Litigation Against the SEC has Spiked in Recent Years. Why?

The Securities and Exchange Commission is an enormously powerful regulator.  The agency’s power stems, in large part, from its traditional response to a problem endemic in the securities laws.  The problem is that broad and vague statutory prohibitions, backed up by onerous liability, risk chilling market behavior in profoundly undesirable ways.  The SEC’s traditional response to this problem has not been to more clearly delineate what the law affirmatively prohibits, or to reduce liability, but rather to bless certain practices that it deems lawful using a variety of regulatory techniques that tend to elide traditional APA-based accountability mechanisms—e.g., safe harbors, no-action letters, guidance, exemptive relief, the strategic exercise of enforcement discretion.  These techniques allow the SEC to effectively micromanage the capital markets in a manner that (to put it mildly) sits in tension with the Brandeisian vision of the SEC as a hands-off regulator focused primarily on disclosure and fraud prevention.  And for most of its existence, the SEC exercised its vast power with very little legal pushback from market participants.  That has changed—dramatically—in recent years.  Empirical research shows litigation against the SEC jumping significantly in the 2010s and then skyrocketing in the 2020s.  In Suing the SEC, forthcoming in the Texas Law Review, I explore why.

Eager readers may already have one of two causal theories in mind to explain the recent uptick in litigation against the SEC.  Those who lean left are likely to view it as part of a broader “conservative crusade” to dismantle the administrative state.  Those who lean right will point to the SEC’s aggressive rulemaking and enforcement agenda under Chair Gensler as the provocation.  There is truth in both accounts, but they are incomplete.  In Suing the SEC, I formalize the conditions under which market actors would find it rational to sue their regulator, and explain how those conditions have changed in recent years in ways that explain market actors’ increased litigiousness toward the SEC.  The analysis helps to make sense of not only the current moment in the SEC’s storied history, but also its relatively litigation-free past. It also leads to insights relevant to both predicting and shaping the SEC’s future.

A Rational Actor Model

A market participant, faced with a regulatory burden, always has choices other than mere compliance.  One is to challenge the legality of the burden; others include lobbying for changes and avoidance of the burden through altered behavior, such as (in the case of SEC-imposed burdens) altering capital raising plans.  I posit that a market actor would rationally choose litigation if the expected benefits associated with that choice exceed expected costs, and if litigation offers higher expected net benefits than the alternatives of lobbying and avoidance.

Expected benefits from litigating are the product of two factors: the value of victory and its probability.  The value of victory is a function of the magnitude of the regulatory costs that would be avoided in the event of success, and the probability of victory turns on the legal vulnerability of the regulator’s position.  Expected costs extend beyond standard litigation expenses (e.g., legal fees, management distraction, bad publicity).  When suing a regulator, a market actor also risks incurring what I call reputational costs: if you antagonize your regulator, it might use its discretion against you in the future.  Market actors will also consider what I call competitive costs, which arise because successful litigation against one’s regulator can benefit one’s competitors in the marketplace.  In this way litigating against one’s regulator presents a classic collective action problem.

Certain frictions complicate a market participant’s cost-benefit calculation, including agency costs and information asymmetries.  Firm managers, for a variety of reasons, are likely to find litigation less attractive than a firm’s equity holders.  Consider, moreover, that most firms interacting with the SEC rely heavily on outside advisors: securities lawyers, investment bankers, auditors. These intermediaries may have structural incentives to discourage litigation, given the value they derive from maintaining an ongoing relationship with the agency, and to the extent that their most lucrative clients are large public companies who benefit from barriers to entry created by SEC regulation.  Notably, smaller, newer entrants to the capital markets will usually be the most dependent on these advisors and thus most susceptible to being dissuaded from litigation.

Changing Variables

In recent years, both sides of the litigation calculus have shifted in directions that make legal challenges against the SEC increasingly attractive.  Frictions have also eroded.  For a full explanation of these changes, please read the paper.  I offer some highlights below.

Increased benefits

The value of victory rises with regulatory costs, and those costs certainly increased in the 2010s (due to the Dodd-Frank Act, which not only led to a vast number of new rulemakings but also expanded the SEC’s enforcement authority in important ways) and 2020s (due to Chair Gensler’s aggressive regulatory agenda). The costs to market participants of the SEC’s use of discretionary regulatory techniques have also likely gone up in recent decades, due to increased agency partisanship. When the SEC exercises its power in stable, predictable ways aligned with investor protection and capital formation, market actors may view these techniques as an acceptable way for the agency to deal with the high-stakes legal uncertainty that pervades the securities laws. But when the SEC appears to use that power in a manner tethered more to shifting political tides than core purposes, those same techniques look far more costly.  Political polarization has also made victories against the SEC more permanent, and hence more valuable, by reducing the likelihood that Congress will step in to validate agency actions struck down in court.

The probability of victory has risen as well. This is the result of a variety of doctrinal developments that make SEC actions more vulnerable to invalidation, starting in 2011 with the D.C. Circuit’s decision in Business Roundtable v. SEC and accelerating with a series of recent Supreme Court cases, including West Virginia v. EPA, Loper Bright Enterprises v. Raimondo, and Axon Enterprise, Inc. v. FTC.  It is also the result of the more ambitious scope of Gensler-era rules and the breakneck pace at which those rules were promulgated (the former bolstering challenges based on lack of statutory authority and the latter bolstering arbitrary-and-capricious challenges).

Decreased costs

While the benefits of litigating have systematically increased in recent years, the costs have declined.  Consider the effect of the explosion of private capital markets on reputational costs. Companies can now raise enormous amounts of capital without SEC interaction, dramatically reducing dependence on the SEC’s future favor. If you don’t need the agency’s help tomorrow, its threat of retaliation today looks much less frightening.  Competitive costs have also been mitigated by the rise of new advocacy organizations helping firms overcome collective action problems by coordinating litigation efforts.  Large public companies and financial market intermediaries have always relied on industry groups like the Business Roundtable and SIFMA to assist in litigation efforts against the SEC, but in recent years other organizations have stepped up to help different groups of market participants with litigation, such as the National Association of Private Fund Managers (NAPFM), the Alternative Investment Management Association (AIMA), and the Blockchain Association.

Reduced frictions

Frictions have diminished as well. Firms going public today are larger, later-stage, and often led by founders with substantial skin in the game. These founder-led companies may be less reliant on traditional intermediaries and more prone to seek information about legal options from other sources—think Elon Musk, who has shown willingness to fight the SEC directly without deferring to the traditional securities bar.  It is also the case that the SEC’s legal vulnerabilities have become common knowledge through policy entrepreneurs actively educating market actors about litigation possibilities.  And high-profile victories cascade into more litigation in a self-reinforcing cycle.

Looking Ahead

Will this litigation wave subside? My analysis suggests not easily.  Yes, lighter regulatory burdens under current Chair Atkins will reduce the value of litigation. But many underlying trends are durable, suggesting that litigation may retain some heightened appeal (or bounce back quickly the next time a more pro-regulatory chair is appointed).  Doctrinal shifts at the Supreme Court won’t reverse any time soon. Private markets aren’t shrinking. Political polarization will likely persist. Advocacy organizations have staying power.

My analysis also suggests that something more profound may be in store for the SEC.  Recall the various discretion-laden regulatory techniques that the SEC employs as a way of addressing what would otherwise be an intolerable level of legal uncertainty in the securities laws.  These techniques, which afford the SEC maximal flexibility while exposing it to minimal accountability, have been around for many decades, in some cases since the very inception of federal securities regulation.  This suggests that they have in the past worked fairly effectively—or at least pleased dominant interest groups.  But if the SEC does not regain a reputation as a stable capital markets regulator, through either a renewed Presidential commitment to fostering an independent, non-partisan SEC, or through some other mechanism, pushback to these regulatory techniques can be expected to intensify—not just through litigation, but also through lobbying and avoidance. This, in turn, may necessitate a need to broadly rethink how the problem of high-stakes legal ambiguity that pervades our securities statutes is best approached.  The SEC has begun making adjustments in this direction—moving toward clearer rules, reducing “regulation by enforcement,” pausing no-action letter guidance in certain areas. These moves suggest institutional self-preservation reflexes kicking in. It remains to be seen whether these actions will suffice to ward off the discontent of market actors.

The full paper is available for download here.