The SEC’s so-called “gag rule” — which prevents a defendant settling with the SEC from denying the SEC’s allegations — has recently come under fire. Recently the Fifth Circuit heard oral arguments in the SEC v. Novinger case challenging the application of the gag rule to a radio host who settled with the SEC over allegations he had misled his listeners. Two weeks ago, SEC Commissioner Hester M. Peirce issued a fiery dissent from the SEC’s denial of a petition to amend the gag rule filed by the New Civil Liberties Alliance (“NCLA”), the same organization representing Mr. Novinger in his appeal.

So, what is the gag rule, and why is it in the crosshairs?

Admissions of Fault in SEC Settlements

Under 17 C.F.R. § 202.5(e), a policy dating back to the 1970s, the SEC will only agree to settle a civil action if the defendant agrees not to deny the SEC’s allegations against it, either directly or indirectly. The SEC considers refusal to admit the allegations as tantamount to denial, so a defendant who does not want to outright admit allegations must also refuse to deny them. In practice, this means that settlement agreements often state that the target “neither admits nor denies” the allegations.

In 2013 SEC Chair Mary Jo White went further, stating that the SEC would require settling defendants to admit wrongdoing where there was “a special need for public accountability and acceptance of responsibility,” including:

• “Cases where a large number of investors have been harmed or the conduct was otherwise egregious;”
• “Cases where the conduct posed a significant risk to the market or investors;”
• “Cases where admissions would aid investors deciding whether to deal with a particular party in the future;” and
• “Cases where reciting unambiguous facts would send an important message to the market about a particular case.”

Mary Jo White, Deploying the Full Enforcement Arsenal (Sept. 26, 2013).

More recently, the SEC’s Director of the Division of Enforcement, Gurbir Grewal, announced that the SEC would “require[e] admissions in certain cases where heightened accountability and acceptance of responsibility are in the public trust.” Gurbir Grewal, Director, Division of Enforcement, Remarks at SEC Speaks 2021 (Oct. 13, 2021).

Admitting the SEC’s allegations can have significant ramifications:

• The admissions could be front-and-center in private civil litigation, including shareholder derivative litigation, giving plaintiffs increased leverage to drive up settlement demands.
• Admitting violations of federal securities laws may give fodder to state authorities seeking to bring their own actions.
• Admitting fraud could adversely affect financial services licenses, government contracts, and insurance coverage, among other things.

Although a failure to deny allegations generally does not have the same legal consequences as an outright admission, the inability to contest the SEC’s allegations, especially allegations of intentional misconduct, can cause significant reputational damage.

The SEC’s Position

The SEC has defended the gag rule as a necessary part of its enforcement program. By settling, the SEC loses the ability to prove its allegations. “The Commission is not required to choose a path whereby it waives its right to try a case while the defendant is free to publicly deny the allegations without any real ability for the Commission to respond in court.” Letter from Vanessa Countryman to Margaret A. Little, New Civil Liberties Alliance (Jan. 30, 2024) (https://www.sec.gov/files/rules/petitions/2024/4-733-letter-013024.pdf). A defendant’s later denial of the SEC’s allegations could erode the public’s trust in the SEC’s enforcement capabilities by placing the defendant outside the SEC’s reach.

Also, the SEC considers the gag rule necessary to maintaining consistent application of the law.  Because complaints reflect the SEC’s view on what constitutes a violation of securities law, a denial by a defendant who settles with the SEC creates confusion as to whether the defendant has actually violated securities law and, by extension, how those laws should be applied.

Ultimately, the SEC views the settlement process as a negotiation between two parties. As Chairman Gary Gensler put it in a recent interview with Politico: “We give up something in a settlement when we don’t go into court, and, of course, a defendant gives up something as well.”  The defendant wants to avoid a costly trial, during which the SEC would publicly air the defendant’s dirty laundry, and the possibility of severe penalties. The SEC is willing to trade lower penalties for a certain result, but it is not willing to give up the ability to create a record of the defendant’s malfeasance. As the SEC sees it, it is just a free as any other litigant to set the parameters of its settlement agreements. If it wants to negotiate for silence, it can.

Criticism of the Rule

Although the gag rule has been in place since the 1970s, it has seen significant criticism over the last fifteen years, likely due in part to the uptick in enforcement actions in the wake of the 2008 financial crisis.

In 2018, the NCLA petitioned the SEC to amend the gag rule to allow a defendant to admit, deny, or neither admit nor deny allegations against it when settling with the SEC. The NCLA attacked the gag rule as an unconstitutional prior restraint on speech in violation of the First Amendment, an argument that the NCLA has also advanced in the Novinger appeal. In denying the NCLA’s petition, the SEC noted that parties can, and often do, waive constitutional rights as part of settlements.

Commissioner Peirce agreed with the NCLA. Faced with the potential for staggering penalties and years of costly litigation, even the most well-resourced targets typically decide to mitigate their risks by settling with the SEC, often before charges are officially filed. Given the power disparity between the SEC and its targets, Commissioner Peirce challenged the notion that defendants could freely bargain away their constitutional rights.

Commissioner Peirce’s concerns echo arguments made by the Cato Institute in a 2019 lawsuit against the SEC. Cato argued that the gag rule violates the unconstitutional conditions doctrine by conditioning the receipt of a benefit — namely, settling the SEC’s charges before trial — on defendants surrendering their First Amendment rights. The District Court for the District of Columbia artfully dodged the issue by finding that Cato lacked standing to bring the lawsuit, as it itself had not settled with the SEC.

In a withering 2022 opinion, Judge Abrams of the Southern District of New York characterized the gag rule as a transparent attempt to avoid “[a]ny criticism, apparently—or, rather, anything that may even ‘create the impression’ of criticism” of the SEC, although she conceded that controlling Second Circuit precedent required her to affirm the consent order in the case before her.

Other critics find the gag rule too weak. In 2011, Judge Rakoff of the Southern District of New York described the gag rule as a “a stew of confusion and hypocrisy.” Rather than building trust in the SEC, as the SEC claims, Judge Rakoff contended that the gag rule did exactly the opposite: “the public will never know whether the S.E.C.’s charges are true, at least not in a way that they can take as established by these proceedings.” Although he approved the proposed consent decree, Judge Rakoff would rather the SEC refuse to settle an enforcement action without an admission of guilt.

The Administrative State Under Fire

Recent challenges to the gag rule come at a time when the administrative state is under heavy scrutiny in the courts. In 2022, the Fifth Circuit held that the SEC’s enforcement of civil penalties for securities fraud in proceedings before Administrative Law Judges violated the Seventh Amendment. The Supreme Court heard oral arguments on the SEC’s appeal last November.

In the same month, the US Court of Appeals for the District of Columbia Circuit heard oral arguments in a case challenging the constitutionality of FINRA, the self-regulatory organization that polices the financial industry.

Just last month, the Supreme Court heard oral arguments in two cases challenging the 40-year-old Chevron doctrine, under which courts give considerable deference to an agency’s interpretation of ambiguous law.

Although the Supreme Court recently declined to hear a former Xerox executive’s challenge to his nearly two-decade old consent order — despite amicus briefs from Mark Cuban and Elon Musk — if as venerable a doctrine as Chevron goes the way of the dodo, critics of the gag rule may have reason to hope that the gag rule will not be too far behind it.