Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part I

On September 24, 2015, the SEC proposed changes to its Rules of Practice governing administrative proceedings, which Chair Mary Jo White said “seek to modernize our rules of practice for administrative proceedings.”  After resisting immediate comment pending a careful review of the proposals and underlying explanations, a considered evaluation can now be made.  Unfortunately, this proposal represents so feeble an effort at modernizing the Commission’s dated Rules of Practice that only one judgment is justified.  If the provision of fair and “due” process to respondents in these actions is the standard, the Commission’s grade is an “F+.”  If providing a reasoned and rational explanation for the proposals is the standard (i.e., do they pass muster under the Administrative Procedure Act), the Commission’s grade is an “F.”  In fact, the only way this set of proposals gets anything more than a “D+” is if the objective was to create a proposal that could act as a Potemkin Village for arguments that the Commission is acting responsibly, and even in that regard, what the Commissioners came up with was a pretty shoddy Potemkin Village.

The proposals do not even begin to analyze or address in any substantive way the issues raised in depth by commentators over the 15 months since the SEC’s General Counsel acknowledged the existing rules are plainly insufficient to adjudicate complex cases.  See, for example, Chamber of Commerce Report Details Concerns with SEC Enforcement and Proposed Reforms.

The proposed revisions to the Rules of Practice can be reviewed here: Proposed amendments to SEC Rules of Practice.

Far from representing a good faith attempt to provide procedures that would allow fair proceedings on a somewhat more expedited basis than most federal courts, the proposals do nearly nothing to alter the pro-prosecution tilt that currently exists. That tilt is well-understood by the securities bar, and was documented statistically by the Wall Street Journal.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.  Virtually nothing in these proposals changes that.  In fact, there are as many changes designed to give even greater advantages to the SEC prosecutorial staff as there are even minor attempts to give respondents a fighting chance.

The next several Securities Diary blogs will address various aspects of the SEC’s proposal and explain why (1) they do not represent a good faith effort at creating a modernized administrative adjudicative process designed to be fair to all parties, including respondents; (2) they are not supported by anything approaching reasoning or analysis that shows the changes proposed are well-designed to achieve identified goals, but instead represent fiats by the Commission that have no support beyond an arbitrary or capricious Commission determination; and (3) they include “goodies” for the benefit of SEC prosecuting staff that achieve no meaningful goal other than to make it easier for the Division of Enforcement to win.

Today we will start with an example so egregious that it is astonishing it got past whatever (apparently feckless) legal quality control was used to winnow out staff requests for new “goodies” that cannot be reasonably justified.

One of the SEC proposals is to amend Rule 220 of the Rules of Practice to mandate that “a respondent must affirmatively state in an answer whether the respondent is asserting any avoidance or affirmative defense, including but not limited to res judicata, statute of limitations, or reliance.” Proposal at 17.  The Commission explains: “This proposed amendment would not change the substantive requirement under the current rule to include affirmative defenses in the answer.  Instead, it is intended to clarify that any theories for avoidance of liability or remedies, even if not technically considered affirmative defenses, must be stated in the answer as well.  Timely assertion of affirmative defenses or theories of avoidance would focus the use of prehearing discovery, foster early identification of key issues and, as a result, make the discovery process more effective and efficient.”  Id.

Current Rule 220 says this about pleading affirmative defenses: “A defense of res judicata, statute of limitations or any other matter constituting an affirmative defense shall be asserted in the answer.”  This provision is roughly consistent with the Federal Rules of Civil Procedure, which require that a defendant’s Answer notify the plaintiff of all affirmative defenses he intends to present.  Importantly, “affirmative defenses” include only those on which the defendant bears the burden of proof, like res judicata, assumption of risk, statute of limitations, and the like.  In court, a defendant is not required to identify the ways in which he intends to introduce evidence counteracting elements on which the plaintiff has the burden of proof.

The SEC’s new proposal seeks to change this long-standing pleading standard by requiring that defendants identify not only “affirmative defenses” (on which they have the burden of proof), but also inform the SEC staff of the ways in which they intend to defend against the charges by refuting elements on which the Division of Enforcement has the burden of proof.  The Commission describes these as “theories for avoidance of liability or remedies, even if not technically considered affirmative defenses.”  This is an insidious “goody” to provide the prosecuting staff with (a) the right to learn defense theories of defense in advance, and (b) presumably the right to preclude certain defense theories if they are not disclosed in advance.

It is not clear what “theories for avoidance of liability” this meant to include, with one exception – the specific reference to requiring that a respondent plead in his answer any defense theory of “reliance.” This is the “tell” that shows you that the SEC staff provided a list of substantive “goodies” it wanted out of this supposed reform of obsolete procedures.  Forgive me, but understanding why this is so requires a little background.

Most of the major cases the SEC litigates involve allegations of fraud.  Fraud requires proof of scienter, that is a state of mind showing that the respondent knowingly violated the law.  The SEC, and all federal appellate courts other than the Supreme Court (which has not ruled on the issue), allow proof of “reckless” conduct to establish the required intent.  But in all instances it is the prosecutor’s (or plaintiff’s) burden to prove scienter.  It is not an “affirmative defense” because it is not a defense on which the respondent bears the burden of proof.  The prosecutor or plaintiff, here the SEC Division of Enforcement, must introduce evidence that the respondent acted with intent, and in the end, the court (or jury) can rule against the respondent only if a preponderance of all of the evidence on that issue supports a finding that the respondent acted with scienter.

The SEC staff often lacks direct evidence showing the respondent acted with scienter.  In those cases, the staff relies on their portrayal of the circumstances to show that a respondent acted with scienter, typically arguing that under the circumstances (as they portray them), the respondent “must have” acted with intent because it was obvious that they were engaging in wrongful conduct, or ignoring whether the conduct was right or wrong.  But the Staff often is faced with a problem: evidence, usually developed by the people it prosecutes (the SEC staff rarely tries to develop a complete record on this during its investigation) that (a) they did not know they were violating the law, and (b) they acted on the basis of information or advice received from others which in fact allowed them to believe reasonably that what they were doing was lawful.  Such evidence undercuts the staff’s circumstantial arguments and tips the scale against finding that the respondent knowingly or recklessly violated the law.

One, but certainly not the only, way this occurs is when respondents want to offer proof that they received legal advice that gave them comfort that what they were doing did not violate the law.  This sometimes is referred to by the staff as a “reliance on counsel” defense, but in fact it is nothing more than introducing additional circumstantial evidence that may weigh in favor of concluding that the respondent did not intentionally violate the law.  The same type of evidence could involve advice or communications from accountants or other professionals, communications from government officials (including SEC officials themselves), and even information conveyed by people with whom the respondent worked, and who could reasonably be expected to provide accurate or reliable information or advice.

(As an aside, the Commission proposal says in footnote 28: “some might argue that ‘reliance on counsel’ is not a formal affirmative defense, but a basis for negating liability.”  That is a blatant misstatement of the law.  This is not a “some might argue” issue.  There is no doubt in the law that “reliance on counsel” is not an affirmative defense – formal or informal.  Accordingly, there is no obligation in federal court to include “reliance on counsel” in the affirmative defenses in the Answer to a Complaint.  Indeed, such a purported affirmative defense could be stricken as improper.  Reliance on counsel is a form of evidence providing a strong inference that the defendant did not act with scienter because he received, and acted in conformity with, advice provided by well-informed legal counsel.)

In court, no aspect of this type of defense needs to be included in the Answer to the Complaint.  And the same is (or should be) true under the current formulation in SEC Rule of Practice 220.  But the staff hates that.  They want to know what theories the defense will use to undermine scienter, but most especially what evidence might be used to show that the respondent reasonably relied on input from another person to believe he was acting properly.  So, lo and behold, a requirement to notify the staff of any such intended theory of “reliance,” gets included in the proposed revised Rules of Practice.  Voila! One of the SEC staff’s greatest banes is removed – poof!

And what is the reasoning provided for making this major change that advantages the SEC staff in these cases?  Try this: “Timely assertion of affirmative defenses or theories of avoidance would focus the use of prehearing discovery, foster early identification of key issues and, as a result, make the discovery process more effective and efficient.”  Proposal at 17.  That is pure blather.  More of a rationale – much more of a rationale – is needed to support a basic, significant change in pleading burden for respondents that gives a major tactical advantage to the prosecution (which we know in these proceedings hardly needs additional advantages).

Slipping this change into the proposed Rules of Practice is an insidious effort to put an additional thumb on the scale in favor of the prosecution in SEC administrative cases.  If adopted in the final rules, it should challenged as, at a minimum, a significant departure from long-standing procedures that is designed to assist the SEC prosecutorial staff but lacks any grounding in a valid objective of the Rules of Practice, and hence is arbitrary and capricious.

Next time: why allowing a maximum of three depositions in a complex case (or five in a case with multiple respondents) (a) fails to achieve any semblance of fairness, (b) is proposed without any supporting analysis suggesting it accomplishes any stated goal, and (c) therefor is arbitrary and capricious as proposed.

Straight Arrow

October 8, 2015

Contact Straight Arrow privately here, or leave a public comment below:

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3 thoughts on “Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part I

  1. Pingback: Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part II | Securities Diary

  2. Pingback: Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part III | Securities Diary

  3. Pingback: Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part IV | Securities Diary

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