By Mark S. Nelson, J.D.
The Supreme Court last week announced the passing of retired Justice Sandra Day O’Connor, who died in Phoenix, Arizona at the age of 93 due to complications related to advanced dementia and a respiratory illness, said a Court press release. In 1981, then-President Ronald Reagan made history by appointing O’Connor to the Court as its first female justice, although other women would gradually be appointed to the court over a number of years, ultimately reaching a total of four women justices on the current Court. O’Connor was perhaps better known for her opinions in abortion cases, but she also wrote or joined numerous opinions dealing with securities regulation and became an early critic of Basic v. Levinson’s fraud-on-the-market theory. With respect to one of her opinions regarding the CFTC’s reparations authority, the issues underlying that case have sprung back to life in the form of a recent challenge to the SEC’s authority to bring administrative proceedings. O'Connor served on the Court from 1981 until her retirement in 2006.
“A daughter of the American Southwest, Sandra Day O’Connor blazed an historic trail as our Nation’s first female Justice. She met that challenge with undaunted determination, indisputable ability, and engaging candor,” said Chief Justice John G. Roberts, Jr. “We at the Supreme Court mourn the loss of a beloved colleague, a fiercely independent defender of the rule of law, and an eloquent advocate for civics education. And we celebrate her enduring legacy as a true public servant and patriot.”
Securities cases. In the securities regulation setting, there is perhaps no more iconic Supreme Court opinion than the one in Basic (1988), in which four justices adopted the fraud-on-the-market theory of reliance in private securities fraud lawsuits. The court in Basic, however, was operating at less than full strength because Chief Justice Rehnquist and Justices Scalia and Kennedy did not participate in the decision.
Justice Blackmun, writing for the four justices backing the fraud-on-the-market theory, concluded that “[i]t is not inappropriate to apply a presumption of reliance supported by the fraud-on-the-market theory.” Earlier in the opinion, Justice Blackmun had cited another case explaining how the presumption of reliance works: “The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements…” (citation omitted).
The presumption of reliance has been criticized as having eliminated the reliance element from most private securities lawsuits because, when the presumption is available, a plaintiff need not directly prove he or she relied on the issuer’s misstatements. That critique was picked up by Justice White, and joined by Justice O’Connor, in Basic, where the two justices both concurred and dissented. Justices White and O’Connor agreed with the other four justices in Basic that the fraud-on-the-market theory adopted by the Court rejected any equivalence between “causation” and “reliance,” and that a securities fraud defendant should be able to rebut the presumption of reliance. “A nonrebuttable presumption of reliance—or even worse, allowing recovery in the face of ‘affirmative evidence of nonreliance”—would effectively convert Rule 10b-5 into ‘a scheme of investor’s insurance’” (citation omitted), said Justices White and O’Connor.
But Justices White and O’Connor saw other “pitfalls” in the Court’s approach to reliance, including whether courts generally were up to the task of applying the presumption. “Confusion and contradiction in court rulings are inevitable when traditional legal analysis is replaced with economic theorization by the federal courts,” posited Justices White and O’Connor. The two justices also believed that Congress should have weighed in on the issue of reliance in these cases.
The Basic presumption remains controversial for some justices, although a majority upheld the presumption in 2014 in Halliburton II (2014 )while clarifying the defendant’s ability to rebut that there was a price impact. A concurrence by Justice Thomas, joined by Justices Scalia and Alito, urged the Court to overrule Basic in a future case. “Today we are asked to determine whether Basic was correctly decided. The Court suggests that it was, and that stare decisis demands that we preserve it. I disagree,” wrote Justice Thomas. “Logic, economic realities, and our subsequent jurisprudence have undermined the foundations of the Basic presumption, and stare decisis cannot prop up the façade that remains. Basic should be overruled.”
Justice O’Connor also wrote for the Court in other types of securities cases. For example, in the 2004 case of SEC v. Edwards (2004), in which Justice O’Connor wrote for a unanimous court, she applied the Howey standard to a payphone business investment and held that an investment scheme promising a fixed rate of return can be an investment contract and, thus, a security. In reaching this conclusion, the Court rejected the lower court’s reasoning that an investment contract must include capital appreciation or a participation in the earnings of the enterprise and that the Howey prong requiring that profits be “derived solely from the efforts of others” could not be met if there was a contractual right to the return.
After explaining that investors seek profits on their investment and not the profits in the scheme in which they have invested, Justice O’Connor clarified why, for purposes of Howey, there is no difference between fixed and variable returns. “There is no reason to distinguish between promises of fixed returns and promises of variable returns for purposes of the test, so understood. In both cases, the investing public is attracted by representations of investment income, as purchasers were in this case by ETS' invitation to ‘watch the profits add up.’ Moreover, investments pitched as low-risk (such as those offering a ‘guaranteed’ fixed return) are particularly attractive to individuals more vulnerable to investment fraud, including older and less sophisticated investors.”
Commodities case. The next area of Justice O’Connor’s writings for the Court requires some brief background. In recent years, respondents in administrative proceedings have repeatedly challenged the authority of federal agencies to conduct in-house proceedings. Many of these cases have been brought against the SEC in light of its expanded powers under the Dodd-Frank Act. It is pure coincidence, that oral argument before the Supreme Court in SEC v. Jarkesy, a broad-based challenge to SEC administrative authority, was held two days before Justice O’Connor’s passing because the following case in which she wrote for a majority upholding a CFTC administrative proceeding was cited numerous times by the SEC and the agency’s challenger at oral argument for widely divergent conclusions. In light of how the current Supreme Court has been remodeling federal administrative law, one could ask if the CFTC case discussed below was brought today, would the Court reach the same conclusion.
In CFTC v. Schor (1986), Justice O'Connor wrote for the court regarding the question of whether the Commodity Exchange Act (CEA) allows the CFTC to entertain state law counterclaims in reparation proceedings and whether such authority would violate Article III of the U.S. Constitution.
In Schor, the broker sued in federal court to collect from the customer a debit balance in the customer’s account. The customer alleged that the debit balance resulted from the broker’s CEA violations; the broker said the customer had racked up trading losses that produced the debit balance. The broker eventually voluntarily dismissed the federal court case and sought to collect the debit balance via a counterclaim in the customer’s reparations matter brought before the CFTC. A CFTC administrative law judge ruled for the broker and, after the Commission declined to review the ruling and it became final, the customer challenged the CFTC’s authority to hear counterclaims in reparations matters.
The D.C. Circuit would later hold in the case that the CFTC may hear counterclaims arising only from the CEA or CFTC regulations but not the state common law counterclaims asserted by the broker. The D.C. Circuit then denied rehearing en banc, although two judges dissented because they viewed the inability of the CFTC to consider state counterclaims in reparations proceedings would defeat the Congressional rational of efficiency that underlay reparations. The Supreme Court would grant, vacate, and remand the case, but the D.C. Circuit once again reached the same conclusion, prompting the justices to finally hear the case on its merits.
Justice O’Connor’s opinion for the Court first addressed Congressional purpose. Among other things, the Court found persuasive the language in Section 14 of the CEA, which created the reparations program, referring to “any counterclaim” (emphasis in Court’s opinion). Justice O’Connor summed up the legislative policy thus: “Our examination of the CEA and its legislative history and purpose reveals that Congress plainly intended the CFTC to decide counterclaims asserted by respondents in reparations proceedings, and just as plainly delegated to the CFTC the authority to fashion its counterclaim jurisdiction in the manner the CFTC determined necessary to further the purposes of the reparations program.”
With respect to Article III, the Court rejected the customer’s challenge to the broker’s attempt to have the CFTC consider his common law counterclaim. “We conclude that the limited jurisdiction that the CFTC asserts over state law claims as a necessary incident to the adjudication of federal claims willingly submitted by the parties for initial agency adjudication does not contravene separation of powers principles or Article III.”
Justices Brennan and Marshall dissented from Justice O’Connor’s majority opinion on the ground that, for purposes of Article III, the Court should recognize only a few exceptions regarding judicial authority of non-Article III federal tribunals for “territorial courts, courts martial, and courts that adjudicate certain disputes concerning public rights” (citations omitted).
In the latest SEC case currently pending before the Supreme Court, the government, speaking to the Seventh Amendment right to jury trial question, posited that the SEC case is squarely a public rights case and, thus, distinguishable from Schor. During questioning for the bench in the SEC case, Justice Kagan noted that the “easy cases” are those involving the government on one side of the case, meaning that the “hard cases” are those like Schor, where there are private parties on both sides of the case. Justice Kagan added that in those cases “we've held that public rights might be involved because their disputes are embedded in federal statutory schemes.”