Wall Street’s top watchdog has a bad case of denial – about denials. As a condition of settling cases, the Securities and Exchange Commission typically bars alleged wrongdoers from later claiming they’re innocent. This so-called gag rule arguably violates free-speech rights, though. If a new lawsuit challenging it succeeds, the regulator may finally have to start – gasp! – proving its accusations.
The suit was filed on Wednesday by the Cato Institute, a libertarian think tank that wants to publish a currently anonymous author’s memoir about being forced to settle what he contends were the SEC’s false charges of running a Ponzi scheme. Cato says the book would probably violate the author’s agreement to keep quiet and has asked a federal court in Washington, D.C. to strike down the promise as unconstitutional.
Most surprising about the lawsuit is that it seems to be the first of its kind. The SEC adopted the gag rule in 1972 as part of an effort to speed settlements by allowing suspected fraudsters to avoid admitting misconduct so long as they didn’t deny it. The rule ensured future compliance, but the bargain’s flaws quickly became apparent.
Actual wrongdoers eagerly signed up, happy to dodge any admissions that might damage their reputation or chances of defeating the costly private lawsuits that often followed SEC action. But even the innocent often settled, wanting to avoid the time and expense of fighting back. In both situations, the problem was that the public could never be sure of what the accused had done.
No one made much of a stink, however, until a feisty federal judge, Jed Rakoff, took Bank of America and the SEC to task in 2009 for asking him to approve an agreement in which the bank neither admitted nor denied that it had lied to shareholders. The judge went further two years later, when he refused to approve Citigroup’s $285 million settlement with the regulator over dodgy mortgage securities. He said doing so without acknowledged facts would be “worse than mindless, it is inherently dangerous.” An appeals court later ruled that he didn’t have the power to second-guess the SEC, however, and ordered the settlement approved.
It didn’t get much notice at the time, but one of the dangers that Rakoff mentioned in his opinion was the threat to free speech. As he put it in a footnote: “An agency of the United States is saying, in effect, ‘Although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.’” That’s the issue that Cato has raised in its federal lawsuit.
On the surface, the case seems simple, requiring a straightforward application of the First Amendment principle that the government generally can’t block speech because of its content – here, the denial of wrongdoing. The SEC has declined to comment on the lawsuit, but it might reasonably argue that the gag rule is legal, because accused wrongdoers have agreed to waive their First Amendment rights in exchange for a favorable settlement.
The big question, though, is whether that waiver is voluntary, and whether the gag rule is what’s known as an unconstitutional condition. Since the late 19th century, the Supreme Court has generally barred the government from conditioning a benefit on waiving a constitutional right. In 1996, for example, the court struck down a Rhode Island law banning stores from exercising the First Amendment right to advertise liquor prices as a condition of receiving a liquor license. There are also some exceptions, such as a 1980 decision upholding speech limits as a necessary condition of working for the Central Intelligence Agency.
The SEC’s gag rule looks a lot closer to the liquor-license case than the CIA example. For starters it seems unnecessary, designed merely to keep the regulator from looking bad for, say, cutting a sweetheart deal with a big bank or extracting a face-saving settlement in a weak case. What’s more, giving up speech rights under the threat of costly litigation hardly seems voluntary.
The most compelling argument against the gag rule, though, may be that the SEC has better alternatives. One is to settle cases only when the accused admits to wrongdoing. In fact, after Rakoff’s criticism of the Citi settlement, the SEC began to demand admissions in certain egregious cases, though they’re still rare. If the defendant refuses and the SEC’s case is strong, the lawsuit should go to trial. Otherwise, it should be dropped.
The downside of this approach, of course, is that it would probably require the SEC to beef up its resources and the skills of its trial lawyers. That’s a small price to pay, though, compared with the cost of leaving investors and the public essentially guessing whether the misconduct the watchdog alleges actually happened or not.
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