On July 15, 2016, the U.S. Chamber of Commerce released a lengthy and detailed report discussing a range of shortcomings in the SEC’s law enforcement investigative and adjudicative processes. Little of what was said is new, in the sense that it raises issues or presents ideas not previously discussed by parties or commentators. But it may be the most comprehensive discussion of SEC enforcement issues in recent years. It discusses how and why the scope and nature of SEC law enforcement has changed over the years, and, importantly, dwells on why rules, procedures, policies, and practices developed or adopted in the past have become obsolete in light of the changed scope and nature of both the SEC’s enforcement actions and the vastly changed information-storage environment which now dominates all forms of litigation.
The report makes 28 wide-ranging recommendations for revised SEC practices, policies, and oversight of the enforcement process. Many of these focus upon and address the increased scope and use of administrative courts to pursue SEC enforcement actions, but they also address issues of fairness, efficiency and cost of the Division of Enforcement’s investigative process, the development and presentation of enforcement recommendations to the Commission, the standards to be used by the Commission in making enforcement prosecutorial decisions, the management and oversight of the enforcement activities of the Division of Enforcement, and the coordination of SEC enforcement with that of other law enforcement agencies. The full report can be read here: Examining U.S. Securities and Exchange Commission Enforcement: Recommendations on Current Processes and Practices.
There is a lot of material here in wide-ranging areas. But by all appearances, the driving force behind the publication of the report is the festering issue of the untethered use of administrative proceedings to pursue SEC enforcement actions of all types, and the increasingly obsolete and unfair tilt of those proceedings in ways that plainly favor the Enforcement Division and impair the ability of respondents to defend themselves.
The tone of the report is measured, and its points are made with context and analysis. The in-depth discussion of fairness issues in SEC administrative proceedings, in light of the antiquated set of rules and procedures governing those proceedings, stands in contrast with the conclusory, and ill-supported, claims of the SEC’s Director of Enforcement that the SEC administrative process gives respondents an equal shot at prevailing over the Division. It also spotlights the particular unfairness of a set of policies and procedures that grants the Division the right to pursue its actions before a jury if it wishes to do so, while respondents are powerless to do so, even though the Supreme Court has made it clear that in many such cases brought in federal court, there is a constitutional right to trial by jury. The discussion also takes the Division of Enforcement to task for the analysis and explanation of its newly-adopted pseudo-policy for determining whether cases should be brought administratively or in court, noting that all of the factors weighed in that document are limited to the vantage point of the Enforcement Division; none of the considerations of fairness, efficiency, and public interest take into account impacts on the persons accused of law violations in these cases.
The report is also useful in reminding us that where we stand now is the artifact of the Gerry-built history of SEC law enforcement powers. As a result, it is not surprising, but to be expected, that there is an ill fit between the peculiarities of the SEC’s administrative court proceedings and the design of a fair and efficient law enforcement process.
Hopefully, the report can serve as a catalyst for the SEC to get past the current no holds barred effort to beat back litigation efforts to balance the litigation playing field and turn to serious, genuine, adult consideration and resolution of the underlying fairness issues. If not, perhaps the report can get lawmakers to do that if the SEC commissioners continue to turn a blind eye to the problem.
Some aspects of the report may assist in turning what has been a vacuum of policy discussion into a productive effort to make things better. First, is the report’s emphasis on the difference between the SEC’s role as the steward of our securities and capital markets and capital, which differs significantly from the prosecutorial role of the Division of Enforcement — and least since that prosecutorial arm moved in recent years from a focus on the public interest to one of wielding crippling punitive sanctions. Second, is the report’s reminder of how the SEC’s enforcement process got to where it is today, and how the development of steroid-like bulking up of SEC enforcement powers outstripped the quaint procedural concepts that of the SEC’s administrative courts, as well as the managerial means of guiding and controlling the army of enforcement lawyers seeking to flex those new muscles.
The report reminds us that the SEC needs to keep in mind that its goal is broader and more complex than just to win enforcement actions.
The report rightly starts out with a discussion of what the SEC should be trying to accomplish as it considers its enforcement program generally, and the specific aspects of that program that are causing controversy.:
The Division of Enforcement, as the prosecutor, should consider the different aspects and implications of the two forums in making its recommendation to the Commission. However, the Commissioners acting as a decisional body should not view their role in the same way as a prosecutor. The Commission has a responsibility to consider the broader statutory questions of what is “necessary and appropriate in the public interest for the protection of investors.” More broadly, it must also adhere to its multiple statutory mandates to protect investors, promote capital formation, and ensure fair and orderly markets. Accordingly, the Commission should predicate its forum selection decisions solely upon a clear determination that its choices uphold and further its responsibility as a government agency to promote the public interest and the protection of investors, while respecting the important rights of those whose conduct the SEC chooses to scrutinize.
Report at 3 (footnotes omitted).
This gets to the heart of the Commission’s failure over the last year to show that it is willing to confront and discuss, in a serious, adult, way, how its enforcement policies may be undercutting, rather than achieving, important broader goals, including respect for its decisiion making process.
The report makes it clear that the history of the growth of SEC enforcement powers shows the current model is founded on happenstance, not design.
The report provides a history lesson about how the SEC got to where it is now. That history shows repeated efforts to enhance and expand SEC enforcement powers and flexibility, but no effort whatsoever to build an managerial and procedural infrastructure necessary to assure that these new-founded powers are used in ways that achieve the SEC’s broader mission. Here is some of that discussion:
Since the SEC’s creation, it has had the authority to bring administrative proceedings to address violations of the securities laws. The scope of its authority to bring an administrative proceeding and the sanctions that can be ordered in an administrative proceeding have grown dramatically over time.
Early in the history of the SEC, the administrative proceeding was limited to proceedings to halt an offering of securities to the public, a so-called stop order, under section 8 of the Securities Act, and proceedings to reject an application for or revoke the registration of a broker-dealer or investment adviser. Administrative proceedings were adjuncts of the Commission’s authority to register securities and register broker-dealers, investment advisers, and investment companies. When the occasion arose to deny a registration or to revoke one, the administrative proceeding was the vehicle to provide the affected entity with a right to hearing prior to Commission action.
In 1964, Congress amended the Exchange Act and provided the Commission with the authority to institute administrative proceedings to censure, place limitations on the activities of, suspend for a period up to 12 months, or bar associated persons of broker-dealers. The grounds for denying or revoking a broker-dealer registration or other disciplinary sanction were also expanded. These new bases included willful violations of the Investment Company Act or the Investment Advisers Act, willful aiding or abetting violations, and importantly, a broker-dealer’s failure reasonably to supervise a person who commits a violation. In 1970, Congress amended similarly the Investment Advisers Act. Comparable authority is also contained in the Investment Company Act. This authority has become a staple of the SEC Enforcement Program.
In 1990, Congress enacted the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the Remedies Act). The Remedies Act dramatically expanded the nature of SEC administrative proceedings. For the first time, the Commission could proceed administratively against persons and entities not directly registered with the Commission and, also for the first time, it could impose monetary penalties on registered entities and associated persons. It authorized the Commission to enter a cease and desist order against any person who is violating, has violated, or is about to violate any provision of the securities laws or any rule or regulation thereunder. In a cease and desist proceeding, the Commission can order a party to take steps to comply with its rules, to provide an accounting, and to disgorge profits gained or losses avoided. This Act also created a proceeding to enable the SEC to issue a temporary cease and desist order. While the Commission has used its cease and desist authority extensively, it has brought only one proceeding under its temporary cease and desist authority.
The Remedies Act also expanded the remedies that the SEC can order in an administrative proceeding against broker-dealers, investment advisers, investment companies, and persons associated with these registered entities. The SEC can order disgorgement and civil penalties comparable to those available in an injunctive action. The Sarbanes-Oxley Act (SOX) expanded the remedies available in a cease and desist proceeding by authorizing the SEC to bar an individual from serving as an officer or director of a public company if they violated the antifraud provisions of the Securities Act or Exchange Act. Section 602 of SOX added section 4C to the Exchange Act and provided explicit statutory authority for administrative proceedings against an attorney, an accountant, or other professional such as an engineer or geologist, engaging in improper professional conduct. This codified Commission rule 102(e).
Section 925 of the Dodd-Frank Act (Dodd-Frank) further expanded the Commission’s sanctioning power to include a “collateral” bar from association under all of the securities laws. It also provided the authority to impose money penalties against persons or entities not registered with the Commission. In effect, the Commission could, in an administrative proceeding, impose substantially the same penalties available in a civil injunctive action. The substantial expansion in administrative proceeding authority, both in the scope of who may be charged in an administrative proceeding (AP) and in the penalties available in an AP, has coincided with a dramatic increase in the total number of administrative proceedings brought by the SEC. While the controversy over this shift in policy has been largely focused on the period following Dodd-Frank, and in particular the past two years, the increased reliance on administrative proceedings has been growing steadily for more than two decades.
Report at 11-12 (footnotes omitted).
At a later point, the report discusses some of the current procedural rules governing the administrative proceedings, and makes the telling point that these rules were adopted long before the Commission (or anyone else) had any conception that this process would be used to try to adjudicate complex enforcement cases that went well beyond the areas subject to SEC regulation:
Commission rule 360 provides that “Under the 300-day timeline, the hearing officer shall issue an order providing that there shall be approximately 4 months from the order instituting the proceeding to the hearing, approximately 2 months for the parties to obtain the transcript and submit briefs, and approximately 4 months after briefing for the hearing officer to issue an initial decision.” At the time they were adopted, the Division was not bringing complex matters administratively, and there was little experience with the explosion of electronic documents that is commonplace today. As such the time periods in Rule 360 never considered the possibility that litigants in some matters would be forced to review in four months literally millions of pages of documents turned over by the staff. Of course in 1994, when the Commission last completed a material update of its Rules of Practice, it also did not consider the possibility of complex litigation in an AP. This explains why the rules provide only the most limited forms of discovery and depositions for respondents. The lack of adequate discovery opportunities and sufficient time to prepare for trials are serious disadvantages that raise fundamental issues as to the efficacy of bringing complex litigation under the existing Rules of Practice.
Report at 16-17 (footnotes omitted).
The most significant difference between an administrative proceeding and a civil action is in the area of pre-trial discovery. Through its investigation and the use of investigative subpoenas, the Commission’s staff will have developed an extensive investigative record over a significant period of time, before instituting an enforcement action. The Division of Enforcement effectively has had extensive discovery. While the current Rules of Practice
create a possibility for issuance of subpoenas by an ALJ, the rigorous deadlines for completion of a proceeding often result in ALJ reluctance to delay a hearing by approving the issuance of subpoenas. The disparity in discovery rules between Commission administrative proceedings and federal litigation is a sore point with SEC defense counsel.
The Commission’s Rules of Practice have not been significantly amended since 1993. The comprehensive review at that time reflected the substantial changes in authority and sanctions contained in the Remedies Act. Since the new authority was in its infancy, there was limited experience to provide a benchmark. It was also not possible to anticipate the additional expansions affected by SOX and Dodd-Frank. As such the project was an
effort to anticipate what would be needed to ensure that administrative proceedings would be conducted and adjudicated in a timely, fair, and impartial manner. It is fair to conclude that no member of the Task Force working on that project envisioned what the norm is more than 20 years later. For this reason, the Commission should update and review its Rules of Practice. This should not be a controversial recommendation, given that the current
general counsel of the SEC has publicly suggested that it is time for a review.
Report at 20-21 (footnotes omitted).
The report puts to rest the bona fides of the ill-conceived response from the Enforcement Director arguing that the rules and procedures governing administrative actions do not favor the Division as prosecutor, and the memorandum from the Division of Enforcement purporting to rationalize the Division’s forum-choice decisions.
When the Director of Enforcement acknowledged a new policy of using the administrative forum more frequently to pursue enforcement cases even in complex actions involving unregulated persons, there was an outcry that this was an effort to stack the deck unfairly in the Enforcement Division’s favor (is there a way to stack a deck fairly?). See, for example, SEC Enforcement Director Announces Future Plans To Avoid Jury Trials, and Former SEC Enforcement Leaders Urge SEC To Reform Administrative Enforcement Process. Instead of acknowledging a problem that needed to be discussed and resolved, Enforcement Director Andrew Ceresney gave a premeditated, yet ludicrous, response that respondents were not harmed at all by being forced into the administrative forum. See Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions.
When this plainly incorrect response failed to quell the sense of outrage, the Division of Enforcement published a memorandum purportedly explaining how it decided, and would decide, which forum to use in a prosecution, presumably in an effort to show that those decisions were not arbitrary. See SEC Attempts To Stick a Thumb in the Dike with New Guidelines for Use of Administrative Court, and Upon Further Review, SEC Memo on Use of Administrative Courts Was Indeed a Fumble.
The report lays waste to each of these efforts to avoid the key substantive fairness issues raised by the increased use of the administrative forum in its current form. It hopefully puts to rest any serious contention that respondents are significantly disadvantaged when the Commission chooses to file a complex case administratively at the same time it dissects the Division of Enforcement memorandum to show it is written without adequately considering impacts of this policy outside of the Division itself, and often relies on false premises:
In early May 2015, the Division of Enforcement posted on its page on the SEC website a document titled Division of Enforcement Approach to Forum Selection in Contested Actions. As the title indicates, the document provides an explanation of the factors that the Division will consider when making a forum recommendation to the Commission. . . .
Four factors are identified and discussed:
• The availability of the desired claims, legal theories, and forms of relief in each forum (factor 1);
• Whether any charged party is a registered entity or an individual associated with a registered entity (factor 2);
• The cost-, resource-, and time-effectiveness of litigation for the Commission in each forum (factor 3); and
• Fair, consistent, and effective resolution of securities law issues and matters (factor 4).
Factor one acknowledges that certain causes of action are unique to each forum. . . .
Factor two restates the long-standing use of the AP process for actions against registered entities and associated persons. . . .
Factor three describes additional time and resource benefits that the staff derive from each type of forum, under certain circumstances. These time and resource considerations
highlight the benefits exclusive to the Division. No recognition or consideration is given to the impact of the forum decision on the parties charged. In this respect, the policy is most troubling. While the apparent efficiency of an administrative proceeding may be a benefit to the Division, it may be a serious and inequitable impediment to the person charged. As a factual matter, the claimed rapidity of an administrative proceeding over a federal court action may also be incorrect.
The speed of the AP process is largely a byproduct of two factors. One factor is the limited availability of pre-hearing discovery. The second factor is the time limits imposed by Commission rule on the length of the process.
The lack of pre-hearing discovery adversely affects the respondent rather than the SEC staff. This is because the staff has been able to compile its evidentiary record, including sworn depositions, through its investigation process. In effect, the staff is able to conduct its prehearing discovery before beginning the proceeding. The respondents in an administrative proceeding have no comparable opportunity. While they may be provided with the staff’s investigative record, this does not provide them with an opportunity to ask their own questions of witnesses or seek documentation to support their position. More important, they may have only a very short amount of time in which to review an investigative file, compiled over years of investigation and encompassing literally millions of pages of material. The unequal impact of this limitation is discussed further below, under the discussion of factor three.
The second factor, specific time deadlines, may not result in the level of efficiency that the Division suggests. . . . Factoring in the extended time period for completion of the Commission’s review suggests that the overall period for completion of an administrative proceeding is likely slower than the time required to complete a trial in district court.
Factor three also refers to the costs and benefits arising from the “additional time and types of pre-trial discovery available in federal court.” While the current AP rules may provide benefits to the staff in terms of resources, they affirmatively disadvantage the respondents in these proceedings. . . . At the time [these rules] were adopted, the Division was not
bringing complex matters administratively, and there was little experience with the explosion of electronic documents that is commonplace today. . . . The lack of adequate discovery opportunities and sufficient time to prepare for trials are serious disadvantages that raise fundamental issues as to the efficacy of bringing complex litigation under the existing Rules of Practice. . . .
The fourth factor broadly raises these fundamental considerations of fairness and efficacy. The only aspects of it that are discussed in the Division’s statements are the traditional statement concerning the superior expertise and experience of ALJs and the Commission, and the benefits that may come from having these experts be the first to examine and interpret the law, subject to appellate review.
Notably absent from this factor is the issue of the right to a jury trial. One of the core constitutional protections is the right of persons to demand a jury trial. The Supreme Court
has held that a defendant is entitled to a jury every time the government demands a civil penalty. . . . Ironically, under the new forum choice process, instead of the defendant controlling the right to request a jury, through the choice of forum the government will have complete control over the right to a jury. If the Division believes a jury would be advantageous, then it can file in district court. If the Division prefers not to have a jury hear a case, then it can file an administrative proceeding. Of all the consequences of the choice of forum controversy, it is likely that most objective persons would view this usurpation of a defendant’s right to request a jury as the most objectionable consequence.
Other fairness issues are also worthy of examination. As previously explained, the lack of time and lack of discovery options also raise serious fairness issues. In addition, one should be careful not to overstate the superior expertise that resides with the Commission’s adjudicators. Under the procedure governing the appointment of ALJs, direct substantive expertise in the applicable law is a minor consideration. The dominating factor in the selection process is experience as an ALJ in the federal government. During the past 30 years, the SEC has not hired a single ALJ who had directly relevant experience or expertise related to the federal securities laws. While one may reasonably assume that each ALJ will, over time, acquire this expertise, currently only two of the six SEC ALJs have been at the Commission for more than two years.
This lack of substantive experience is particularly relevant when one considers the different standard for appellate review of SEC opinions compared to federal district court decisions…. This limited standard of review applies even in matters in which the Commission interprets the law differently from judicial interpretation. . . .
Report at 14-17 (footnotes omitted).
The report makes many recommendations for action by the Commission. Many are fairly obvious for laying a foundation of fairness in this process. Others may ask too much. But each is a serious proposal meriting thought, analysis, and discussion, beyond the scope of this article. The point to be made first is that the report leaves little doubt that it is time for the SEC commissioners to join in a “conversation” about how best to reform the SEC’s enforcement and administrative process, rather than mutely filing briefs in the administrative and federal courts that do their best to try to prevent anyone from causing meaningful reform.
July 16, 2015