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

This is the fourth and final post discussing the SEC’s proposals for revising the Rules of Practice in its administrative court.  These proposals purport to modernize antiquated procedures in that forum.  Our first three posts addressed three unacceptable aspects of the SEC’s proposals: (1) requiring that respondents plead in their answers certain defense theories that are not “affirmative defenses” required to be pled in response to complaints filed by the SEC in the federal courts; (2) providing for a discovery process limited to a maximum of 5 depositions, requiring that those be shared among multiple respondents, allowing the Division of Enforcement an equal number of depositions (in addition many investigative depositions taken before the case was filed), and limiting the scope of witnesses that respondents could depose within the tiny allotment provided; and (3) the proposals continue to handcuff the respondents with respect to third party discovery and discovery from the SEC itself by maintaining highly restrictive rules limiting the issuance of subpoenas, while the SEC staff has essentially unlimited access to these sources of evidence.  You can review these comments here (Part I), here (Part II), and here (Part III), respectively.

The last part of the SEC proposed rule changes we will discuss involves the administrative trial itself.  Many commentators have noted the unfairness of the current SEC administrative proceedings with respect to the court’s acceptance of unreliable information into evidence.  The Federal Rules of Evidence do not apply in this forum, and administrative law judges, who effectively control the record, accept into evidence testimony and exhibits that would not be admitted into evidence in federal court.  As with almost all of the exercises of discretion by the SEC ALJs, this freedom to introduce into evidence material that would not be permitted in a court proceeding usually advantages the SEC staff.  The SEC ALJs treat the SEC staff with deference, lessening the usual standards under the theory that the staff is presumptuously acting in good faith.  That is one of the fundamental, hidden differences between SEC administrative proceedings and SEC court proceedings: the ALJs are accorded more discretion than judges with respect to evidentiary matters, and their use of that discretion tends to favor the litigant they presume is acting in the public interest – the Division of Enforcement and its lawyers.

The SEC’s proposed changes to Rules of Practice 235 and 320 would make what is already an unfair aspect of these proceedings even worse.  Rule 235 addresses when “a prior, sworn statement of a witness, not a party, otherwise admissible in the proceeding” may accepted into evidence.  It allows such evidence to be admitted when witnesses are dead, out of the country, incompetent to testify, cannot be subpoenaed, or “it would be desirable, in the interests of justice, to allow the prior sworn statement to be used.”  The SEC proposes that Rule 235 be expanded to cover “sworn deposition [testimony in the case], investigative testimony, or other sworn statement or a declaration pursuant to 28 U.S.C. 1746, of a witness, not a party, otherwise admissible in the proceeding.”  It further proposes that an “adverse party” may use any such prior statements of “a party or anyone who, when giving the sworn statement or declaration, was the party’s officer, director, or managing agent” may be used “for any purpose,” apparently without any showing of unavailability.  The latter change is presumably intended to benefit only the SEC staff, not respondents, because it seems unlikely that the adverse party to respondents in these proceedings – the Division of Enforcement – would have made any “sworn statements” relevant to the proceeding.

Rule 320 currently provides that the ALJ “may receive relevant evidence and shall exclude all evidence that is irrelevant, immaterial or unduly repetitious.”  The SEC’s proposed changes would require the exclusion of “unreliable” evidence, but would add specifically that “evidence that constitutes hearsay may be admitted if it is relevant, material, and bears satisfactory indicia of reliability so that its use is fair.”  Now, apparently, the Division can obtain mere declarations from some important witnesses like current or former officers, directors, or agents of the respondent — crafted by the SEC lawyers themselves — and submit them as evidence proposed under new Rule.  No court in the land would permit that.

As a result of the current lax standards governing admissibility of evidence, the ALJs already allow many forms of hearsay into the record.  That allows the SEC staff to make much of its case in administrative proceedings with evidence that would not be permitted in federal court. Among the most consistent and worst use of hearsay evidence in these cases is the general acceptance into evidence of transcripts of investigative testimony taken by the SEC staff. Because these examinations are conducted by the Enforcement Division’s lawyers, and are statements made under oath, the ALJs typically accept them into evidence without serious inquiry into their reliability.  However, they often are not reliable. There are several reasons for this:

  • First, these examinations take place in a context in which witnesses are often blindsided with inquiries about things that occurred years before with limited, if any, access to materials that could allow them to refresh their recollection of those dated events.  Sometimes, basic aspects of the subject matter the staff intends to inquire into are not known in advance.
  • Second, these questions and answers take place at a time when the primary goal of the witness is to try to convince the same staff not to take an adverse action against the witness.  This causes the witness to try as hard as possible to please the examiners.  That includes being reticent to tell them when the questions do not make sense, or are based on assumptions that are not valid, or reflect a lack of understanding (sometimes a very basic understanding) of the business matters or transactions involved.  Even defense counsel often resist criticizing questions or tactics for fear that the staff lawyers will become more antagonistic as a result.
  • Third, these examinations often are conducted in a manner that is more in the nature of an inquisition than an examination. It is not unusual for two, three, or four lawyers and sometimes accountants to act like a tag team, taking turns at the examination.  And often the staff is trying to create a record that implicates the witness or others and pressures the witness into providing its desired response, lest the witness otherwise be perceived as uncooperative or recalcitrant.
  • Fourth, the staff lawyers often formulate confusing and ambiguous questions, including regularly misusing technical terms.  That is sometimes because of lack of skill, sometimes lack of experience, and sometimes in an effort to cajole the witness into making statements that can later be portrayed as admissions when they are nothing of the kind.  No judge, magistrate, or even senior SEC official is there to prevent this, and objections by counsel are feckless, because the staff need do nothing to respond to those objections.  The end result is often a transcript that leaves open multiple interpretations of what the testimony actually says.
  • Fifth, the staff will often use limited materials during the examination that do not allow the witness to put documents or events in context, because the context is not made available. That often occurs with the misleading use of emails to portray one picture of events when other emails are not used that create a very different context.
  • Sixth, there is no real right to cross-examine the witness, nor an incentive for the defense counsel to do so.  Defense counsel is given the opportunity to ask questions, but typically lacks the materials that would allow useful questions to be formulated.  And without knowing where the investigation is headed, the defense counsel typically is loathe to get back into matters that may be ambiguous on the record, knowing there should be opportunities at later times to discuss the subject matters addressed with the staff, when a greater knowledge of entire record is possible and the direction the staff may be headed is more clear.

I believe that in contested cases in federal court, one significant reason for the SEC’s greater percentage of losses at trial is the unreliability of the investigative testimony the staff (and Commission) rely upon when a case is brought.  At trial, often the picture that is revealed by court testimony varies in significant ways from the record the staff created during the investigative testimony.  That in turn results in the staff having difficulty proving the Commission’s allegations.  When investigative transcripts are used to try to impeach witnesses by showing a supposed difference between the earlier statements and trial testimony, the infirmities of the investigative testimony undercut staff efforts to challenge the witness’s credibility, and in some cases serve only to impeach the credibility of the SEC and its lawyers.

The SEC’s new proposed Rules 235 and 320 are designed to codify the ALJ practice of treating investigative transcripts as a reliable form of “sworn statement,” as well as to codify the acceptability of hearsay evidence more generally, apparently without regard to a realistic examination of reliability.  Proposed new Rule 235 explicitly calls out investigative transcripts as proper forms of evidence, and allows their use against respondent parties “for any purpose.” And proposed Rule 320, specifically approves the use of hearsay evidence as long as it “bears satisfactory indicia of reliability.”  Having previously defined investigative transcripts as having “satisfactory indicia of reliability” in proposed Rule 235, the proposed new rules assure that ALJs will continue the unseemly and harmful process of using staff-controlled investigative transcripts as valid evidence.

That is the opposite of what should have been done.  There are strong reasons why hearsay evidence is permitted only under specific exceptions in the Federal Rules of Evidence.  A long history of evidentiary theory, thought, and practice, produced explicit understandings of when it is fair to allow out of court statements to be used to prove a case at trial.  Instead of endorsing a broad swath of hearsay evidence as acceptable, the SEC should have taken note of that history and careful thought.  It should have started with the assumption that the federal evidentiary rules are cogent and well-conceived, and departed from those rules only as necessary to achieve specific goals unique to its administrative proceedings that the federal rules impede.  If this standard were applied, I have little doubt that most of the Federal Rules of Evidence would be incorporated into the SEC administrative process.  There is no indication that any such analysis was done by the Commission, which in my view makes its evidentiary choices in the proposed rules arbitrary and capricious.

In fact, this same fundamental flaw in the way the Commission formulated its new proposed Rules of Practice infects the entire proposal.  There is an existing system of procedures, discovery, and evidence, that is in place in the federal courts which has been examined and refined over the years with enormous experience and attention.  In contrast, the SEC’s administrative process is broken and desperately needs repair.  But instead of using the federal court experience as a valuable benchmark for SEC administrative rules, the Commission decided to make only marginal changes — at best — to its broken system.  Why it chose this approach is not clear, because that analysis, if it occurred, is never discussed in the proposal.  My guess is that the bureaucrats took control of the process and desperately sought to avoid any major changes.  But for whatever reason, the SEC failed to use the many years of federal court practice and experience to generate a new, better set of rules for its administrative forum.

The Commission should have started from what we know to be fair and due process in the federal courts and replicated that process to the extent possible and appropriate in the context of an administrative proceeding.  It should have used the many years of federal court practice and experience to generate a new, better set of rules for the administrative forum.  If it perceived specific flaws in the federal court discovery or evidentiary process that could cause undue delay or expense, it should explain those, and make only those changes that would improve the process for all of the parties, not just the SEC.

Instead, it is painfully apparent that little effort was made to make the SEC administrative court a fairer forum for those prosecuted.  Minor changes were made in the timing of cases and the availability of discovery – changes transparently insufficient to accomplish any fairness goal. And these were accompanied by granting to the SEC staff several “goodies” from the Division of Enforcement wish list – e.g., requiring additional pleading of defenses and expressly permitting the use of hearsay evidence and investigative transcripts – that, in the end, probably make the administrative forum even more biased in favor of the SEC prosecutors, and against the respondents, than it is now.

The SEC Needs To Be More Transparent and Forthcoming To Recover Any Credibility

One final note.  The degree of disingenuousness by the SEC during this whole process has been shameful.  All along, both the Division of Enforcement and the SEC Chair have been touting the high degree of fairness in the SEC administrative courts in ways that do not pass the “ha ha” test.  See, for example, Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions.  SEC Chair Mary Jo White was a capable – indeed, admired – private practitioner, and she must fully understand the huge advantage the SEC staff has in SEC administrative proceedings.  But she nevertheless maintains the bureaucratic fiction that everything is just fine there.  And she does so with statements that are obviously, embarrassingly, wrong.

The latest statement along these lines was Ms. White’s cynical performance in a recent Wall Street Journal interview.  See Mary Jo White explains the new SEC rules.  Here is what she said about SEC administrative proceedings:

One of the things that I think was a good thing for us to do was put out public guidelines as to what factors are considered in choosing the forum [in which to bring a case].  The commission, by the way, has to approve the choice of venue in every single case.  It isn’t up to the enforcement division.

There have been questions raised.  For example, I think in one year, if you look at the win rates in administrative proceedings versus district court, you’ll see a higher win rate.  But again, it’s cyclical to some degree.  If you look at this past year, we have a nearly 100% win in district court, and a lesser success rate in administrative proceedings, which have unique due-process rights.  For example, you have to turn over what’s called Jencks and Brady material in administrative proceedings, which is essentially exculpatory information, to the respondent, the defendant.  You don’t have that requirement in district court.  Recently we’ve put out for comment [proposed rules] to modernize our administrative proceedings. Should there be more discovery?  Should there be more time provided before there’s a hearing? . . .

I think they’re very fair proceedings. But you always want to critically examine what you’re doing so that you’re conveying not only in reality the fairness of a particular forum, but the appearance of it, too.

What nonsense.  And Ms. White is a good enough lawyer and securities litigator to know it.  With this statement, she reduced herself to rote adoption of the bureaucratic party line.

First, the statement that the SEC “put out public guidelines as to what factors are considered in choosing the forum,” as if there is some binding and useful guidance on that issue, is wrong, and she knows it.  She must know it because virtually every person and law firm to comment on that release recognized that it provided no useful information about the forum selection process, and essentially said no more than that the Commission has total discretion to choose whatever forum it prefers.  See SEC Attempts To Stick a Thumb in the Dike with New Guidelines for Use of Administrative Court; SEC’s New Guidance on the Use of Administrative Proceedings: “It’s Up to Us.”.

Second, the argument that the administrative forum provides greater rights to the persons sued because the Division of Enforcement is required “to turn over what’s called Jencks and Brady material in administrative proceedings, which is essentially exculpatory information, to the respondent, the defendant, and “[y]ou don’t have that requirement in district court” is both misleading and false.  To begin, the SEC staff’s determination of what is Brady and Jencks material is notoriously narrow.  In the staff’s view, if a document does not itself say that the respondent is innocent, it is not exculpatory – which leaves out many documents that are building blocks in proving the respondent’s innocence (for example, materials that show that a key SEC witness is lying would not be delivered).  Likewise, unless a document is a verbatim recording of what a witness said previously, it is not delivered as Jencks material.  That leaves out important summaries of interviews that report on many important things that were said in unrecorded interviews.  In addition, in both Brady and Jencks disclosures, the staff withholds anything it considers to be work product or subject to the so-called deliberative process privilege, which excludes large amounts of important information.  And there is no effective review of these decisions.  The ALJs almost uniformly accept the staff’s determinations on these disclosures because they assume the SEC staff acts in good faith (which is itself a breach of their duty to serve as neutral judges).  As a result, they are nearly useless in helping a respondent get true Brady and Jencks production.

In contrast, in federal court, a defendant can issue a document request for all Brady and Jencks material, and much more, and force the staff to produce all useful materials for the defense of the case.  When (not if) the SEC lawyers fail to deliver all of the relevant material, they can bring the issue to an independent judge who will treat both parties equally and not defer to the SEC staff’s determinations (at least in most cases).  So how exactly are an accused’s Jencks and Brady rights better in the administrative forum better than a federal court?  They are not.  Ms. White certainly understands that, but chooses to say otherwise.

If the SEC is ever going to reform its administrative forum, and make it into a fair alternative to the federal courts, it must recognize the problems in the current system, speak honestly about them, and make a genuine effort to produce new rules that flatten the playing field.  At the behest of SEC bureaucrats, Ms. White and her fellow Commissioners have plainly decided to avoid that route and make proposals that do not move perceptibly in the direction of fairness, but instead defer to the preferences of the SEC staff.  As a result, the proposals are grossly inadequate, and the SEC’s credibility on the issue is in shreds.

The proposed changes to the SEC Rules of Practice should be rejected.  Because the Commission has shown it is effectively captive to its staff, the best way to proceed is to appoint a committee of well-regarded SEC litigators to put together proposals for new Rules of Practice.  The Commission often seeks the assistance of professionals to address key regulatory issues, and the fairness of its administrative forum is no less important than those.  Of course, the SEC staff would fight tooth and nail to avoid this, so don’t hold your breath.

Straight Arrow

December 3, 2015

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

Advertisements

One thought on “Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part IV

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s