GUEST BLOG: The SEC's Gagging Rights by Aegis Frumento Esq

January 17, 2019

The SEC's Gagging Rights

If you email most folks at the SEC these days, you'll get back this:

Due to a lapse in appropriations for the federal government, the U.S. Securities and Exchange Commission is currently closed. I am currently out of the office, and will return to the office once an appropriation has been enacted. During the closure, I will not be monitoring or responding to my emails.

For those of us who've experienced the SEC as a black hole, this would ordinarily prove that we weren't imagining it. Several clients are glad to have OCIE and Enforcement off their backs for awhile. But still, I miss them.

And now I also wonder will there be anyone at the SEC to answer the federal court complaint the Cato Institute filed against it last week. It would be poetic justice for that complaint to be met with silence.

You see, it has long been the SEC's policy not to settle cases without including a gag. Not a joke kind of gag (though I've had clients say that about SEC charges now and then), but an agreement not to publicly dispute any of the SEC's findings in the case you just settled. Now, mind you, you don't have to admit the charges. You can outright deny them and even prove them false in other legal proceedings. But you can't voluntarily publicize your contrary side of the story to make the SEC look bad in public. You can't, for example, give press interviews or write a book to the effect that the SEC was full of it. That's why these days Elon Musk, after having settled with the SEC, can't subject it to much more than name-calling (name-tweeting?).

The Cato Institute's case is pretty simple: Everyone has a First Amendment right to criticize the government, and since the SEC is part of the government, we can aim all the slings and arrows at it we can muster. That includes settling SEC respondents and defendants as to charges they have not admitted. The Institute says it has a book manuscript by someone who settled a case with the SEC showing that "the SEC's allegations against him were unfounded and unfair." But for the gag order in the author's settlement agreement, the Institute says it would publish that book.

The policy not to settle cases without a gag order is memorialized in Rule 5(e) of the SEC's Informal and Other Procedures as such: "it is important to avoid creating, or permitting to be created, an impression that a decree is being entered or a sanction imposed, when the conduct alleged did not, in fact, occur." Remember the word "impression;" we'll come back to it.

Anyone familiar with criminal practice -- or who have followed the Paul Manafort and Michael Cohen plea deals -- will recognize in that policy some similarity to an allocution. The point of an allocution is to protect a criminal defendant against an overbearing prosecutor. The defendant who pleads guilty has to convince a judge that the plea is truly voluntary and justified because he really did what the prosecutor said he did, and not because he succumbed to persuasive end of a tire iron.

But a similarity does not make an analogy. SEC enforcement cases are not criminal cases, and you can settle them without admitting any guilt whatever. You don't need the protection of an allocution against a false admission of guilt when you're not admitting guilt to begin with.

Of course, SEC will say its civil cases are fundamentally no different than any other civil lawsuit. Parties to civil lawsuits can settle on whatever terms they choose. Targets of SEC cases are therefore as free as any other party to a lawsuit to agree to be gagged. Anyone who doesn't like it is can simply not settle and go to trial.

It is true that in settling private lawsuits, a gag order is often included in the settlement agreement to prevent any public commentary that would make the settling party look bad. But in all such cases the party who benefits from the gag has paid something to the party it wants to keep quiet. The SEC never pays anything to settle its cases -- you all knew that I hope!

Let's get real here. I have made a living representing parties in SEC enforcement matters, and I can tell you that more often than not parties settle with the SEC not because they are in shock and awe of its case but simply to avoid the cost of defending it.

It is expensive to defend against an SEC assault. Securities cases typically involve a lot of transactions, a lot of conversations, a lot of emails. All that stuff needs to be parsed and analyzed to prevent a bad narrative from controlling the outcome. And all too often, SEC cases are just that -- bad narratives concocted from out of a jumble of ambiguous facts. On the receiving end of such narratives are respondents already in dire straits because the venture that drew the SEC's attention in the first place failed. Often, the cost of settling is less than the cost of defense. Indeed, I would say settlements are compelled by the need to stop paying legal fees more than anything else. At least that is true for small firms and individuals. Major firms always settle and pay up because for them getting caught violating the securities laws is just a cost of doing business. They know they'll make it up somewhere else.

As the Cato Institute complaint states, the SEC settles 98% of the cases it brings. But of the 2% that go to trial, the SEC tends to "win" only 88% overall, and only 57% of the time when the charges involve insider trading. Those are still high numbers, but they are not 98%. They suggest that of the approximately 800 cases that the SEC settles each year, perhaps 100 of them might reasonably be contested at trial, including perhaps 25 of the over 50 insider trading cases. Yet the SEC tries less than 20 cases a year. Of course, with the SEC suffering under a hiring freeze since 2016, it would not have the staff to try 120 cases a year, even if the government wasn't shut down. But still, maybe 100 respondents a year settle who might have beaten the SEC in court. A hundred ensnared innocent respondents is not insignificant.

None of my clients who fought the SEC wanted to write a book about it. They just wanted to get the whole thing behind them. That's typical, which is why the SEC never gets any pushback when it demands a gag order. Once the parties have reached economic terms for a settlement, they generally agree to the gag order without a second thought.

But don't let that overshadow the truth. Gag orders do not protect any substantive right. Rather, as Rule 5(e) clearly says, they exist only to prevent an "impression" that the conduct being charged didn't really happen. They foster the illusion that respondents are guilty even if they really aren't, so that the SEC might look more awesome than it really is. Gag orders force -- they are intended to force -- settling respondents to become complicit in the SEC's self-aggrandizing propaganda.

The First Amendment protects the public's right to speak up, in the hope that public exposure, even the threat of it, will curb a government's natural impulse to act imperiously. SEC gag orders directly undercut that right. I hope the Cato Institute succeeds in getting rid of them.


Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of Blog.