, FTC File No. 131-0104, Statement of the Federal Trade Commission Concerning the Proposed Merger of Office Depot, Inc. and Office Max, Inc. (2013).

[40] Id.

[41] Fed. Trade Comm’n, No. 141-0207 n.4, Analysis of Agreement Containing Consent Orders to Aid Public Comment, In the Matter of Dollar Tree, Inc. and Family Dollar Stores, Inc. (2015), https://www.ftc.gov/system/files/documents/cases/150702dollartreeanalysis.pdf.

[42] Id.

[43] Competitive Impact Statement at 6, United States, et al. v. Springleaf Holdings, Inc., et al., No. 1:15-cv-01992 (RMC) (D.D.C. Nov. 13, 2015), https://www.justice.gov/opa/file/793141/download.

[44] Id.

[45] Id.

[46] FTC v. Steris Corp., 133 F. Supp. 3d 962, 963, 984 (N.D. Ohio 2015).

[47] Complaint at 6, 17, FTC v. Steris Corp., 133 F. Supp. 3d 962 (N.D. Ohio 2015) (No. 1:15-cv-01080-DAP).

[48] Id. at 7–8.

[49] FTC v. Steris Corp., 133 F. Supp. 3d 962, 971–72, 982 (N.D. Ohio 2015).

[50] Id. at 981, 984 (noting that “problems . . . plagued the development of x-ray sterilization” since 2012).

[51] See Maureen Ohlhausen, Comm’r, Fed. Trade Comm’n, Antitrust Tales in the Tech Sector: Goldilocks and the Three Mergers and Into the Muir Woods, 8–9 (Jan. 26, 2016), https://www.ftc.gov/system/files/documents/ public_statements/910843/160126skaddenkeynote.pdf.

[52] Id.

[53] FTC v. Staples, Inc., No. 15-02115 (EGS), 2016 WL 2899222, at *23 (D.D.C. May 17, 2016).

[54] Competitive Impact Statement, supra note 43, at 6.

[55] Id. at 9.

[56] Complaint at 5, United States v. Halliburton Co., No. 1:16-cv-00233-UNA (D.D.C. April 6, 2016), https://www.justice.gov/atr/file/838661/download.

[57] Id. at 4.

[58] Id.

[59] Id. at 5.

[60] Id.

[61] Complaint at 20–21, United States. v. Aetna Inc., 2016 WL 3920816 (D.D.C. July 21, 2016) (No. 1:16-cv-01494), https://www.justice.gov/opa/file/877881/download.

[62] Id. at 21.

[63] Id.

[64] Competitive Impact Statement at 2, United States v. Anheuser-Busch, No. 1:16-cv-01483 (D.D.C. Jul. 20, 2016), https://www.justice.gov/opa/file/877511/download.

[65] Press Release, Department of Justice, Justice Department Requires Anheuser-Busch InBev to Divest Stake in MillerCoors and Alter Beer Distributor Practices as Part of SABMiller Acquisition (July 20, 2016), https://www.justice.gov/opa/pr/justice-department-requires-anheuser-busch-inbev-divest-stake-millercoors-and-alter-beer.

[66] Competitive Impact Statement, supra note 43, at 2.

[67] Fed. Trade Comm’n, FTC File No. 141-0168, Analysis of Agreement Containing Consent Order to Aid Public Comment, In re Reynolds American Inc. and Lorillard Inc. 3 (2015), https://www.ftc.gov/system/files/documents/ cases/150526reynoldsanalysis.pdf.

[68] Id. at 3.

[69] Id.

[70] Id.

[71] Id.

December 3, 2016 By ehansen

Bitcoin and Virtual Currencies: Welcome to Your Regulator

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Matthew Kluchenek^†

I. Introduction

Among all the U.S. regulators interested in regulating Bitcoin and virtual currencies, the Commodity Futures Trading Commission (CFTC) is determined to be at the forefront. Since the announcement by CFTC Chairman Timothy Massad in late 2014 that Bitcoin derivatives should fall within the scope of the CFTC’s jurisdiction,^[1] the CFTC has been aggressive in addressing not only wrongful conduct involving Bitcoin derivatives, but also wrongful conduct involving certain spot Bitcoin transactions.

The CFTC’s actions are a clarion call for market participants to understand the broad breadth of the CFTC’s jurisdiction, and to take notice of the requirements that may apply both to derivatives and to certain physical transactions involving Bitcoin and other virtual currencies.

II. Scope of CFTC’s Jurisdiction

The U.S. Commodity Exchange Act (CEA),^[2] as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act),^[3] regulates transactions in “commodity interests.”^[4] The CFTC, an independent federal agency, is charged with administering the CEA and has exclusive jurisdiction over transactions involving commodity interests.^[5] Throughout the history of the CFTC, and particularly with respect to the Dodd-Frank Act, Congress has ceded broad power to the CFTC to interpret and promulgate rules regarding commodity interest products, transactions, and market participants.^[6]

As a general matter, the CFTC’s jurisdiction flows from the definition of a “commodity” under the CEA.^[7] At bottom, if a “commodity” is not involved in a contract, agreement, or transaction, the CFTC lacks the statutory basis to regulate the contract, agreement, or transaction.^[8] The definition of a “commodity,” however, is exceedingly broad under the CEA. The definition delineates a laundry list of agricultural products, but also sweeps in “all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.”^[9] As a result, almost anything except onions^[10] and movie box office receipts^[11] can constitute a “commodity” under the definition, including bottles of wine, baseball cards, reference rates, indices, mathematical permutations, services, intangibles, and contingencies that would not seemingly fall within the traditional view of a commodity.^[12]

If, however, a commodity is involved, then the CFTC may only assert jurisdiction if a “commodity interest” is based on the commodity.^[13][ A “commodity interest” refers to the types of instruments that are subject to the CFTC’s regulation, which are: (i) futures contracts, (ii) options on futures contracts, (iii) swaps, (iv) leveraged retail foreign exchange contracts, (v) leveraged retail commodity transactions, and (vi) certain other leveraged products.^[14] Importantly, the CFTC’s jurisdiction is thus not—as many assume—limited to “derivatives,” but rather also extends to certain spot, or physical market, transactions.

As a result, in seeking to assert jurisdiction over a contract, agreement, or transaction involving a commodity, the CFTC’s jurisdictional hook is premised upon whether a commodity interest is involved. If so, and assuming that no exclusions or exemptions apply, the CFTC has a basis to assert regulatory authority.

III. Bitcoin as a “Commodity” under the Commodity Exchange Act

In the context of Bitcoin (and other virtual currencies), the threshold issue is whether Bitcoin is a “commodity.” If Bitcoin is a commodity, then the CFTC may regulate commodity interests based on the commodity. If Bitcoin is not a commodity, then the CFTC lacks the authority to so regulate.

In December 2014, CFTC Chairman Timothy Massad telegraphed the CFTC’s intent to regulate Bitcoin derivatives, stating that “derivatives contracts based on a virtual currency represent one area within [the Commission’s] responsibilit[ies].”^[15] Little elucidation was given. However, in September 2015, the CFTC took a significant step in asserting jurisdiction when it issued an order determining that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”^[16]

The CFTC’s determination did not arise out of a rulemaking or an interpretation, but rather via an enforcement action against an online Bitcoin trading platform called “Derivabit,” which was owned by Coinflip, Inc.^[17] Coinflip operated the trading platform, which was designed for risk management purposes, in an effort to bring together buyers and sellers of Bitcoin option contracts.^[18] Coinflip was not registered with the CFTC.

In making the pronouncement that Bitcoin is a commodity, the CFTC effectively determined that Bitcoin is not a currency. According to the CFTC, “Bitcoin and other virtual currencies are distinct from ‘real’ currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance.”^[19]

Importantly, the CFTC’s determination is not limited to Bitcoin, but extends to “other virtual currencies,” which the CFTC broadly defines as “a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but does not have legal tender status in any jurisdiction.”^[20] Thus, the definition of “virtual currency” could also engulf Litecoin and Dogecoin, among others yet to be created.

Based on its determination that Bitcoin is a commodity, the CFTC applied the CEA’s provisions to the Derivabit trading platform, finding that Coinflip unlawfully offered commodity options by operating a facility for the trading of such options without being registered as a designated contract market (that is, a futures exchange) or a swap execution facility (SEF).^[21] Importantly, because Coinflip offered commodity options, which are derivatives, the CFTC had an ostensibly clear basis to assert jurisdiction once the agency determined that Bitcoin is a commodity.^[22]

Just one week after the Coinflip settlement, and armed with its determination that Bitcoin is a commodity, the CFTC brought its second Bitcoin-related enforcement action, this time against TeraExchange, LLC (Tera), an SEF.^[23] In the action, the CFTC alleged that Tera failed to enforce its prohibition on wash trades by facilitating the prearrangement of a single Bitcoin swap transaction.^[24]

As with the Coinflip matter, the CFTC’s enforcement action against Tera involved a derivative—that is, here, swaps based on Bitcoin. The presence of the swap, coupled with Tera’s provisional registration with the CFTC as an SEF, provided the CFTC with an unambiguous pathway to assert jurisdiction. Soon thereafter, however, the CFTC’s path would take a different, and more aggressive, turn.

IV. The CFTC’s Enforcement Action Against Bitfinex

In June 2016, the CFTC filed charges against a Hong Kong-based company called Bitfinex, which operates an online platform for trading in cryptocurrencies, including Bitcoin.^[25] Unlike Coinflip and Tera, however, Bitfinex did not list or permit the trading of derivatives, such as futures, options, or swaps.^[26] Rather, Bitfinex merely facilitated spot transactions in cryptocurrencies.^[27] Generally, a “spot” transaction is the everyday transaction of buying and selling a good, much like one does when purchasing an item on eBay. Payment is made for the item, and the item is promptly delivered to the buyer. The CFTC is generally not authorized to regulate spot transactions.^[28] However, by adding a couple of characteristics to an otherwise vanilla spot transaction, the transaction can be transformed into a commodity interest transaction subject to the full panoply of provisions under the CEA.

The basis for the CFTC’s authority to regulate certain spot transactions derives from the jurisdictional hook that the agency has used so successfully to prosecute retail precious metals transactions^[29]—the so-called “retail commodity transaction” provision under the CEA.^[30] The retail commodity transaction provision is a relatively short provision set forth in CEA section 2(c)(2)(D). It provides:

(D) Retail commodity transactions

(i) Applicability[.] Except as provided in clause (ii), this subparagraph shall apply to any agreement, contract, or transaction in any commodity that is—

(I) entered into with, or offered to (even if not entered into with), a person that is not an eligible contract participant or eligible commercial entity; and

(II) entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.^[31]

The elements of a retail commodity transaction are thus threefold—the agreement, contract, or transaction must:

(1) involve a commodity;

(2) be entered into with, or offered to, a person that is not an eligible contract participant (ECP);^[32] and

(3) be entered into, or offered, on a leveraged, margined or financed basis.^[33]

All three elements must be present for there to be a retail commodity transaction. Any person that deals in commodities subject to the retail commodity transaction provision is required to be registered with the CFTC as a futures commission merchant (FCM).^[34]

While a retail commodity transaction is a form of commodity interest, such a transaction is fundamentally different from a derivatives transaction, the latter of which derives its value from an underlying commodity and contains an element of futurity. Critically, where a derivative is not involved, market participants are often caught off-guard with respect to the broad scope of the CFTC’s jurisdiction.

Like so many requirements under the CEA, however, there are exceptions to the retail commodity transaction provision. One such exception involves the timely “actual delivery” of a commodity to the buyer.^[35] If a seller offers to enter, or enters into, a commodity transaction with a non-ECP on a leveraged basis, the transaction will not fall under the retail commodity transaction provision if the seller actually delivers the commodity to the buyer within 28 days of the date that the contract is entered into.^[36] The meaning of “actual delivery” has been the subject of extensive interpretation by the CFTC.^[37]

In determining that Bitfinex violated the CEA, the CFTC’s order found that the transactions executed on the Bitfinex platform fell within the purview of the retail commodity transaction provision, and that no “actual delivery” occurred. According to the CFTC:

Bitcoin is a commodity;
Bitfinex did not limit its customers to ECPs, but rather sold Bitcoins to retail persons;
Bitfinex facilitated the financing of Bitcoin transactions;^[38] and
Bitfinex did not actually deliver Bitcoins to the buyers.^[39]

In addressing the most controversial aspect of the order—whether actual delivery of the Bitcoins occurred—the CFTC explained that Bitfinex held its customers’ Bitcoins in an omnibus private wallet that was controlled solely by Bitfinex, not the customers.^[40] Through the use of a private key, only Bitfinex had access to the omnibus wallet.^[41] Consequently, because Bitfinex solely controlled access to the wallet, the CFTC found that Bitfinex’s customers did not actually receive delivery of any Bitcoins.^[42] The CFTC’s explanation seems to suggest that satisfying the requirement of “actual delivery” would require that virtual currencies be delivered to a deposit wallet for which the recipient controls the private key.^[43] However, neither the CEA, the CFTC’s rules, nor the CFTC’s guidance on “actual delivery” discuss or contemplate the delivery requirements of virtual currencies.^[44]

Nonetheless, based on the satisfaction of the elements of the retail commodity transaction provision, coupled with the absence of actual delivery, the CFTC found that Bitfinex violated the CEA’s retail commodity transaction provision by failing to register as an FCM.^[45] The CFTC’s action against Bitfinex marks the agency’s initial foray into the regulation of Bitcoin via the retail commodity provision transaction. If the history involving the CFTC’s regulation of retail precious metals transactions is any guide, more enforcement actions should be expected.

V. What’s Next?

In at least one respect, the CFTC should be given credit for taking the lead in seeking to regulate a novel product under its jurisdiction. With such an effort, however, comes responsibility. The CFTC should clearly articulate, through an interpretation rather than ad hoc enforcement actions, the manner in which the agency intends to apply the actual delivery exception to virtual currencies. Such an interpretation is necessary so as not to stymie innovation.

At the same time, the CFTC should strive to coordinate the regulation of virtual currencies with other federal agencies, some of which have shown an interest in regulating such products.^[46] For example, if the Securities and Exchange Commission were to classify Bitcoin or another virtual currency as a “security,” market participants could be compelled to comply with two fundamentally different, and in some ways redundant, regulatory regimes. We have seen dual jurisdiction applied to certain other products—security futures and mixed swaps come to mind—and the outcomes have not been ideal. Here, as before, the CFTC should be aggressive in seeking to address regulatory harmonization.

Finally, for market participants, the CFTC has sounded the bell. In offering virtual currencies to customers, market participants must understand and be sensitive to the scope of the CFTC’s jurisdiction. If a swap or futures contract is involved—including a seemingly innocuous embedded option in which the customer has the right to cancel or offset a purchase—or a retail spot transaction involves any form of financing, margin or leverage, the CFTC has shown its willingness to take action—even in the absence of allegations of fraud or other wrongdoing.

† Partner, Global Head of Derivatives, Baker & McKenzie LLP.

[1] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[2] Commodity Exchange Act of 1936, Pub. L. No. 74–675, 49 Stat. 1491 (codified as amended in scattered sections of 7 U.S.C.) (replacing the Grain Futures Act of 1922).

[3] See generally Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, 124 Stat. 1376 (2010).

[4] See 17 C.F.R. § 1.3(yy) (2016).

[5] See Commodity Futures Commission Trading Act of 1974 § 101, 7 U.S.C. § 2(a)(1)(A) (2012). When Congress created the CFTC in 1974, it “confer[red] on the CFTC ‘exclusive jurisdiction’ over commodity futures and options thereon, which means that these instruments cannot be regulated by any other federal or state agency (except in certain limited circumstances where the CEA explicitly contemplates shared authority between the CFTC and another agency).” President’s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (1999). The purpose of the exclusive jurisdiction provision “was to separate the functions of the new CFTC from those of the SEC and other regulators.” Leist v. Simplot, 638 F.2d 283, 314 (2d Cir. 1980).

[6] See, e.g., Binyamin Appelbaum, On Finance Bill, Lobbying Shifts to Regulation, N.Y. Times (June 26, 2010), http://www.nytimes.com/2010/06/27/business/27regulate.html? (noting that the Dodd-Frank Act is “basically a 2,000-page missive to federal agencies, instructing regulators to address subjects ranging from derivatives trading to document retention” and observing that “it is notably short on specifics, giving regulators significant power to determine its impact—and giving partisans on both sides a second chance to influence the outcome”).

[7] See 7 U.S.C. § 1(a)(9) (2012).

[8] See id. at § 2(a)(1)(A).

[9] See id. at § 1(a)(9).

[10] In 1958, as a result of rife manipulations in the onion market, Congress enacted the Onion Futures Act to ban futures trading in onions. Id. at § 13-1; see also Bd. of Trade of Chi. v. SEC, 677 F.2d 1137, 1142 n.9 (7th Cir. 1982) (discussing the onion carve out from the CEA).

[11] As part of the Dodd-Frank Act, Congress banned—at the urging of associations representing the motion picture industry—the trading of derivatives on motion picture box office receipts. See 7 U.S.C. § 13-1 (2006), amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-190, § 721(e)(10), 124 Stat. 1376, 1672 (2010); see also Daniel Frankel, 10 Key Moments in the Life of Movie Derivatives, THE WRAP (Aug. 13, 2010, 6:53 PM), http://www.thewrap.com/movies/article/10-key-moments-life-movie-derivatives-20122.

[12] See 7 U.S.C. § 1a(9).

[13] See 7 U.S.C. § 2(a)(1)(A).

[14] See 17 C.F.R. § 1.3(yy) (2016) (“Commodity interest . . . means (1) Any contract for the purchase or sale of a commodity for future delivery [a futures contract]; (2) Any contract, agreement or transaction subject to a Commission regulation under section 4c [commodity options] or 19 of the Act [leveraged contracts]; (3) Any contract, agreement or transaction subject to Commission jurisdiction under section 2(c)(2) of the Act [retail foreign exchange and commodity transactions]; and (4) Any swap as defined in the Act, by the Commission, or jointly by the Commission and the Securities and Exchange Commission [a swap as defined in CFTC Rule 1a(47)].”).

[15] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[16] In re Coinflip, Inc., CTFC No. 15-29, 2015 WL 5535736, at *3 (Sept. 17, 2015).

[17] Id. at *2.

[18] Id.

[19] Id. at *n.2.

[20] Id.

[21] Id. at *3–4. A swap execution facility is a trading system or platform, other than a designated contract market, in which multiple participants have the opportunity to enter into swaps by accepting bids and offers made by multiple participants on the facility. See Commodity Exchange Act of 1936 § 1a(50), 7 U.S.C. § 1a(50) (2012).

[22] See id. at *5 (explaining that under the terms of settlement, the defendants agreed to cease and desist from future violations of the CEA and the CFTC’s rules, but no financial penalty was imposed).

[23] In re TeraExchange LLC, CFTC No. 15-33, 2015 WL 5658082 (Sept. 24, 2015).

[24] Like the Coinflip matter, the CFTC and the defendants agreed to a settlement involving a cease and desist order, but no financial penalty. Id. at *8–9.

[25] In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612 (June 2, 2016).

[26] See id. at *2.

[27] See id. at *3.

[28] The CFTC staff has defined a spot transaction as one where immediate delivery of the product and immediate payment for the product are expected on or within a few days of the trade date. See CFTC No-Action Letter, CFTCLTR No. 98-73, 1998 WL 754623 (Oct. 8, 1998). The Supreme Court has defined a spot transaction as a purchase or sale agreement for a commodity that is intended to settle in the period that is ordinary for dealings in the relevant type of commodity. See Dunn v. CFTC, 519 U.S. 465, 472 (1997). As noted by the Sixth Circuit, “because the CEA was aimed at manipulation, speculation, and other abuses that could arise from the trading in futures contracts and options, as distinguished from the commodity itself, Congress never purported to regulate ‘spot’ transactions (transactions for the immediate sale and delivery of a commodity) or ‘cash forward’ transactions (in which the commodity is presently sold but its delivery is, by agreement, delayed or deferred).” CFTC v. Erskine, 512 F.3d 309, 321 (6th Cir. 2008). Spot transactions are, however, subject to the anti-manipulation provisions under the CEA and the CFTC’s rules to the extent that such attempted or actual manipulations affect prices in commodity interests. See, e.g., 7 U.S.C. §§ 9, 15 (2012); 17 C.F.R. § 180.1(a) (2016); see also CFTC v. Atlantic Bullion & Coin, Inc., C.A. No. 8:12-1503-JMC (D.S.C. 2010), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfatlanticcomplaint060612.pdf.

[29] See, e.g., CFTC v. Hunter Wise Commodities, 21 F. Supp. 3d 1317 (S.D. Fl. 2014); CFTC v. Palm Beach Capital, No.14-cv-80636 (S.D. Fl. 2014), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfpbeachorderdf073114.pdf.

[30] See 7 U.S.C. § 2(c)(2)(D).

[31] Id.

[32] An ECP is defined to include, among others, (i) an organization with total assets in excess of $10 million; (ii) a corporation that (a) has a net worth in excess of $1 million and (b) uses commodity interests in connection with its business or to hedge commercial risk; (iii) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $10 million; or (iv) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $5 million, where such individual is using the instrument in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual. 7 U.S.C. § 1a(18). An eligible commercial entity is defined in § 1a(17).

[33] The CFTC takes a broad view of the scope of this element. Essentially, if the purchaser of the commodity is not required to fully pay for the commodity upon purchase, then the CFTC will likely presume that leverage or financing is involved in the transaction. See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1) (“New CEA section 2(c)(2)(D) of the CEA broadly applies to any agreement, contract, or transaction in any commodity that is entered into with, or offered to (even if not entered into with), a non-eligible contract participant or non-eligible commercial entity on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.”) (emphasis added).

[34] See 7 U.S.C. § 6d.

[35] See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[36] See id. at 52,427.

[37] See Retail Commodity Transactions Under Commodity Exchange Act, 76 Fed. Reg. 77,670 (Dec. 14, 2011) (to be codified in 15 C.F.R. pt. 922); Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[38] The Bitfinex platform permitted maximum leverage of 3.33-to-1 (that is, a 30% initial margin requirement). See In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612, at *2 (June 2, 2016).

[39] Id. at *5.

[40] Id.

[41] A “private key” is a secret number associated with a deposit wallet that allows Bitcoins in that wallet to be accessed and spent. The private keys, which are randomly assigned, are mathematically related to all Bitcoin addresses generated for the wallet. See Private Key, Bitcoin Wiki, https://en.bitcoin.it/wiki/Private_key (last visited Oct. 26, 2016).

[42] See In re BFXNA Inc., 2016 WL 3137612, at *5.

[43] See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[44] Cf. In re BFXNA Inc., 2016 WL 3137612. The Bitfinex order prompted a petition that requests the CFTC to clarify the “actual delivery” requirements in the context of virtual currencies. See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[45] Under the terms of the settlement, Bitfinex agreed to pay a civil money penalty of $75,000 and cease and desist from further violations of the subject CEA provisions. Id. at *6.

[46] See, e.g., Investor Alert: Bitcoin and Other Virtual Currency-Related Investments, U.S. Sec. & Exch. Comm’n (May 7, 2014), https://www.sec.gov/oiea/investor-alerts-bulletins/investoralertsia_bitcoin.html.

August 9, 2016 By ehansen

It Ain’t Broke: The Case For Continued SEC Regulation of P2P Lending

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Benjamin Lo^†

Introductory Note

In 2008, the Securities and Exchange Commission made waves by deciding to regulate the nascent peer-to-peer lending industry. Only two lending platforms survived the SEC’s entry into a previously lightly-regulated market. Under this regulatory setup, the SEC would regulate the lending-investing process, while other agencies like the Consumer Financial Protection Bureau and Federal Trade Commission would regulate the borrower side of the business. In subsequent years, entrepreneurs, academics, and lawmakers struggled with the question of whether this bifurcated approach should be replaced by a consolidated regulatory approach, supported by an exemption of P2P lending platforms from federal securities laws. This Article argues that the existing bifurcated system works and is continually getting better as the SEC amends existing exemptions and introduces new regulations to smooth the path for financial innovation. It uses data and empirical methods to further examine the relative welfare of borrowers and retail lenders in P2P transactions. It concludes that (i) unlike brick-and-mortar transactions, retail lenders require more protection than borrowers in the P2P world and (ii) the SEC is uniquely suited to protect these retail lenders and should continue to do so, with some recommended modifications.

* * *

I. Introduction

In 2006, a company called Prosper had an audacious idea: helping people borrow thousands of dollars online from strangers. News coverage at the time was slightly incredulous, describing the startup as “ingenious and faintly surreal – its premise is that strangers . . . will come together to execute meaningful, serious[,] and risky transactions in a self-consciously anonymous environment.”[1] Ten years later, peer-to-peer (P2P) loan platforms in the United States have issued $5.5 billion in loans.[2] In a significant departure from traditional bank-based lending, individual retail lenders (“lenders” or “individual lenders”) are loaning money to anonymous borrowers on P2P loan platforms, often based on a combination of verified and unverified data. This is how it works: borrowers register on a P2P loan platform and submit information in a loan application;[3] the loan platform then assigns the loan a quality score before posting the loan anonymously to their platforms to attract lender funding.[4]

This novel industry has been the subject of intense regulatory debate, due to concerns over consumer protection. The early days of P2P lending were fraught with risk to lenders, who were largely individuals rather than traditional institutional creditors.[5] Even as the industry grew, lenders bore painfully high default rates―Prosper was charging off more than 20% of loans issued before 2008, while Lending Club fared better, but still had 8.5% of its pre-2008 loans in default.[6] In comparison, consumer loan charge-offs and delinquencies at commercial banks averaged around at 5.5% and 4.7% respectively during the same period in 2009.[7]

Regulatory ambiguity ended in 2008; the Securities and Exchange Commission (SEC) fatefully intervened on November 24 and entered a cease-and-desist order (the Order) against Prosper.[8] According to the SEC, Prosper (and by extension, other for-profit P2P loan platforms) were selling “securities” and thus came under the ambit of the 1933 Securities Act. These P2P loans thus had to be registered with the SEC to comply with federal securities laws.[9] This caused a massive industry shakeout. Prosper and Lending Club successfully registered their offerings with the SEC, but other P2P loan platforms such as Loanio, Virgin Money, and Pertuity soon folded under the burden of complying with the SEC’s Order.[10]

The SEC’s Order had far-reaching implications for the P2P lending model. Lending Club and Prosper faced significant registration and reporting requirements. These for-profit P2P loan platforms had to shelf-register each loan (known as a “note”) ahead of any given lender’s investment.[11] They had to record details of each funded loan with the SEC in a “posting supplement” placed on EDGAR (the SEC’s disclosure archive),[12] thus publicly storing the borrower’s data and disclosures for the public to see. Unsurprisingly, these registration requirements were difficult to implement for incumbents, and are nearly insuperable for new entrants.

The SEC’s Order also fundamentally changed the transactional relationships among the borrower, lender, and platform. Prior to the SEC’s Order, when borrowers and lenders matched, “Prosper would signal WebBank, a Utah-chartered industrial bank, to make the loan to the borrower. WebBank would assign the note to Prosper, which then assigned it to the lender.”[13] Effectively, the platform merely intermediated a loan between the borrower and the lender. The transaction has become significantly more complicated after the SEC’s Order. Today, the lender starts the process by signaling interest in a prospective borrower. When the loan receives enough indications of interest, WebBank funds the borrower but assigns the loan to the platform, not to the lenders. The platform then sells a separate debt instrument backed by the original loan to the lenders, who become creditors of the platform rather than the borrower.[14] The approach is cumbersome and exposes lenders to additional risk, as it entirely eliminates any status lenders may have as secured creditors of the platform.[15] Unfortunately, offering lenders a partial or whole security interest in the loan would potentially make them registrants or underwriters of the security, and thus this workaround resulted.[16]

Despite these restrictions, P2P lending has taken off. Lending Club and Prosper have issued more than $13 billion in loans since 2006, with the majority of loan growth concentrated in the past three years.[17] These online marketplaces for personal loans have also benefited both borrowers and lenders by stripping some costs out of the transaction. For example, Lending Club claims that “the traditional banking system is burdened by its high fixed cost of underwriting and services, in part due to its physical infrastructure and labor- and paper-intensive business process . . . .”[18] These platforms may drive additional benefits, such as the potential to harness the “collective intelligence of potential lenders” and its function as an alternative source of capital during the 2008 credit crunch.[19]

One of the central questions gripping the industry has been that of the optimal regulatory structure. As P2P lending took off, entrepreneurs, academics, and lawmakers struggled with deciding who should regulate the industry. Should they allow the SEC to retain jurisdiction alongside other regulators (the bifurcated approach), or should they consolidate oversight under the Consumer Financial Protection Bureau (CFPB) and exempt platforms from federal securities laws (the consolidated approach)? This Article answers that question with the benefit of new data and developments. Section I describes the battle between the bifurcated and consolidated approaches. Section II refutes criticisms of the bifurcated approach. Section III explains the novel risks individual lenders face in P2P lending markets, thus justifying SEC involvement. Section IV outlines modest proposals for the SEC to improve their oversight of the industry.

II. Concerns Around An Ill-Fitting Regulatory Approach

In 2011, a Government Accountability Office (GAO) report studied two distinct approaches toward regulating P2P lending. The status quo involved a bifurcated regulatory regime, with the SEC and state securities regulators protecting lenders through disclosure requirements, and prudential regulators such as the Federal Deposit Insurance Corporation and CFPB focusing on borrower protection.[20] The alternative consolidated regulatory regime “would assign primary federal responsibility for borrower and lender protection to a single regulator, such as [the] CFPB[,] . . . [and] would require exempting person-to-person lending platforms from federal securities laws.”[21] The report noted that “[t]he key distinction between the two primary options for regulating person-to-person lending is how they would protect lenders.”[22]

Shortly after the GAO report was published, Andrew Verstein, who is now a Wake Forest Law School professor, published the first comprehensive study analyzing the shortcomings of SEC regulation of P2P lending.[23] Broadly, Verstein advances three criticisms of SEC regulation. First, the cost of SEC compliance would selectively burden certain P2P business models and restrict industry growth. Second, the SEC had no mandate to protect borrowers and might privilege lenders over borrowers when requiring information disclosure. Third, SEC involvement actively hurt lenders by imposing additional risks.

On the first issue, Verstein describes how for-profit P2P loan platforms would continue to be harmed by the registration process. P2P loan platforms cannot sell notes before the registration statement becomes effective, and must continue to amend their SEC filings in the post-effective period at great effort.[24] Verstein notes, “The costs and delays from SEC regulation of P2P lending resulted in a substantial reduction in the number of P2P platforms . . . . In this climate, many P2P platforms have found it difficult to compete and grow.”[25] As for borrowers, Verstein worries that mandatory disclosures in SEC filings compromised borrower privacy with little benefit to the lenders, since even the SEC admitted that few people use EDGAR to access information about P2P investments.[26] The SEC has no mandate to protect borrowers and could potentially “ossify a ruthlessly pro-lender bias for P2P disclosure.”[27] Finally, securities registration may have made lenders worse off. P2P loan platforms were forced to opt for shelf registration under Securities Act Rule 415, which is the only way for issuers to register a group of securities far in advance of their issuance.[28] However, shelf registration meant that the platform had to serve as the issuer, rather than the individual borrowers, thus exposing the lender to the credit risks of both borrowers and the platform.[29]

Verstein believes that the better solution would be to consolidate regulation of P2P loan platforms under the CFPB. This new agency could craft tailored disclosures that balanced borrower privacy against misleading advertising and disclosures for lenders. The CFPB’s prudential regulatory scheme could further negate some of the unwanted side effects of a purely disclosure-based regime.[30] This perspective helped clarify two opposing positions on the “optimal regulator” for the P2P lending industry. One camp strongly supported the CFPB, since it would impose none of the registration costs outlined above, while also furnishing the additional benefit of being better placed to apply federal consumer protection laws on behalf of borrowers.[31] In contrast, the opposing camp argued for a “wait-and-see” approach that permitted the bifurcated regime to continue. Chief among their reasons were concerns that experienced securities and lending regulators would be foreclosed from applying their expertise to a rapidly evolving industry, instead replacing joint oversight with a single new regulatory entity potentially subject to regulatory capture.[32] Proponents of the bifurcated regime also argued that it was too early to claim that the industry was “stifled by overregulation” and that unchecked growth might foretell a crash.[33] The bifurcated regime has turned out to be the correct choice, due to changes in the SEC’s approach, as well as new empirical data suggesting that lenders require more protection than borrowers in P2P lending markets.

III. The SEC’s Approach Ain’t Broke No Longer

Four years later, the dire shortcomings of the bifurcated approach have failed to materialize. Proponents of a consolidated approach under the CFPB had fretted that the cost of SEC regulation was simply too high and would halt industry growth in its tracks.[34] Yet the SEC has expanded private placement exemptions and put in place new regulations to lower the regulatory barrier to entry, effectively exempting new P2P loan platforms from the dreaded registration burden. The bifurcated approach will also likely benefit borrowers, since the centrality of loan platforms in P2P transactions offers an easier single point of application of consumer financial protection laws. But perhaps the most powerful argument in favor of the SEC’s continued role comes from protections that disclosure rules may offer lenders. Empirical analysis shows that the tables have turned on lenders. Unlike traditional credit markets, lenders require more protection than borrowers in P2P lending transactions due to their retail status. Thus, each of the original arguments against the SEC’s involvement have been mitigated or even overturned with time.

A. Rule 506(c) and Regulation Crowdfunding Lower Barriers to Entry

At the outset, the notion that P2P lending growth has been chilled by regulation should be dispelled. P2P lending volumes at Prosper and Lending Club (both of whom collectively controlled 98% of the P2P market in 2014) grew from $871 million in loans in 2012 to $2.4 billion in 2013.[35] By one estimate, P2P loans in the U.S. reached $5.5 billion in 2014, and are projected to reach $150 billion by 2025.[36] By any measure, growth has been rapid.

The remaining concern should thus be whether new entry is still significantly challenged by regulatory barriers to entry. But, since 2013, the SEC has adopted new rules that lower these barriers. The main hurdle faced by for-profit P2P loan platforms, following the SEC’s application of the Howey test,[37] was the need for costly and burdensome registration regardless of business size. In 2011, there were several exemptions that could have removed P2P loans from the ambit of federal securities laws (and, correspondingly, eliminated the need for registration), but most had aggregate offering amount caps which were too low to support the scale of a P2P lending operation.[38] An exemption under Rule 506, which does not have an aggregate offering limit, could have permitted the platforms to execute private placements but for the prohibition on “general advertising” and “general solicitation” (stemming from the Rule 502(c) limitations on the manner of offering).[39] A securities offering made over the Internet—a fundamental sales channel for a P2P loan platform—might be deemed by the SEC to involve general advertising or general solicitation and thus would not qualify for the Rule 506 exemption.[40] Thus, to avoid registration, P2P loan platforms would either have to stay extremely small and give up any economies of scale, or would have to avoid marketing the securities through standard sales channels—both untenable propositions for any consumer-focused business.

Fortunately, the SEC implemented Rule 506(c) in September 2013, which “permits issuers to use general solicitation and general advertising . . . when conducting an offering pursuant to [Rule 506(c)], provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors.”[41] What this means is that as long as the platforms make a reasonable effort to ensure that lenders are “accredited investors,”[42] they should be able to offer and sell an unlimited amount of loans to lenders without going through registration.

The dominant lending platforms, Lending Club and Prosper, do not need this exemption since they already have a shelf-registration process in place. But new entrants into the P2P lending arena may yet take advantage of this exemption, especially as it grows in popularity. General use of Rule 506(c) is still small. More than 900 new offerings were conducted in reliance on Rule 506(c) in 2014, raising more than $10 billion in new capital.[43] But this is small compared to the 9,200 offerings valued at $233 billion sold under the old “private” Rule 506 exemption.[44] As the Rule 506(c) exemption gains popularity, it could emerge as a powerful tool to incubate new platforms among informed lenders, thus undercutting concerns around insuperable regulatory barriers to entry. Previous commentators have noted that P2P lending startups are in a catch-22: they cannot legally begin operating without registration or afford registration without venture funding, but they will not get venture funding without acquiring customers through their operations.[45] This exemption dispels some of those concerns. The new entrants can start with Rule 506(c) to grow their customer base. Once they obtain funding, they can then transition to shelf-registration to ensure that their securities enjoy the full benefits of a registered offering, such as the ability for buyers to freely resell their securities.

In a related development, the SEC recently implemented a separate crowdfunding exemption pursuant to the CROWDFUND Act of 2012.[46] Some provisions of the SEC’s final rule regarding crowdfunding (Regulation Crowdfunding) appear to further ease entry into the P2P lending market. Borrower companies may raise up to $1 million in a 12-month period, from both accredited and unaccredited investors, subject to individual investment limits and certain financial statement disclosure requirements.[47] The offering must also be made through a broker or funding portal.[48] Regulation Crowdfunding allows platforms to match borrowers and lenders on a marketplace, without requiring the platform to register any securities. This partially resurrects the original transaction structure proposed by lending platforms: lenders can lend money directly to borrowers, with the platform only providing a marketplace in which the transaction can take place. Admittedly, Regulation Crowdfunding does not fully open the door to the original model, since the exemption exempts small business issuers from registration, and further requires issuers to file certain disclosures with the SEC.[49] But while this exemption would not necessarily benefit new entrants seeking to replicate Lending Club or Prosper’s business model, it opens the door to currently unavailable P2P lending structures such as a platform for crowdfunded small business loans.[50] The increasing availability of exemptions for all aspects of P2P funding is evidence that the slow-growth and barrier-to-entry concerns are unwarranted.

B. Single Point of Application for Consumer Financial Protection Regulation

Proponents of the consolidated approach were justifiably concerned that the SEC would focus on protecting lenders at the expense of borrowers.[51] Holding aside that the status quo involves a multi-agency approach that includes the CFPB, there have been additional benefits accruing to borrowers due to the SEC’s involvement. The SEC’s registration requirement forces the lending platform to issue loans to borrowers in the platform’s own name. Essentially, the platforms have stepped in to act as a clearinghouse. This structure may be detrimental to lenders since they no longer retain a security interest in the borrower’s loan.[52] However, it may have the happy, and likely unintended, consequence of providing additional protections for borrowers. Many of the major consumer financial protection laws, such as the Truth-in-Lending Act (TILA) and the Equal Credit Opportunity Act (ECOA) can be more effectively applied against a lending platform than against individual lenders. By issuing lenders a borrower-dependent payment note instead of assigning the borrower’s obligation to the lender, the platform truly assumes the role of “creditor” in each transaction. The platform thus provides a single point of application for the enumerated consumer financial protection laws.

To highlight how this works, consider creditors’ obligations under TILA. A covered creditor must “disclose any finance charge; report interest rates as annual percentage rates; identify the creditor; list the amount financed; enumerate the payment schedule; describe late fees; and suggest that the consumer consult a tax adviser.”[53] However, not everyone who lends money is a covered creditor. A creditor is only subject to TILA requirements if he “regularly extends . . . consumer credit” and “is the person to whom the debt arising from the consumer credit transaction is initially payable on the face of the evidence of indebtedness. . . .”[54] An entity “regularly extends” credit if it did so more than twenty-five times in the preceding year.[55] In the original transaction structure where the notes were made payable to the individual lender, attaching TILA obligations to the platform or the funding bank could be difficult if the debt was initially payable to the individual lender. It would be even more difficult to attach TILA obligations to individual lenders—logistics of forcing lenders to comply with TILA aside, the lenders have to regularly extend credit to be covered under TILA. Having the borrowers be clearly obligated to the funding bank or platform provides a logical and sensible party to which TILA duties can attach.

The benefits of a single point of application for ECOA are even clearer. One of the key ECOA requirements is the adverse action notice: if the borrower’s application for credit is denied, he is entitled to an adverse action “providing statements of reasons in writing as a matter of course to applicants against whom adverse action is taken.”[56] In the original transaction model, lenders might arguably have been required to issue adverse action notices, as ECOA creditors include “any assignee of an original creditor who participates in the decision to extend, renew, or continue credit.”[57] This requirement would have been unworkable, and potentially imposed civil liability on lenders, as ECOA provides a private right of action.[58] However, the present model appropriately places the full weight of ECOA compliance on lending platforms and funding banks since they are the creditors actually making the loans.[59]

The above arguments posit that borrowers receive better protections because of the transactional structure imposed by the SEC. However, they do not directly address the issue of borrower privacy and the potential ossification of a “ruthlessly pro-lender bias” that so concerns Verstein.[60] In Section III-A, this Article describes how empirical analysis shows that borrowers are getting a good deal and face a relatively low risk of exploitation by lenders and the lending platforms.

C. Lenders, Not Borrowers, Need Help in the P2P Lending Market

The traditional borrower-lender dynamic has typically favored lenders over borrowers due to the disparity in negotiating leverage between the parties. Borrowers often pit themselves against banks selling financial products with “incomprehensible terms and sharp practices that have left families at the mercy of those who write the contracts.”[61] This does not appear to be the case here. Based on loan data provided by Lending Club, it appears that in P2P lending transactions, borrowers are doing quite well. They are not subject to the same risks as those in the brick-and-mortar lending world. Conversely, lenders have entered the lending market for the first time, and are making small but significant mistakes when processing the reams of data made available to them. The tables have turned on lenders, and the SEC is uniquely suited to protect these neophyte investors through better disclosure.

IV. The Tables Have Turned On Lenders

The following analysis is based on an empirical study of 391,888 of Lending Club’s loans made from 2007 to 2013, of which 33,592 are matured and have been fully paid down or charged off.[62] Each loan contains significant borrower disclosures that lenders rely on to make an investment decision. This appears to be the first empirical contribution to the bifurcated versus consolidated regulatory approach debate. Results show that borrowers appear to enjoy better rates than they would have obtained on their immediate source of credit—credit cards. They are also well protected from lender exploitation by a combination of Lending Club collection policies and the collective action problem of collecting on small loans. In contrast, lenders may need to be protected from themselves, since they often misinterpret key information offered by borrowers. Summary statistics are reproduced below.

Table 1: Lending Club Loans By Grade And Year

Table 2: Loans by Selected Verified Borrower Information Variables

Table 3: Loans By Borrower Disclosure Information (Discrete Variables)

A. Borrowers Get Better Rates While Subject to Fewer Abusive Practices

To evaluate whether Lending Club borrowers are getting better interest rates, the empirical study regresses average Lending Club rates for 36-month loans on alternative sources of credit from 2007 to 2012. Controlling for individual borrower characteristics, the study shows that for every 100 basis point (bps) increase in rates for comparable credit products—for example, personal loans, existing credit card APRs, and new card APRs—Lending Club’s average rates rise between eight and thirty bps. Thus, Lending Club’s average rates appear less sensitive than bank rates, which would have benefited borrowers during the 2008 to 2010 credit crunch. During this period, credit card interest rates stayed mostly flat, between 13% and 14% APR—though personal loan rates fell, likely due to rapidly tightening loan issuance standards.[63] Lending Club’s rates stayed relatively flat at 11% to 12% over the same period, resulting in relatively better rates for the average borrower during the credit crisis. It is possible that Lending Club was capturing higher credit-quality borrowers from banks during this period, generating a compositional shift that dampened rate increases. However, banks were implementing tighter lending standards, and fewer borrowers were qualifying for traditional bank credit.[64] Thus, Lending Club may have been able to offer lower rates for equivalent- or greater-risk customers who were unable to obtain bank loans.[65]

Most Lending Club borrowers also appear insulated from overpayment exploitation. Overpayment occurs when missed payments and late fees begin compounding, increasing the borrower’s outstanding obligation. This is a common concern in payday lending.[66] Table 1 analyzes just-matured loans, showing the breakdown of overpaying borrowers and the amount overpaid relative to loan size. Lower quality borrowers have a higher risk of overpaying as they are more likely to be miss payments, consistent with their poorer credit quality. Yet on the whole, only 3.8% of borrowers—1,277 out of 33,592 borrowers whose loans terms were completed—paid more than the contracted installments, including charged-off loans. This is in line with the overall delinquency rate on consumer loans at commercial banks, which ranged from 2.4% to 4.9% from 2007 to 2012.[67] Further, borrowers overpaid from 0.4% to 1.5% of the amount borrowed. These overpayment amounts are unremarkable. For comparison, credit card accountholders with FICO above 660 (non-subprime borrowers) historically paid 2-4% of their average daily balance in late fees and over-limit fees, which indicate that overpayment ratios on P2P loan platforms are reasonable.[68]

Table 4: Borrower Overpayment By Loan Grade

Borrowers also appear relatively free from predatory penalties and collections practices. Lending Club’s collection and recovery process appears fairly forgiving. Borrowers are given a fifteen-day grace period, after which they are charged a $15 flat fee or 5% of the missed monthly payment, whichever is greater.[69] This charge only occurs once per missed payment, avoiding potential pyramiding charges.[70] If the borrower is thirty or more days late, the loan is often turned over to an external collection agency; at 150 or more days late, it is charged off the investors’ portfolios.[71] However, Lending Club does not make a policy of aggressively pursuing recoveries, and notes that “recoveries on previously charged-off loans are infrequent.”[72] Table 4 shows the results of these comparatively lenient policies: average late fees per loan range between $14 and $32. Recoveries rarely exceed 1% of total loan amounts and are typically less than $60 per loan; the only anomaly is a large recovery in Grade G loans, which dramatically skews the small sample of Grade G loans. Correspondingly, it is reasonable to conclude that P2P borrowers have significantly different experiences from payday loans and other forms of predatory lending. The P2P borrower experience is far more in line to that of a typical consumer loan customer or credit card customer with solid credit at a commercial bank.

Table 5: Breakdown Of Total Payments Made By Overpaying Borrowers

B. Lenders Are Confused by Their Options

While borrowers are getting a good deal, lenders still misinterpret certain borrower disclosures when choosing which loans to invest in, resulting in suboptimal investment decisions. This may be particularly true for the pre-2012 lending population, which was largely composed of individual lenders.[73] In short, lenders are given a dizzying array of information upon which to base a lending decision, but may need more verification and platform guidance to correctly process the data. These are policies that the SEC is well-suited to require of lending platforms.

The empirical analysis discussed below was conducted based on the following procedure. A series of regressions evaluating the effect of various borrower disclosures on three independent variables were run to deduce how lenders treat each piece of information.[74] The well-informed, rational investor should invest more quickly in attributes that predict better loan performance, resulting in matching signs between Column 2 and Columns 3 and 4. Table 6 provides an overview of congruencies and discrepancies between lender interest and loan performance.

The need for greater lender protections and clearer disclosures becomes evident when the regression results are compared. On the one hand, Lending Club grading criteria appear to be accurate, and lenders can profitably rely on Lending Club’s grades. Table 6 highlights this in Columns 3 and 4, where Lending Club’s grades are strongly predictive of default probability and loss severity. Additionally, the signs on disclosed information in Column 1 closely match those in Columns 3 and 4, implying that Lending Club is correctly incorporating disclosed information into its assessment of loan quality. Yet lenders do not rely solely on Lending Club’s grades. Instead, they revisit borrower disclosures and assign their own interpretation to those data, sometimes resulting in higher default probabilities.

Table 6: Borrower Information Influencing LC, Lenders And Loan Performance[75]

The key takeaways from Table 6 are summarized in the following Exhibit A. The items in the center column describe mismatches between lender expectations—as represented by the variables’ effect on time-to-fund—and actual loan performance.

Exhibit A: Relationship Between Lender Investing Speed And Loan Outcomes

Significant outcome in Columns 3 & 4, matching sign in investor response

Significant outcome in Columns 3 & 4, not matching sign in investor response

Insignificant sign in Columns 3 & 4, cannot be compared

LC assigned outcomes

§ Assigned LC grade

§ Interest rate

§ Loan amount

LC assigned outcomes

§ N/A

LC assigned outcomes

§ N/A

Lender responses

§ Time to fund

§ Number of investors

Lender responses

§ N/A

Lender responses

§ N/A

Verified information

§ Verified annual income

§ Public record derogations

§ Revolving balance

Verified information

§ Inquiries in the last six months

§ Earliest credit line

§ Revolving utilization

Verified information

§ FICO score

§ Number of delinquencies

§ Number of open accounts

§ Verified income source

§ Annual verified income

Unverified information

§ Unverified annual income

§ No employment info

§ Purpose / moving

§ Purpose / other

§ Purpose / small business

Unverified information

§ Employment length (1 – 10)

§ Purpose / credit card

§ Purpose / education

§ Purpose / medical

§ Purpose / renewable

§ Narrative length

Unverified information

§ Debt-to-income

§ Homeownership / mortgage

§ Homeownership / rent

§ Homeownership / other

§ Homeownership / N/A

§ Homeownership / none

§ Purpose / debt consolidation

§ Purpose / house

§ Purpose / major purchase

§ Purpose / vacation

§ Purpose / wedding

§ Narrative available

The most significant lender mistakes appear to be around interest rates and credit inquiries, which are respectively categorized as Lending Club-assigned outcomes and verified information. Lenders aggressively seek higher interest rates—a 1% increase in interest rate within the same subgrade will reduce time to fund by nearly half a day. However, higher rates are associated with higher charge-offs even controlling for all other factors, possibly due to the effect on borrower ability-to-pay—an effect well-established in the literature.[76] Additionally, lenders appear to disregard inquiries made in the last 6 months, despite a significant impact on default risk. Lenders also disdain higher FICO and prefer higher revolving utilization. Unfortunately for them, lower FICOs and higher revolving utilization lead to higher charge-offs.

For unverified information, lenders make fewer “mistakes” but could still benefit from clearer guidance. They appropriately stay away from borrowers who do not disclose employment, and are correctly wary of borrowers whose stated loan purpose is “moving,” “small business,”[77] and “other.”[78] However, lenders may be missing certain indicators of poor performance. For example, they do not respond significantly to medical and education loans, even though those tend to charge off at a greater rate with higher severity. Conversely, they also tend to base their decisions on attributes that do not seem to have a significant impact. In particular, lenders lend more quickly to borrowers paying rent or mortgages, relative to borrowers who own their homes. Yet these types of homeownership are not associated with significantly better or worse loan performance than that of a home-owning borrower. When it comes to borrower narratives, lenders care about whether descriptions are offered, but appear to care less about the quantity of information disclosed in those descriptions. Having a description reduces time to fund by 0.1 days, but does not significantly affect loan performance. Conversely, the amount of information volunteered by borrowers in their descriptions does impact charge-off probability and loss severity, which lenders fail to take into account. Longer borrower narratives are correlated to lower charge-off probability. Borrowers may be, somewhat surprisingly, using this section to establish their bona fides, rather than tricking soft-hearted lenders into extending foolish credit.

Lenders need the SEC’s help. Admittedly, the SEC’s involvement is not uniformly beneficial to lenders. Lenders’ inability to receive a security interest in the underlying loan surely puts them at greater risk should a P2P loan platform become insolvent. But the preceding analysis shows that this may be a necessary cost to keep the SEC involved and protective of lenders. Lenders are offered literally dozens of categories of information, which can be material or immaterial, verified or unverified, voluntary or mandatory. This is a scenario that fits well in the SEC’s wheelhouse, despite playing out in a novel P2P setting. The SEC’s mission to “protect investors, maintain fair, orderly and efficient capital markets, and facilitate capital formation”[79] applies neatly to P2P lending transactions, especially as platforms begin moving upmarket into bigger loans—for example, small business loans.[80] Keeping the SEC front and center, alongside other agencies such as the CFPB and state lending agencies, ensures that lenders who invest in the booming P2P lending market will continue receiving the disclosure protections they need most.

V. Proposals To Fine-Tune The Existing Disclosure Regime

Lenders need additional protections and better disclosure to flourish in the brave new world of P2P lending. The SEC has identified several strategic goals (the Strategic Plan) that are relevant to lenders. Chief among them is “work[ing] to ensure that investors have access to high-quality disclosure materials” containing initiatives such as “design[ing] and implement[ing] new disclosure regimes for specialized categories of issuers so that investors in these products have relevant and useful information to make informed investment decisions.”[81] While the Strategic Plan did not specifically call attention to P2P financing, the rapid growth of this market means that it cannot be overlooked as the SEC implements its initiatives under this goal. The SEC should consider two reforms that would encourage production of reliable information to assist lenders in their decision-making.

First, the SEC should direct P2P loan platforms to improve their verification processes. Lenders appear to rely on much of the unverified information when making lending decisions. Currently, platforms focus verification efforts on income data, with useful results. Borrowers with verified income are typically considered worse risks, since poor quality borrowers are required to, or may volunteer, additional information such as tax returns or pay stubs to verify their disclosed income.[82] This is only one example of how verification improves material information. To build on these informational benefits, P2P loan platforms should be required to verify all income disclosures, and take reasonable steps to verify other material disclosures such as employment and homeownership.[83] For less-easily verifiable information, such as loan purposes, platforms might be able to increase truthfulness by highlighting the borrower’s potential antifraud liability for misrepresentation. While these would be difficult to enforce privately, it might nonetheless increase truthful disclosure on the margin.

Second, the SEC should direct P2P loan platforms to provide more explanatory disclosures to its lenders. Exhibit A shows several examples of relevant borrower disclosures that seem to be ignored by lenders. For example, certain unverified information (such as borrowing to pay off credit card debt) and even verified information (such as number of inquiries in the last six months) do not appear to affect lender enthusiasm. The platforms’ risk-scoring algorithms are closely-held secrets, and may already account for these attributes during the loan-grading process. However, lenders might benefit from clear and prominent summaries by the platforms about which attributes tend to predict better or worse loan performance, all else held equal. Notably, this disclosure will only help if all material information is verified, since doing otherwise would invite borrowers to game the system by manipulating their information.

Finally, the SEC itself needs a more targeted approach towards defining materiality. The SEC’s “basic perspective is as follows: if a platform gives lenders any shred of information, it must matter to lenders; if it matters to lenders, it must be material to their lending decision; and if it is material to the lending decision, it must be posted on the EDGAR system.”[84] But by forcing all borrower-disclosed information onto EDGAR, the SEC may have chilled certain valuable disclosures from ever being made. Table 5 shows that borrower narratives tend to reduce charge-off probability and loss severity. Yet over the past few years, narratives have nearly disappeared from the platform. According to Table 6 below, 98% of loans had narratives in 2007. By 2014, less than 10% of loans contained narratives. One possible reason might be borrowers’ increasing unwillingness to disclose more than they have to, since these personal stories are etched into EDGAR for eternity.

Table 7: Frequency of loans with voluntary borrower narratives

Any regulatory effort to further protect lenders must take these tradeoffs into account. One approach would be to define a tighter materiality standard. A standard based on the classic “total mix of information available” formulation could be assessed via the statistical significance of investor responses.[85] An alternative materiality standard based on the size of the misstatement could also be applied. For example, the SEC could evaluate the effect on expected losses (default probability multiplied by loss severity) should the borrower misstate or misrepresent a particular loan attribute, to provide a preliminary assessment as to whether the erroneous disclosure is material. In either case, the platforms would have to collaborate closely with the SEC to correctly identify material items. This narrower reading of materiality would bring several benefits. First, it would quantify “materiality” of disclosures in P2P loan offerings and bring it in line with the SEC’s “rules of thumb” on materiality for other securities.[86] Second, it would allow the SEC to select only the most “material” information to capture in EDGAR, and potentially relieve some of the reporting burdens shouldered by the platforms.

To truly ameliorate privacy concerns, however, the SEC should provide some discretion to P2P loan platforms regarding how borrower disclosures that contain personally identifiable information get captured in the shelf registration. For example, it may not be necessary to capture the entire borrower narrative—instead, platforms might be allowed to categorize the narrative under one of several different narrative types. Herzenstein et al. finds six “identity claims” in narratives provided by Prosper borrowers, such as “trustworthy,” “moral,” and “economic hardship.”[87] Using these categories may better protect borrower privacy by preventing inadvertent over-disclosure.

VI. Conclusion

When the GAO issued its P2P lending report, commentators worried that the SEC’s dominant role in the industry would chill growth and block new market entrants; it would fail to protect borrowers and would only harm lenders. But the SEC’s approach has managed to address many of those concerns. It has implemented new exemptions to help people more easily access capital markets. Rule 506(c) and Regulation Crowdfunding should permit other novel transactional structures to fill consumers’ need for capital. The SEC’s required transactional structure may also have had the unintended consequence of making consumer financial protection laws easier to enforce, since it provides regulators with a single point of application to attach relevant obligations. Finally, while the lack of a security interest is indeed unfortunate, the SEC’s role is not uniformly detrimental to lenders. Lenders in this market, more than ever, need better disclosure and information verification, and the SEC is the right agency to continue building those protections.

This does not give the SEC a free pass. More must be done to tailor the disclosure regime to be maximally useful to lenders. Reforms such as more platform verification of borrower information, and plain English descriptions of borrower information and its effects, could help lenders make better decisions. In addition, the SEC must define a better materiality standard to strike the right balance between borrower privacy and lender information. The approach may not be broken, but that doesn’t mean it couldn’t use more fine-tuning.

† J.D. Candidate, Yale Law School, 2017. B.A. in Economics, Dartmouth College, 2010. The Author would like to thank Professor Ian Ayres and Adriana Robertson for their invaluable assistance in developing and reviewing this research, and Professor John Morley for his insights on recent developments in securities regulation.

[1] Farhad Manjoo, The Virtual Moneylender, Salon (May 22, 2006, 9:00 AM), http://www.salon.com/006/05/22/prosper/.

[2] See PriceWaterhouseCoopers LLP, Peer Pressure: How Peer-to-Peer Lending Platforms are Transforming the Consumer Lending Industry 2 (2015), http://www.pwc.com/us/en/consumer-finance/publications/assets/peer-to-peer-lending.pdf.

[3] U.S. Gov’t Accountability Off., GAO-11-613, Person-To-Person Lending: New Regulatory Challenges Could Emerge as the Industry Grows 10–11 (2011).

[4] Id. at 11 (noting that the same process applies to Lending Club, the only other major for-profit P2P lending platform).

[5] Lending Club’s investor base was mostly comprised of individuals until 2012. See How Has Lending Club’s Investor Base Changed?, Lending Club (last visited May 24, 2016), http://kb.lendingclub.com/investor/ articles/Investor/How-has-Lending-Club-s-investor-base-changed/?l=en_US&fs=RelatedArticle (hereafter “Lending Club Investor Base”).

[6] Amy Barrett, Peer-to-Peer Lending Pain, Bloomberg Business (Apr. 2, 2009, 12:00 AM), http://www.bloomberg.com/bw/stories/2009-04-02/peer-to-peer-lending-pain.

[7] See Charge-Off Rate On Consumer Loans, All Commercial Banks, Economic Research Federal Reserve Bank of St. Louis (Feb. 19, 2016, 2:06 PM), https://research.stlouisfed.org/fred2/series/CORCACBS (place cursor over graph where it indicates “2010 Q2”).

[8] Prosper Marketplace, Inc., 2008 WL 4978684 (2008).

[9] See Andrew Verstein, The Misregulation of Person-to-Person Lending, 45 U.C. Davis L. Rev. 445, 475–76 (2012).

[10] Id. at 476 n.144.

[11] Shelf registration allows an issuer to offer securities on a delayed or continuous basis, unlike a standard registered offering, which must typically be offered and sold within a short period of time. See 17 C.F.R. § 230.415 (2015). This is particularly important for high-volume P2P loan platforms, since they can rely on a single effective registration to offer and sell many securities, instead of going through the registration process for every subsequent security offering. See Valerie Demont, Show Me the Money and How to Get It: The Speed and Flexibility of Universal Shelf Registrations, Pepper Hamilton LLP (May 28, 2009), http://www.pepperlaw.com/publications/show-me-the-money-and-how-to-get-it-the-speed-and-flexibility-of-universal-shelf-registrations-2009-05-28/.

[12] LendingClub Co., Member Payment Dependent Notes (Rule 424(b)(3) Filing) (Dec. 20, 2010).

[13] Verstein, supra note 9, at 476–77.

[14] Id. at 477.

[15] Prosper Marketplace, Inc., Amendment No. 3 to Registration Statement (Form S-1) 8 (Apr. 14, 2009).

[16] Id. at 7.

[17] See Prosper Marketplace Surpasses $2 Billion in Personal Loans on Its Platform, Prosper Media Room (Oct. 27, 2014), https://www.prosper.com/about-us/2014/10/27/prosper-marketplace-surpasses-2-billion-in-personal-loans-on-its-platform/; see also Lending Club Statistics, Lending Club (last updated Jun. 30, 2015), https://www.lendingclub.com/info/statistics.action.

[18] LendingClub Co., Annual Report (Form 10-K) 5 (Feb. 27, 2014).

[19] Eric C. Chaffee & Geoffrey C. Rapp, Regulating Online Peer-to-Peer Lending in the Aftermath of Dodd-Frank: In Search of an Evolving Regulatory Regime for an Evolving Industry, 69 Wash. & Lee L. Rev. 485, 503–05 (2012).

[20] See U.S. Gov’t Accountability Off., supra note 3.

[21] Id.

[22] Id.

[23] Verstein, supra note 9.

[24] Verstein, supra note 9, at 51–511.

[25] Verstein, supra note 9, at 512–13.

[26] Verstein, supra note 9, at 501.

[27] Verstein, supra note 9, at 506.

[28] See 17 C.F.R. § 230.415 (2008).

[29] See Verstein, supra note 9, at 491.

[30] See Verstein, supra note 9, at 524–26.

[31] See Paul Slattery, Square Pegs in a Round Hole: SEC Regulation of Online Peer-to-Peer Lending and the CFPB Alternative, 30 Yale J. on Reg. 233, 265–73 (2013).

[32] See Chafee & Rapp, supra note 19, at 529–30.

[33] See Chafee & Rapp, supra note 19, at 530.

[34] See, e.g., Slattery, supra note 31, at 256–258; Carl Smith, If It’s Not Broken, Don’t Fix It: The SEC’s Regulation of Peer-to-Peer Lending, 6 Am. U. Bus. L. Brief 21, 23 (2010).

[35] Banking Without Banks, The Economist, Mar. 1, 2014, http://www.economist.com/news/finance-and-economics/21597932-offering-both-borrowers-and-lenders-better-deal-websites-put-two.

[36] PriceWaterhouseCoopers LLP, supra note 2, at 1.

[37] SEC v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946) (describing the test for whether a financial instrument is an investment contract under the SEC’s jurisdiction―that is., “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”).

[38] See 17 C.F.R. § 230.504 (2015) (providing a $1 million annual limit on Rule 504 exempt offerings); see also 17 C.F.R. § 230.505 (2015) (providing a $5 million annual limit on Rule 505 exempt offerings).

[39] See 17 C.F.R. § 230.506 (2015).

[40] Peter Manbeck & Marc Franson, Chapman and Cutler LLP, The Regulation of Marketplace Lending 7 (Apr. 2015), https://www.aba.com/Tools/Offers/Documents/ChapmanRegulationofMarketplaceLending WhitePaper040815.pdf.

[41] Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 33-9415, 2013 WL 3817300 (Jul. 10, 2013).

[42] See 17 C.F.R. § 230.501 (2015) (defining a natural person as an accredited investor if his net worth exceeds $1 million, excluding the value of his primary residence, or if his individual income exceeding $200,000 in each of the past two years and he has a reasonable expectation of reaching that same income in the current year).

[43] Keith F. Higgins, Director, SEC Div. of Corp. Fin., Keynote Address at the 2014 Angel Capital Association Summit (Mar. 28, 2014), http://www.sec.gov/News/Speech/Detail/Speech/1370541320533.

[44] Id.

[45] Slattery, supra note 31, at 256.

[46] Pub. L. No. 112-106, 126 Stat. 306, §§ 301–305 (2012).

[47] See Crowdfunding, Securities Act Release No. 33-9974, Exchange Act Release No. 34-76324, 80 Fed. Reg. 71388, 71390 (Oct. 30, 2015).

[48] See id.

[49] See id. at 71390, 71398–418.

[50] But see Christine Hurt, Pricing Disintermediation: Crowdfunding and Online Auction IPOs, U. Ill. L. Rev. 217, 251–58 (2015) (describing challenges associated with equity crowdfunding, many of which apply to debt crowdfunding).

[51] See Verstein, supra note 9, at 506.

[52] See Verstein, supra note 9 at 491–92.

[53] Slattery, supra note 31, at 266 (citing Truth in Lending Act, 15 U.S.C. §§ 1605(a), 1667(a), 1638(a) (2012)).

[54] 15 U.S.C. § 1602(g) (2012).

[55] 12 C.F.R. § 226.2(a)(17)(v) (2016).

[56] 15 U.S.C. § 1691(d)(2)(A) (2012).

[57] 15 U.S.C. § 1691a(e) (2012).

[58] 15 U.S.C. § 1691e (2012).

[59] Slattery argues that even now, the path to ECOA compliance remains confusing because either the platform or funding bank would have to provide a reason for refusing credit, and “P2P lending platform members [deciding] not to fund you” is unlikely to satisfy adverse action notice requirements. See Slattery, supra note 31, at 269. In any case, the present setup is certainly clearer than the alternative under a model with privity between borrowers and lenders.

[60] Verstein, supra note 9, at 506.

[61] Elizabeth Warren, Unsafe at Any Rate, 5 Democracy 8, 16 (2007).

[62] A brief description of the data is in order. Lending Club has made available a rich dataset of 391,888 individual loans made from 2007 to 2014. This dataset contains mature loans (loans that have been fully paid back or charged off) and unmatured loans (loans still outstanding). The mature loan dataset spans from 2007 to 2012, while unmatured loans span from 2010 to 2014. Each loan is associated with six major categories of information: (i) Basic loan characteristics (for example, term, amount requested, date submitted); (ii) Verified information about the borrower obtained from a credit bureau (for example, FICO score, earliest credit line opened, revolving balance, zip code); (iii) Unverified information furnished by the borrower (for example, annual income, job title, employment length, home ownership, loan purpose); (iv) Self-narrative provided by borrower (for example, self-provided voluntary description of borrower’s character, needs or any other information that may convince lenders); (v) Lending Club’s assigned grades (for example, assigned grades indicating loan quality, interest rate); and (vi) Loan performance (for example, loan status, payments collected to date, recoveries collected, recovery fees charged). Two variables not disclosed by Lending Club were also collected: the amount of time taken to fund a loan (the difference between the loan’s submission date and issuance date) and the total number of investors funding each loan. Since Lending Club fixes interest rates, the primary indicator of investor interest or demand will be the speed at which the loan is funded. All else equal, a “better” loan should be funded more quickly. Several caveats and conditions apply. Lending Club performs loan vetting in parallel with the funding process. If Lending Club has a standard period that is binding on loan funding speed, time to fund would be a weaker proxy for investor demand. However, there is no clustering around specific periods, indicating an absence of strongly-binding standard vetting periods. Additionally, hedge funds and other institutional investors began investing on the Lending Club platform in late 2012. Since the dataset does not contain information on lender identity, the lender welfare analysis is restricted to loans made from 2007–2012 to avoid capturing lending activity from sophisticated institutions during this time period.

[63] See Consumer Credit, Fed. Reserve Board (Dec. 7, 2010), http://www.federalreserve.gov/releases/G19/20101207/.

[64] See The January 2010 Senior Loan Officer Opinion Survey on Bank Lending Practices, Fed. Reserve Board (Jan. 2010), http://www.federalreserve.gov/boarddocs/snloansurvey/201002/default.htm (“[S]ubstantial net fractions of banks indicated that they had reduced credit limits on credit cards and had become less likely to issue cards to customers not meeting credit scoring thresholds.”).

[65] No direct data is available to compare Lending Club borrowers against equivalent-risk bank borrowers during the 2007 to 2012 time period. However, Lending Club’s own surveys offer some evidence for better rates in later years. See Personal Loans, Lending Club, https://web.archive.org/web/20141218193735/ https://www.lendingclub.com/public/credit-card-loans.action (stating that 23,716 borrowers surveyed from January 1, 2014 to September 30, 2014 who received a loan to consolidate existing debt or pay off their credit card balance, received a rate that was 6.6% lower than their outstanding debt or credit cards).

[66] See Factsheet: The CFPB Considers Proposals to End Payday Debt Traps, CFPB Newsroom (Mar. 26, 2015), http://www.consumerfinance.gov/newsroom/cfpb-considers-proposal-to-end-payday-debt-tra/.

[67] See Federal Reserve Economic Data, Delinquency Rate On Consumer Loans, All Commercial Banks (Feb. 19, 2016), https://research.stlouisfed.org/fred2/series/DRCLACBS. Consumer loan delinquency rates proxy for P2P loan overpayment rates, since delinquencies similarly trigger late fees and additional interest on unpaid balances.

[68]See Sumit Agarwal et. al, Regulating Consumer Financial Products: Evidence from Credit Cards, 130 Q. J. Econ. 111, 137 (2015).

[69] Compare Lending Club Rates, LendingClub, https://www.lendingclub.com/public/borrower-rates-and-fees.action (last visited Mar. 30, 2016).

[70] Id.

[71] Collection of Monthly Payments, LendingClub, https://www.lendingclub.com/public/collections-process.action (last visited Mar. 30, 2016).

[72] What Happens When a Loan is Charged Off, LendingClub, http://kb.lendingclub.com/investor/articles/ Investor/What-happens-when-a-loan-is-charged-off (last visited Mar. 30, 2016).

[73] See Lending Club, supra note 5 (showing only 2% of standard program loans going to institutional investors in 2012, and predominantly self-managed individual investors (that is, retail lenders) funding loans in 2010 and 2011).

[74] The independent variables are Lending Club’s proprietary score (Column 1), the level of lender interest (time taken to fill the loan request, denoted as “time to fund”) (Column 2), probability of default (Column 3), and loss severity (Column 4). An ordered probit was used to evaluate how Lending Club assigns grades and interest rates based on borrower information. A linear regression was used to analyze how quickly lenders respond to that same information. Finally, a probit and linear regression were used, respectively, to assess how that information predicts loan charge-offs and loss severity. Time to fund is the key variable of interest here. A negative time to fund coefficient on an attribute implies that lenders “fill” loans with those attributes more quickly.

[75] Green cells (marked with a “+”) are “desirable” loan outcomes, implying that an increase in the associated variable (for example, FICO score) results in a better Lending Club grade, lower default rates (We don’t use “etc.”) Red cells (marked with a “-”) are “undesirable” loan outcomes. “*” denotes significance at the 10% level, and “**” denotes significance at the 5% level. Coefficients have been omitted for brevity, as the table is meant primarily to illustrate investment patterns. Specifications were tested for multicollinearity, yielding an acceptable level of multicollinearity with mean VIF between 6.9 and 7.3.

[76] See, e.g., Joseph E. Stiglitz & Andrew Weiss, Credit Rationing in Markets with Imperfect Information, 71 Am. Econ. Rev. 393 (1981).

[77] “Small business” is a use category voluntarily chosen by borrowers, and does not imply that the loan receives different treatment (for example, as part of an SBA 7(a) loan program). Lending Club has recourse against these small business borrowers since they are still treated as personal loans. See, e.g., Terms of Use, LendingClub, https://www.lendingclub.com/info/terms-of-use.action (last visited Mar. 30, 2016).

[78] See supra Table 6 and Exhibit A.

[79] The Role of the SEC, Investor.gov, https://www.investor.gov/introduction-markets/role-sec (last visited June 21, 2016).

[80] See Robb Mandelbaum, How Lending Club Is Shaping the Future of Small-Business Loans, Inc. (May 2015), http://www.inc.com/magazine/201505/robb-mandelbaum/lending-club-money-on-demand.html (describing Lending Club’s 2014 entry into providing small business loans).

[81] Sec. and Exch. Comm’n, Strategic Plan Fiscal Years 2014–2018 Draft for Comment 38–39 (2014), https://www.sec.gov/about/sec-strategic-plan-2014-2018-draft.pdf.

[82] Income Verification, Lending Club, https://www.lendingclub.com/public/income-verification.action (last visited Mar. 30, 2016).

[83] This echoes previous calls for greater verification efforts. See Jack R. Magee, Peer-to-Peer Lending in the United States: Surviving After Dodd-Frank, 15 N.C. Banking Inst. 139, 170 (2011).

[84] Slattery, supra note 31, at 258.

[85] TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) (“[T]here must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”).

[86] SEC Staff Accounting Bulletin No. 99, Release No. 99 (Aug. 12, 1999) (“The use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that – without considering all relevant circumstances – a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statements is unlikely to be material.”).

[87] Michal Herzenstein et. al , Tell Me a Good Story and I May Lend You Money: The Role of Narratives in Peer-to-Peer Lending Decisions, 48 J. Marketing Res. (Special Issue) S138–49 (2011).

Stuck with Steckman: Why Item 303 Cannot be a Surrogate for Section 11

Age Before Equity? Federal Regulatory Agency Disgorgement Actions and the Statute of Limitations

I. Introduction

II. Circuit Split on the Application of Statutes of Limitations to Regulatory Enforcement Suits Seeking Disgorgement

III. Critical Analysis of the Three Paradigms

IV. Application of Relevant Maxims of Equity

V. Conclusion

A Federal Fiduciary Standard Under the Investment Advisers Act of 1940: A Refinement for the Protection of Private Funds

Increased Antitrust Merger Enforcement: Considerations for Your Next Deal

Bitcoin and Virtual Currencies: Welcome to Your Regulator

It Ain’t Broke: The Case For Continued SEC Regulation of P2P Lending

Table 1: Lending Club Loans By Grade And Year

Table 2: Loans by Selected Verified Borrower Information Variables

Table 3: Loans By Borrower Disclosure Information (Discrete Variables)

Table 4: Borrower Overpayment By Loan Grade

Table 5: Breakdown Of Total Payments Made By Overpaying Borrowers

Table 6: Borrower Information Influencing LC, Lenders And Loan Performance[75]

Exhibit A: Relationship Between Lender Investing Speed And Loan Outcomes

Table 7: Frequency of loans with voluntary borrower narratives

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I. Introduction

II. Circuit Split on the Application of Statutes of Limitations to Regulatory Enforcement Suits Seeking Disgorgement

III. Critical Analysis of the Three Paradigms

IV. Application of Relevant Maxims of Equity

V. Conclusion

Table 1: Lending Club Loans By Grade And Year

Table 2: Loans by Selected Verified Borrower Information Variables

Table 3: Loans By Borrower Disclosure Information (Discrete Variables)

Table 4: Borrower Overpayment By Loan Grade

Table 5: Breakdown Of Total Payments Made By Overpaying Borrowers

Table 6: Borrower Information Influencing LC, Lenders And Loan Performance[75]

Exhibit A: Relationship Between Lender Investing Speed And Loan Outcomes

Table 7: Frequency of loans with voluntary borrower narratives

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