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First Circuit Rebuffs SEC in Flannery and Hopkins Case and Vacates SEC Order

The SEC suffered a stunning loss in the First Circuit in a December 8, 2015 decision ruling that the SEC’s findings of securities law violations by two executives in connection with the operation of a State Street Bank bond fund lacked substantial supporting evidence.  The Commission had, by a 3-2 divided vote, overturned a decision by one of its administrative law judges that no violations had occurred, and in doing so wrote a highly controversial opinion in which it staked out aggressive positions on a variety of securities law issues.  See SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5; New, Thorough Academic Analysis of In re Flannery Shows Many Flaws in the Far-Reaching SEC Majority Opinion; and SEC not entitled to deference in State Street fraud appeal – law prof.

The First Circuit panel found, however, that the underlying evidence simply failed to support the finding of any violation on any  theory, even the aggressive interpretations set forth by the Commission in its opinion.  As a result, the First Circuit never ruled on the validity or invalidity of several important legal issues raised by the Commission in its overreaching opinion.  Therefore, the key issue whether the SEC’s attempt at aggressive revisions of the scope of the law are entitled to deference or acceptance was not reached.  The end result, however, which vacates the SEC Order, leaves no SEC precedent in place to support those aggressive opinions.

The First Circuit’s opinion is available here: 1st Circuit Decision in Flannery v. SEC.  The now-vacated SEC opinion is available here: In re Flannery Majority Opinion.

Perhaps the most stunning aspect of the First Circuit opinion is the way in which the court schooled the SEC — the supposed experts on securities —  by explaining why the evidence the SEC found compelling (despite a contrary ruling by its ALJ) was in fact deeply flawed.  Where the Commission majority found evidence of material intentional and negligent misrepresentations, the appellate court found no substance whatever.  What does this say about the competence of the SEC and its staff to consider such issues?  If you read the opinion, you will see that the SEC’s willingness to stretch minimal evidence into supposed violations of law, and to disregard the lack of real evidence of materiality and state of mind proffered during the trial, seems a lot like the strained efforts of plaintiffs’ lawyers to find securities fraud everywhere.  And that is the reality faced by those being investigated and prosecuted by the SEC: the investigation and prosecution proceeds on the basis of a distorted view of what constitutes important information, and intentional or negligent behavior, that puts almost every decision in the SEC’s cross-hairs based largely on backward-looking, “fraud by hindsight” reasoning.

 The First Circuit opinion is based on an analysis of the specific evidence in the record, and therefore is not easily summarized.  The case turned on two sets of events.

The case against Mr. Hopkins turned on a short presentation to investors in which he participated, and, indeed, a single power-point slide in that presentation.  That slide set forth various parameters of the bond fund at issue (State Street’s Limited Duration Bond Fund, hereafter “the Fund”) under the heading “Typical Portfolio Exposures and Characteristics.”  It never purported to lay out the exact characteristics of the Fund at the time of the presentation, although Mr. Hopkins had that information available if any investor asked about them.  The SEC charged Mr. Hopkins with fraud for discussing this power-point slide without providing the exact information about the Fund at that time, which in some respects differed from the “typical” slide, and in others did not.  In particular, the percentage of holdings of different types of asset-backed securities — ABS (asset-backed securities, included residential mortgage-backed securities), CBS (commercial-backed securities), MBS (mortgage-backed securities), and other designations — at the time varied from the “typical” slide by having heavier ABS holdings.

The case against Mr. Flannery focused on two letters sent by State Street to investors regarding the impact of the 2007 financial crisis on the Fund and steps being taken to respond to that.  Mr. Flannery signed one of those letters, but not the other.  Many State Street officials participated in the drafting of these letters, including its General Counsel.  The SEC contended that Mr. Flannery negligently participated in a “course of business” that “operated as a fraud” in his role in connection with these letters.  The alleged misrepresentations in the letters related to whether steps taken to divest the Fund of certain bonds were properly described as lessening its exposure to risk.

As you can see, these are “in the weeds” issues to which the SEC should be able to bring sophistication and expertise.  Instead, they pursued a blunderbuss case that ignored the context of the disclosures, the realities of these types of communications (what they are intended to communicate and what not), and the actual language used.  The SEC essentially waved its hands around and said “this is bad; this is bad” and “look how badly the funds did when the mortgage-backed securities market tanked.”  But it failed to present evidence that what was said was wrong, or that the aspect that it contended was wrong was even important to investors, and ignored substantial evidence to the contrary.

Here is some of what the court said with respect to the case against Mr. Hopkins:

Questions of materiality and scienter are connected. . . .  “If it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact.” . . .

Here, assuming the Typical Portfolio Slide was misleading, evidence supporting the Commission’s finding of materiality was marginal.  The Commission’s opinion states that “reasonable investors would have viewed disclosure of the fact that, during the relevant period, [the Fund’s] exposure to ABS was substantially higher than was stated in the slide as having significantly altered the total mix of information available to them.”  Yet the Commission identifies only one witness other than Hopkins relevant to this conclusion. . . .

[T]he slide was clearly labeled “Typical.”  [The witness and his firm] never asked … for a breakdown of the [Fund’s] actual investment….  Further, the Commission has not identified any evidence in the record that the credit risks posed by ABS, CMBS, or MBS were materially different from each other, arguing instead that the percent of investment in ABS and diversification as such are important to investors.  Context makes a difference.  According to a report [the witness] authored the day after the meeting, the meeting’s purpose was to explain why the [Fund] had underperformed in the first quarter of 2007 and to discuss its investment in a specific index that had contributed to the underperformance.  The Typical Portfolio Slide was one slide of a presentation of at least twenty. Perhaps unsurprisingly, the slide was not mentioned in [the witness’s] report.

Hopkins presented expert testimony . . . that “[p]re-prepared documents such as . . . presentations . . . are not intended to present a complete picture of the fund,” but rather serve as “starting points,” after which due diligence is performed.  [The expert] explained that “a typical investor in an unregistered fund would understand that it could specifically request additional information regarding the fund.”  And not only were clients given specific information upon request, information about the [Fund’s] actual percent of sector investment was available through the fact sheets and annual audited financial statements.  The … fact sheet … six weeks prior to the … presentation [said] the [Fund] was 100% invested in ABS.  The [fact sheet one-month after the presentation said] the [Fund] was 81.3% invested in ABS. These facts weigh against any conclusion that the Typical Portfolio Slide had “significantly altered the ‘total mix’ of information made available.” …

This thin materiality showing cannot support a finding of scienter here….  Hopkins testified that in his experience investors did not focus on sector breakdown when making their investment decisions and that [Fund] investors did not focus on how much of the [Fund] investment was in ABS versus MBS….  He did not update the Typical Portfolio Slide’s sector breakdowns because he did not think the typical sector breakdowns were important to investors.  To the extent that an investor would want to know the actual sector breakdowns, Hopkins would bring notes with “the accurate information” so that he could answer any questions that arose.  We cannot say that these handwritten notes provide substantial evidence of recklessness, much less intentionality to mislead — particularly in light of Hopkins’s belief that this information was not important to investors….

We conclude that the Commission abused its discretion in holding Hopkins liable under Section 17(a)(1), Section 10(b), and Rule 10b-5.

Slip op. at 21-24 (footnotes omitted).

The court said in a footnote: “… We do not suggest that the mere availability of accurate information negates an inaccurate statement.  Rather, when a slide is labeled ‘typical,’ and where a reasonable investor would not rely on one slide but instead would conduct due diligence when making an investment decision, the availability of actual and accurate information is relevant.”  Slip op. at 22 n.8.

And here is some of the discussion about the case against Mr. Flannery:

… At the very least, the August 2 letter was not misleading — even when considered with the August 14 letter — and so there was not substantial evidence to support the Commission’s finding that Flannery was “liable for having engaged in a ‘course of business’ that operated as a fraud on [Fund] investors.”

The Commission’s primary reason for finding the August 2 letter misleading was its view that the “[The Fund’s] sale of the AAA-rated securities did not reduce risk in the fund.  Rather, the sale ultimately increased both the fund’s credit risk and its liquidity risk because the securities that remained in the fund had a lower credit rating and were less liquid than those that were sold.” At the outset, we note that neither of the Commission’s assertions — that the sale increased the fund’s credit risk and increased its liquidity risk — are supported by substantial evidence.

First, although credit rating alone does not necessarily measure a portfolio’s risk, the Commission does not dispute the truth of the letter’s statement that the [Fund] maintained an average AA-credit quality. Second, expert testimony presented at the proceeding explained that the July 26 AAA-rated bond sale reduced risk because these bonds “entailed credit and market risk that were substantially greater than those of cash positions. In addition, a portion of the sale proceeds was used to pay down [repurchase agreement] loans and reduce the portfolio leverage.”

Further, testimony throughout the proceeding indicated that the [Fund’s] bond sales in July and August reduced risk by decreasing exposure to the subprime residential market, by reducing leverage, and by increasing liquidity, part of which was used to repay loans.

To be sure, the Commission maintained that the bond sale’s potentially beneficial effects on the fund’s liquidity risk were immediately undermined by the “massive outflows of the sale proceeds . . . to early redeemers.”  But this reasoning falters for two reasons. First, the Commission acknowledged that between $175 and $195 million of the cash proceeds remained in the LDBF as of the time the letter was sent; it offered no reason, however, why this level of cash holdings provided an insufficient liquidity cushion.  Second and more fundamentally, even if the Commission was correct that the liquidity risk in the [Fund] was higher following the sale than it was prior to the sale, it does not follow that the sale failed to reduce risk.  Rather, to treat as misleading the statement in the August 2 letter that State Street had “reduced risk,” the Commission would need to demonstrate that the liquidity risk in the LDBF following the sale was higher than it would have been in the counterfactual world in which the financial crisis had continued to roil — and in which large numbers of investors likely would have sought redemption — and the [Fund] had not sold its AAA holdings. But the Commission has not done this.

Independently, the Commission has misread the letter. The August 2 letter did not claim to have reduced risk in the [Fund].  The letter states that “the downdraft in valuations has had a significant impact on the risk profile of our portfolios, prompting us to take steps to seek to reduce risk across the affected portfolios” (emphasis added).  Indeed, at oral argument, the Commission acknowledged that there was no particular sentence in the letter that was inaccurate. It contends that the statement, “[t]he actions we have taken to date in the [Fund] simultaneously reduced risk in other [State Street] active fixed income and active derivative-based strategies,” misled investors into thinking [State Street] reduced the [Fund’s] risk profile.  This argument ignores the word “other.”  The letter was sent to clients in at least twenty-one other funds, and, if anything, speaks to having reduced risk in funds other than the [Fund].

Even beyond that, there is not substantial evidence that [State Street] did not “seek to reduce risk across the affected portfolios.”  As one expert testified, there are different types of risk associated with a fund like the [Fund], including market risk, liquidity risk, and credit or default risk.  The [Fund] was facing a liquidity problem, and … the Director of Active North American Fixed Income, explained that “[i]t’s hard to predict if the market will hold on or if there will be a large number of withdrawals by clients.  We need to have liquidity should the clients decide to withdraw.” Flannery noted that “if [they didn’t] raise liquidity [they] face[d] a greater unknown.”  … [The Fund’s] lead portfolio manager, noted that selling only AAA-rated bonds would affect the [Fund’s] risk profile.  After discussion of both of these concerns, the Investment Committee ultimately decided to increase liquidity, sell a pro-rata share to warrant withdrawals, and reduce AA exposure. And that is what it did.…  The August 2 letter does not try to hide the sale of the AAA-rated bonds; it candidly acknowledges it. At the proceeding, Flannery testified that selling AAA-rated bonds itself reduces risk, and here, in combination with the pro-rata sale, was intended to maintain a consistent risk profile for the [Fund].  [Another witness] testified that the goal of the pro-rata sale was to treat all shareholders — both those who exited the fund and those who remained — as equally as possible and maintain the risk-characteristics of the portfolio to the extent possible.  These actions are not inconsistent with trying to reduce the risk profile across the portfolios.

Finally, we note that the Commission has failed to identify a single witness that supports a finding of materiality….  We do not think the letter was misleading, and we find no substantial evidence supporting a conclusion otherwise. 

We need not reach the August 14 letter…. Even were we to assume that the August 14 letter was misleading, in light of the SEC’s interpretation of Section 17(a)(3) and our conclusion about the August 2 letter, we find there is not substantial evidence to support the Commission’s finding that Flannery engaged in a fraudulent “practice” or “course of business.”

Slip op. at 25-30 (footnotes omitted).

As noted above, it is obvious that the court’s decision turned on a close examination of the evidence, and an understanding of what the statements made by Hopkins and Flannery really meant, within their context.  The generalized power-point slide used by Mr. Hopkins, in the context of a broader presentation, and the availability of specific information on request, was so close to immaterial that Mr. Hopkins’ understanding that investors would not place significant weight on the “typical” data could not be reckless.  And the State Street letters to investors in which Mr. Flannery participated were not inaccurate because the SEC did not understand that the transaction described was, in fact, a means of reducing risk exposure.  That last point is a killer: the SEC could not even understand how to evaluate the risk exposures of these types of portfolios!  How good does that make you feel about the Commissioners that are responsible for understanding and protecting our capital markets?

This is a huge loss for the Commission because so much effort was made to make this case a showpiece for enforcement against individuals for supposed securities violations in the sale of the mortgage-backed securities that were devastated in the financial crisis.  The SEC was loaded for bear to hold some individuals responsible, regardless of the evidence.  Thank goodness a court was ultimately available to return us to the true rule of law.

Straight Arrow

December 9, 2015

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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:

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

This is the third in a series of posts addressing 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 two posts addressed two blatant inadequacies in 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; and (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.  You can review these comments here (Part I), and here (Part II), respectively.

Before we turn to the third respect in which the SEC’s proposals continue and expand the unfairness of the SEC’s administrative forum, we pause to report that SEC Chair Mary Jo White publicly embarrassed herself by insisting that the current forum is perfectly fair and needs only to be “modernized,” whatever that actually means.  As reported in the Wall Street Journal, here is what she said about the new proposals:

The SEC chief said that the commission recently proposed rules to modernize the administrative law proceedings and submitted a draft for public comment.  The proposal came amid calls for overhauling the system, which critics say is biased toward the agency and provides few protections to defendants.  The proposed change, she noted, includes allowing for additional time and discovery depositions before the trials.

Ms. White described the administrative law judge system as “very fair proceedings” that offer even more due-process rights to defendants than district court.  The 2010 Dodd-Frank financial overhaul law allowed the SEC to handle a broader range of cases in the in-house court.  Still, she acknowledged that the agency needs to critically examine the system for the sake of both fairness and appearance because “the rules haven’t been modernized for almost 10 years.”

SEC’s White Defends In-House Courts, but Sees Need to Modernize.

As an experienced defense counsel, Ms. White certainly knows that what she is saying is false.  There is no conceivable way that one could describe the SEC’s current administrative litigation process as offering “even more due-process rights to defendants than district court.” Similar statements in disclosures by public companies would be prosecuted as section 10(b) frauds by the SEC itself, if they were material.  Perhaps she could beat the fraud charge on the theory that her misstatements were “mere puffery” (a defense the SEC staff itself rarely accepts).  It is sad, indeed, that such an eminent lawyer in private practice has fallen into lock-step acceptance of the SEC mantra that it is gloriously clothed and everything is really fine, when the outside world knows the opposite is true: the SEC enforcement process is clothed in rags and the administrative enforcement forum is badly in need of reform.

Now we turn to the third respect in which the SEC’s regulatory proposal for its court is grossly inadequate: The new proposals do nothing to cure the extreme unfairness of the current Rules of Practice regarding the issuance of subpoenas to the SEC and third parties.

Remember the starting point for the respective parties when a case is commenced.  The SEC staff starts after having conducted years of investigation, in which it is able to obtain virtually limitless information from any person it chooses to subpoena, or ask for a “voluntary” production of materials.  The defense, on the other hand, typically has no access to information from third parties, and may only have had at best limited access to information from co-respondents, including other respondents who settled rather than litigate the charges against them (e.g., in many cases, the company they work for).  Thus, at the start of the case, the SEC itself is in possession, custody, or control of many potentially relevant materials, and the respondent typically has very little access to most of the materials the SEC has.

In cases filed in federal court, this imbalance between the parties can be remedied by means of aggressive use of the document production and subpoena powers available under the Federal Rules of Civil Procedure.

First, because the SEC is a party, it is subject to discovery as a civil litigant, including requests for documents in its possession, custody, or control.  Although the SEC struggles mightily in these cases to avoid discovery that typically occurs against other civil litigants, and it succeeds before some pro-government judges, the general rule is that once it files its case, it is a civil litigant under the federal rules just like any other civil litigant, and therefore subject to the same discovery rules as other plaintiffs.  In a well-publicized discovery decision by Judge Shira Scheindlin in SEC v. Collins & Aikman Corp., the judge noted tersely that “[w]hen a government agency initiates litigation, it must be prepared to follow the same discovery rules that govern private parties.”  See Case Study: SEC v. Collins & Aikman Corp. (Law 360).

Second, Fed. R. Civ. P. 45 allows defendants to issue subpoenas directly to third parties for relevant evidence, or for other information likely to lead to the discovery of admissible evidence.  There is no “gateway” procedure for these subpoenas – the party need not convince the judge to issue a subpoena; it can do so itself.  The burden then falls on the subpoenaed party to figure out how to respond, knowing that the courts usually take the view that discovery should be permitted unless it plainly imposes an undue burden or obviously seeks information not calculated to lead potentially useful evidence.  What happens following the issuance of these subpoenas is predictable.  In some, but few, cases, the third party will simply comply.  In some, but also few, cases, the third party will seek to quash the subpoena in its entirety.  In the vast majority of cases, the party issuing the subpoena and the third party will enter into discussions during which they reach some agreement about what material will be provided in response to the subpoena and which requests will be withdrawn.  The end result is that the defendant can gather what he or she considers important information from third parties without having to defend that view before a judge, but also typically agrees to accept less than he or she might get if the issue were fully litigated before a judge.

In contrast, in an SEC administrative proceeding, the respondents have no subpoena power.  That is so even though their opponent – the SEC staff – was accorded essentially unlimited subpoena power during the investigative stage, and typically uses that power to gather information that would support a potential charge, not defend against one.  (That is why production of the “investigative file” is often far from sufficient for adequate trial preparation by the respondent.)  The Rules do provide for the possible issuance of subpoenas, to third parties and the SEC itself, but only by application to the administrative law judge, who decides whether the subpoena will be issued.  The ALJ places the burden on the respondent to show that the subpoena is warranted, often asking for supporting information about the materials sought in the subpoena that is not, and cannot, be known by the respondent.  The ALJ also typically sets a higher bar for discovery than the standard in federal court.  The SEC staff almost always objects to the issuance of these subpoenas because they are focused on winning, not on seeking the truth.

SEC Rule of Practice 232 governs this process.  It says:

[A] party may request the issuance of subpoenas requiring . . . the production of documentary or other tangible evidence. . . .

Standards for Issuance.  Where it appears to the person asked to issue the subpoena that the subpoena sought may be unreasonable, oppressive, excessive in scope, or unduly burdensome, he or she may, in his or her discretion, as a condition precedent to the issuance of the subpoena, require the person seeking the subpoena to show the general relevance and reasonable scope of the testimony or other evidence sought.  If after consideration of all the circumstances, the person requested to issue the subpoena determines that the subpoena or any of its terms is unreasonable, oppressive, excessive in scope, or unduly burdensome, he or she may refuse to issue the subpoena, or issue it only upon such conditions as fairness requires. . . .

. . . Any person to whom a subpoena is directed, or who is an owner, creator or the subject of the documents that are to be produced pursuant to a subpoena, or any party may . . . request that the subpoena be quashed or modified. . . .

If compliance with the subpoena would be unreasonable, oppressive or unduly burdensome, the hearing officer or the Commission shall quash or modify the subpoena, or may order return of the subpoena only upon specified conditions. . . .

This sets up the ALJ as a gatekeeper for all subpoenas.  And history shows that the ALJs are, at the prodding of the SEC staff prosecuting the case, stingy gatekeepers indeed. The end result is the inverse of the environment for document discovery in the federal courts.  Instead of giving the party the authority to commence the process to obtain documents, which gives the opposing party, or the third party recipient, the burden of having to negotiate a resolution or appear in court to defend its intransigence, the respondent must plead for the issuance of a subpoena and bear the initial burden of convincing the ALJ to do so.  Even if that happens and the subpoena is issued, the recipient (or other persons) still can move to quash the subpoena.

As a result of this highly restrictive set of rules governing subpoenas by respondents – compared to almost no restrictions for subpoenas issued by the SEC staff during the investigative process – very modest document discovery is possible in SEC administrative proceedings.

Recent cases show that an ALJ will issue a subpoena to the SEC, but only a narrow one and only in rare circumstances.  In In the Matter of Charles L. Hill, Jr., the respondent sought discovery relevant to his defense that the administrative process was biased and the administrative prosecution violated his constitutional rights.  Mr. Hill asked for a subpoena to the SEC for ten categories of materials.  ALJ James Grimes issued a subpoena for two of those categories – materials on administrative prosecutions of similar cases and reflecting allegations by a former ALJ of internal communications encouraging favoring the SEC staff in these cases.  See SEC ALJ James Grimes Issues Important Discovery Order Against SEC.  But he refused to allow other aspects of the subpoena, which included materials sought to support contentions of equal protection and due process infringements.  That order turned on a detailed judgment that the materials sought could not assist those defenses based on a merits analysis, which is a far more demanding standard than the discovery standard in federal court – whether the material could possibly lead to admissible evidence.  See Order Denying in Part Subpoena Request in In the Matter of Charles L. Hill, Jr..

In In the Matter of Ironridge Global Partners, LLC, ALJ Grimes refused to issue a subpoena for materials bearing on the respondents’ defenses of bias and constitutional infringements (see Decision by SEC ALJ James Grimes on Motion for Issuance of Subpoenas in In the Matter of Ironridge Global Partners).  He also refused to permit a subpoena of the notes of SEC staff witness interviews “to the extent those portions relate to the facts and circumstances of this case, [and] the portions do not reflect attorney-opinion work product.”  He rejected this request — which seeks factual material that has often been ordered produced in federal courts — because he found the respondents had not sufficiently shown the need to obtain those materials, including because they were unable to show specifically how portions of the materials they had never seen could be useful in defending the case.  That is a standard far beyond what would apply in federal court.  In a federal court, at the worst, on a motion to compel production, the court would perform an in camera review of the materials and typically mandate production of the factual portions of those materials.  More likely, the court would try to force the parties to negotiate a compromise.  Amazingly, ALJ Grimes ruled that the respondents’ argument that it was important that they learn what fact witnesses told the SEC about the very practices at issue in the case was not a sufficient showing of need because “Respondents necessarily already know how they conducted their business. . . .  They therefore already possess information about the facts addressed in the Division’s interview notes.”  See Third Order on Subpoenas in In re Ironridge Partners, LLC.  The notion that the need to learn about actual evidence to be presented in the case fails to satisfy the burden for supporting a subpoena shows the unreasonably narrow scope used by SEC ALJs in ordering discovery against the SEC.

The current Rules of Practice support and encourage the ALJs’ niggardly approach to granting subpoenas.  They also fundamentally alter the balance of discovery in these cases as compared to those filed in federal court.  Discovery against the SEC in the administrative forum is very difficult and always very limited.  The ALJs believe that the limited scope of materials specifically made available to respondents under Rule 230 (which is limited to the so-called “investigative file”) operates against discovery from the SEC of other sorts of materials.  The federal courts do not generally hold the same view — they note that the federal rules of discovery apply equally to all parties.  And in federal court, the ability of a defendant to cause a third party to negotiate document production by issuing a subpoena directly to that party provides access to a much wider range of material than could possibly be available by seeking approval from ALJs, who apply discovery standards far more stringent than those used in federal court, and focus excessively on adhering to the Commission-set schedule (since that is what the Commission requires them to do).

The SEC’s proposed changes to the Rules of Practice do nothing to cure this fundamental, and deeply consequential, bias allowing the SEC staff far greater access to evidence or potential evidence than respondents.  In fact, there is no discussion at all of how well or poorly Rule 232 has operated, nor any discussion of whether some changes to that rule might enhance fairness or efficiency in the administrative court.

The only material change proposed for Rule 232 is to add another reason to quash a subpoena.  No effort is made to try to equalize access to evidence or potential evidence, or to try to equalize subpoena rights between federal court and the administrative court.  But for some reason the SEC found it necessary to grant ALJs additional grounds for quashing subpoenas previously approved, adding as a new reason for quashing a subpoena whether it “would unduly delay the hearing.”  As a result, even if the ALJ found the subpoena appropriate when first sought, and it is not oppressive or excessive, he or she must (“shall”) quash the subpoena if it will “unduly delay the hearing.”  This is yet another respect in which the Commission views compliance with its (arbitrary and artificial) schedule to be more important than giving respondents a fair and just proceeding.

The document discovery process in SEC administrative proceedings is unfair, unjust, and a major reason why targets of SEC prosecutions do better in federal courts than in the administrative forum.  Since the SEC seems not to care much about any of those things, no reforms were proposed.  That is our third reason why the proposed rule changes are woefully inadequate and should be rejected as arbitrary and capricious.

Straight Arrow

November 18, 2015

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

Today we present Part II of our discussion on the proposed changes offered by the SEC to the Rules of Practice governing its administrative proceedings.  Those proposals can be reviewed here.  They purported to be an effort to modernize rules adopted many years ago, long before significant changes to both the nature of litigated proceedings (based primarily on the enormous increase in evidentiary material available in the digital era), and the nature of the specific proceedings before the SEC’s administrative courts (based on jurisdictional changes over time, most recently the addition of new authority under the Dodd-Frank Act).

The proposals are patently inadequate to address the current problems in the administrative court, virtually all of which have the effect of tilting those proceedings against respondents and in favor of the prosecutor, which is the SEC’s Division of Enforcement.  The reasons why the current procedural rules are unfair have been discussed at length over the past two years, including on several occasions in this blog.  (See Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions, and Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions.)  The reasons why these proposed changes fail to come close to solving those fairness problems are the subject of the multi-part discussions here.

In Part I, we described one of the more blatant flaws in the proposal, by which the SEC actually seeks to increase the advantage the Division of Enforcement has in the administrative court versus federal court proceedings – the proposed new requirement that in their Answers, respondents must disclose certain defense theories even though they are not “affirmative defenses,” including defenses based on “reliance.”  See Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part I.

Today we address another one of the major shortcomings of the new proposal – the proposed limits on depositions of witnesses or potential witnesses.  The proposal is described by the SEC as follows:

Rule 233 currently permits parties to take depositions by oral examination only if a witness will be unable to attend or testify at a hearing.  The proposed amendment would allow respondents and the Division to file notices to take depositions.  If a proceeding involves a single respondent, the proposed amendment would allow the respondent and the Division to each file notices to depose three persons (i.e., a maximum of three depositions per side) in proceedings designated in the proposal as 120-day cases (known as 300-day cases under current Rule 360).  If a proceeding involves multiple respondents, the proposed amendment would allow respondents to collectively file notices to depose five persons and the Division to file notices to depose five persons in proceedings designated in the proposal as 120-day cases (i.e., a maximum of five depositions per side).  Under the amendment, parties also could request that the hearing officer issue a subpoena for documents in conjunction with the deposition.

This proposal lacks any reasoned support — and really any attempt to provide reasoned support.  It ignores historic practices in federal courts, which have had to address this issue for many years.  Instead of adopting a flexible set of principles or guidelines that can be applied in different ways under varying facts and circumstances, it picks a magic number of depositions that applies to all cases without regard to variations in cases.  But alas, the magic of the number is never described.  And it makes assumptions about how the magic number is to be applied that (a) fly in the face of reality, and (b) act as a potential severe hardship on the defense when there are multiple defending respondents, without any discussion whatsoever of those issues.  The only apparent guiding principle is to assure that the SEC staff’s well-known — and now documented (see Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal) — advantage in the administrative court will continue.  The proposal is successful in only one respect: it provides a textbook case of arbitrary and capricious rulemaking.

Where the Parties Start Matters

To evaluate this proposal, we need to consider some context.  We need to understand that when an enforcement proceeding of any type – judicial or administrative – begins, the parties are not even close to equally prepared to litigate the case.  That is because one party – the Division of Enforcement – has already been gathering and examining evidence for years, while those accused of violating the law have had very limited access to information, and have been focused on avoiding an enforcement action, not litigating one.  Any set of litigation rules that ignores this basic fact is destined to be biased in favor of the party given a multi-year head start.

An SEC enforcement proceeding, whether brought in federal court or the SEC’s administrative court, occurs only after an extensive investigation by the Division of Enforcement.  That investigation may last years, and usually does.  In that investigation, the SEC staff has virtually unlimited subpoena power, both to seek documents to obtain sworn investigative testimony from anyone the staff chooses.  It is not unusual for serious investigations involving contested issues to go on for more than three years.  Lots of documents may be produced – in corporate cases, often millions of pages of materials are produced to the SEC by various parties.  Many persons may be required to testify – 15 to 30 would not be unusual – and several of them will be required to testify on multiple occasions.  In addition to this, the SEC staff will interview other witnesses or potential witnesses without recording their testimony.

The “investigative testimony” is controlled by the SEC staff.  It often is not clear whether individuals are being targeted for possible action, and if so, which ones.  As a result, witnesses are vulnerable to manipulation because their objective is to avoid being accused of violations, and they are concerned that appearing combative and “pushing back” on questions will undercut that goal.  And manipulation does occur.  Witnesses may be (and are) bombarded by questions from several examiners at once; questions may be (and are) leading; questions may be (and are) deceptive, in an effort to induce responses the staff may be looking for; witnesses are not given advance access to materials to allow them refresh their memory or think about (or look for) other relevant materials that could place documents in their proper context; the examiners pick and choose the exhibits they use, and often do so as a means of influencing the testimony (e.g., they will use an email out of context when the broader context shows the content in a very different light); the examiners may (and do) suggest answers and pressure witnesses to change their testimony when the answers they receive do not match their perceptions or contentions; and the examiners do not typically pursue lines of examination designed gather information about defenses to possible violations.  Defense counsel is given an opportunity to ask questions, but without access to the evidence is limited in doing so.  The end result of these examinations is often a transcript of testimony that is designed to support the staff’s “going in” theory of violations of law that they are considering to pursue with the Commission.

[To those who may be skeptical that these questionable practices really occur, I can only say that I witnessed each of them on many occasions as a practicing securities defense counsel.  Not all SEC enforcement staff lawyers do these things, but many do, and they are not subject to meaningful controls by their supervisors.]

The only outside person who may be given a copy of testimony by the staff is the person testifying.  Even that occurs under rules set by the SEC, and a transcript can be denied to a witness if the staff objects, although that is rare.  Only to the extent that witnesses agree to share transcripts might they be able to get an understanding of the testimony of other witnesses.  That often occurs among witnesses with parallel interests, but it is rare that those being investigated have anything approaching a complete record of what people said before a case is brought.

When a case is brought, the SEC staff turns over to the accused what they consider to be non-privileged portions of the formal investigative file.  That normally includes all transcripts of investigative testimony, and all documents obtained by subpoena or other staff solicitations, but not records of witness interviews or compilations of relevant materials gleaned from all of the produced documents, which the staff almost always treats as privileged.  The investigative file is also narrowly defined as the materials specifically developed for the case against the accused.  It does not include other relevant documents that may be in the SEC’s possession that were obtained in other ways – perhaps, for example, in the course of other investigations on the same general subject matter.  For example, if the SEC staff is investigating a particular accounting practice and decides to bring an enforcement action alleging the practice was wrong, or even fraudulent, the “investigative file” produced would exclude all materials the SEC gathered about the use of that same accounting practice by other persons, whether or not they might provide valuable evidence in the specific proceeding brought.  But the SEC staff always has access to that additional data to the extent they choose to use it.

As noted, the SEC staff is typically involved in an investigation for years.  But the persons sued learn that they are targets only when they are asked for a “Wells Submission” (or sometimes a “pre-Wells Submission”). (A pre-Wells Submission is a relatively recent practice in which the staff advises a target of a potential action and gives an opportunity to respond, but does not label it a so-called “Wells Call.”  That happens because many companies now treat the formal request for a Wells Submission as an event that should be disclosed publicly, and even the SEC staff understands that it might be irresponsible to take steps requiring the public disclosure of possible violations identified in the midst of an investigative process.)  The Wells Submission process is one in which the staff informs targets of its conclusion that violations of law occurred and intent to seek approval from the Commission to prosecute, describes the alleged violations, and gives the accused persons a chance to prepare a submission that would accompany that memorandum to the Commission.  In practice, the Wells (or pre-Wells) Submission also serves as the first chance for a target to try to convince the staff that he or she did not violate the law as alleged by the staff.  The Wells Submission process is mandatory – the staff cannot avoid it.  But when the Wells Submission is drafted, the accused only has access to whatever materials he or she has been able to gather without any subpoena authority – either from those that may have submitted them to the SEC, if they choose to share them, or those the SEC staff agrees to allow them to see.

(As an aside, historically, Wells Submissions “back in the day” were often helpful in convincing the staff not to move forward with the charges, or least to mitigate them.  But in more recent years, Wells Submissions are much less likely to succeed at avoiding a proceeding along the lines originally proposed by the staff.  In fact, many experienced members of the securities defense bar now advise that no submission be made because it mostly provides the staff with a roadmap of a future defense of the accused.)

The end result is that when an enforcement proceeding is commenced, the SEC staff has already, usually for several years, been: (1) reviewing a large amount of relevant evidence; (2) developing an “investigative record” molded to support their charges; (3) producing witness testimony that often is slanted in favor of the staff’s theories because of the way those examinations are conducted; (4) gathering information about likely testimony of potential additional witnesses in secret interviews that are not transcribed; and (5) obtaining information about the likely defenses of the accused violators through the Wells Submission process.  In contrast, the accused violators have limited information. Indeed, in many cases, their defense counsel was often not even involved in the investigation because it was not until a late stage (a Wells Call) that the actual targets were identified, and often only at that time do they obtain separate counsel to defend the threatened case against them.

The SEC’s New Proposed Discovery Rules Are Plainly Unfair

This context makes it painfully clear that the current discovery provisions for administrative proceedings in the SEC’s Rules of Practice are designed to handcuff defense counsel and prevent a fair opportunity to develop a reasonable defense.  We won’t here belabor the shortcomings of those existing rules.  The facts speak for themselves.  Defense counsel are given an extremely limited period to learn the record and develop a defense, even in cases in which millions of pages of documents were produced, and the SEC staff has had years to sift through and analyze them. Defense counsel has no right to depose any witness except in very limited circumstances.  Investigative transcripts are typically admitted into evidence with no right to cross examination on the fiction that they provide a reliable picture of the facts.  The SEC staff is rarely required to provide access to its non-transcribed interviews, and often is not even required even to identify the people that were interviewed.  Relevant evidence in the SEC’s possession is rarely required to be produced if it lies outside the narrow confines of the so-called “investigative record,” even when the SEC staff has access to plainly relevant materials located elsewhere.  None of these limitations applies if the case is brought in federal court.

The new proposed rules do almost nothing to remedy this.  They allow an arbitrary number of depositions that is divorced from any analysis of what cases really require, and from any recognition that these are far from “one size fits all” cases.  They allow only modest and plainly insufficient increases in time to prepare the case for trial.  The periods chosen fail to take account of the fact that the SEC staff has years to prepare a case and the defense merely months.  They also reflect no effort to analyze the trial preparation needs of these cases in federal courts, at least as a baseline for figuring out what might be reasonable in the administrative forum.  Amazingly, no effort is made to analyze whether the demonstrable advantage the SEC staff has in access to evidence and witnesses, and in preparation time, may impact the fairness of the proceedings.  These failures are quintessential examples of arbitrary and capricious decision-making under the Administrative Procedure Act.

This post is focused on the inadequacy of the proposed revisions to Rule of Practice 233 with regard to the provision for depositions.  The proposed new Rule 233 would allow depositions as follows:

(1) “If the proceeding involves a single respondent . . . , the respondent may file written notices to depose no more than three persons, and the Division of Enforcement may file written notices to depose no more than three persons”; and

(2) “If the proceeding involves multiple respondents, the respondents collectively may file joint written notices to depose no more than five persons, and the Division of Enforcement may file written notices to depose no more than five persons. The depositions . . . shall not exceed a total of five depositions for the Division of Enforcement, and five depositions for all respondents collectively.”

This proposed provision is arbitrary, capricious, and blatantly unfair in several respects.

First, without any consideration or analysis of the imbalance between the SEC staff and the respondents in case preparation and access to evidence and potential witnesses, it assumes that the SEC staff and the respondents (as a group) should be entitled to an equal number of depositions.  By ignoring the fact that the SEC staff previously had access to many witnesses, perhaps on multiple occasions, and the defense had no such access, the proposal’s determination that an equal number of depositions for the prosecution and defense is appropriate is purely arbitrary, lacking any supporting analysis or explanation.  Indeed, it is not clear, nor discussed, why the SEC staff needs to take any depositions after having had unrestricted access to subpoenaed, sworn witness testimony during the entire investigative process.

Second, apart from that fundamental shortcoming, the determination that in cases with multiple respondents, the SEC staff should be entitled to five depositions while the respondents as a group must split five depositions (i) lacks any basis or analysis; (ii) places respondents in a position of having to compete for limited depositions without any discussion of why this is appropriate; (iii) assumes – without support in either theory or common practice – that the respondents as a group will be able to agree on how to divide the five depositions, and fails to discuss the impact of potential conflicts among the respondents; and (iv) ignores a wealth of experience about fair ways to divide limited numbers of depositions among a plaintiff and multiple defendants.  It also chooses an approach that differs greatly from what typically is adopted in the courts in similar situations, without any indication that the Commission has even considered those precedents, or why, if that consideration occurred, the judicial precedents were ignored.  The notion that in a proceeding brought by the SEC against five respondents, the SEC staff is entitled to five depositions while each respondent is entitled to only one defies logic or common sense, and the Commission attempts to provide no reasoned explanation for this arbitrary decision.

Third, even apart from the division of depositions among the parties, no rationale or reasoned explanation is given for the number of depositions permitted.  One would expect that a reasoned process would develop data about the historic need for deposition discovery in comparable cases in federal court, along with analysis of whether reductions in those numbers could be justified in the name of efficiency without sacrificing fairness.  There is no indication by the Commission that it undertook any such analysis or made any such considerations.  In fact, in factually challenging cases, it would not be unusual to have ten to thirty fact depositions in a federal court case, followed by at least two expert depositions per side.  Perhaps some of these could be avoided, but there is no analysis of either the common practice in federal court, or how that could be improved upon in the administrative court.

Out of curiosity, I did a little research to see how many depositions are permitted by the courts — usually based on a stipulation between the SEC and defendants — in SEC enforcement actions in federal court.  As noted above, this certainly is an analysis the Commission should have done before picking its own number.  My research was limited to a few of the enforcement cases reported to have been litigated by the SEC in recent years.  I did not find any case that did not permit at least 10 fact depositions for each side (expert depositions would be additional).  The number could be much larger.  In SEC v. Cuban (N.D. Tex.), each side was permitted 10 fact depositions, by mutual agreement; in SEC v. Steffes (N.D. Ill.), each side was permitted to depose “more than ten witnesses”; in SEC v. Kovzan (D. Kan.), each side was permitted 15 fact depositions; in SEC v. Anselm Exploration (D. Col.), each side was permitted 20 depositions, by mutual agreement; in SEC v. Collins & Aikman Corp. (S.D.N.Y.), the parties proposed that the SEC could notice 25 depositions and multiple defendants could notice 50, and the court allowed 15 fact depositions by the SEC and 20 fact depositions by defendants; in SEC v. Jensen (C.D. Cal.), each side was permitted 30 fact depositions, by joint agreement; in SEC v. Moshayedi (C.D. Cal., each side was allowed 25 fact depositions, by joint agreement; and in SEC v. Mudd (S.D.N.Y.), each side was permitted 75 fact depositions by joint agreement, plus as many expert depositions as there were experts designated.

Another possible approach, would be to look at the number of investigative witnesses examined by the SEC staff in these cases, plus the number of witnesses subject to informal SEC interviews, as a starting point for figuring out how many examinations the defense should be permitted.  There is no indication that the Commission did any such analysis, or even took that factor into account.

So where, exactly, is origin for the notion that five depositions (including expert depositions) is fair and sufficient?   We don’t know, because no effort is made to explain, or justify, the choice.  There is simply a number (the number 5) plucked out of the air.  Perhaps a commissioner was a fan of the famous William Carlos Williams poem “The Great Figure”:

Among the rain
and lights
I saw the figure 5
in gold
on a red
firetruck
moving
tense
unheeded
to gong clangs
siren howls
and wheels rumbling
through the dark city.

 

Or perhaps a commissioner was fond of the painting by Charles Demuth in the Metropolitan Museum of Art, “The Figure 5 in Gold,” made in homage to the Williams poem (see Where Paint and Poetry Meet).  I could understand that, because that was my favorite artwork as a kid.

Charles Demuth - The Figure 5 in Gold

Charles Demuth – The Figure 5 in Gold

Whatever may have occurred to yield the number 5, nothing we have been told suggests anything other than purely arbitrary decision-making.

Fourth, choosing a number as small as five for the number of depositions permitted (and even fewer per respondent for multiple respondents) obviously advantages the party with more access to information and witnesses outside of the deposition process, which is the SEC staff.  If a larger, and more reasonable, number were chosen, at least the defense might have an opportunity to catch up to the SEC in access to possible witnesses, learning the facts and evidence, and preparing for trial, by taking full advantage of its allocation.  But with at most five depositions permitted, this will almost never occur because most of these cases have many more potential fact witnesses (not to mention experts).

Fifth, even within the limited number of depositions, the proposed new rules also hamstring the defense of cases by limiting the witnesses the defense may subpoena.  Remember, the SEC staff has free-ranging access to witnesses during its investigation using its subpoena power, without having to sustain the burden of showing why those witnesses should be examined.  But the Commission’s proposed limit on who can be deposed places a burden and limitation on the defense, even beyond the meager numbers, because it requires that motions to quash deposition subpoenas be granted unless the party can show that the proposed deponent (i) “was a witness of or participant in any event, transaction, occurrence, act, or omission that forms the basis for any claim asserted by the Division of Enforcement, or any defense asserted by any respondent in the proceeding”; (ii) “is a designated as an ‘expert witness’” [sic]; or (iii) “has custody of documents or electronic data relevant to the claims or defenses of any party.”  The rationale given for this limitation is that: “This provision should encourage parties to focus any requested depositions on those persons who are most likely to yield relevant information and thereby make efficient use of time during the prehearing stage of the proceeding.”  But the limited number of depositions already creates ample pressure to make the best use of them, and if the defense values a deposition sufficiently to use a precious slot on a deponent even if he or she is not “a witness or participant” in the matters at issue, or a designated expert, the Commission provides no rational reason why that should not be permitted.

For example, in cases involving allegations of scienter based on a theory that the respondent’s conduct was “reckless,” the critical issue in the case may be determining the appropriate industry standard against which the judge could compare the conduct proved to determine whether it departs from that standard so egregiously that it was “reckless.”  A key witness on that issue may be one who has knowledge of the industry standard or practice — not necessarily as an expert, but as an industry participant giving fact testimony.  In fact, the fact testimony of several such witnesses could be highly relevant, until they became unduly cumulative, by which time the key factual point would be made.  Under the SEC’s limitation, such a person, who was not “a witness or participant” in an act that forms the basis for the claim, could not be deposed.  But it is hard to imagine any rational reason why that deposition testimony should be barred.  Indeed, it would seem likely that providing such evidence to the ALJ by means of a deposition transcript would be much more efficient and economic than hearing the testimony live.

Finally, there is no discussion at all about why it is appropriate to choose a single number for depositions without regard to the nature of the case, the complexity of the facts, the number of experts to be used, the length and complexity of the investigation, or any of the myriad of factors that differentiate cases from one another.  In other words, the very decision of choosing a single maximum number of permitted depositions for all cases lacks any discussion or support.  It also flies in the face of reason, reality, and years of litigation experience.  There is a reason why the number of depositions in federal court civil cases is a discovery issue to be discussed by the parties and ultimately decided by the presiding judge.  As the precedents discussed above show, cases differ, and discovery needs differ with them.  The decision to choose a single maximum number for all cases regardless of their nature and needs is by all appearances a capricious choice, even without regard to the fact that the number chosen is unconscionably low.

There no doubt are more reasons why the arbitrary choice of five depositions, to be divided among all of the respondents, lacks any reasonable basis.  But the point is sufficiently made already.  The Commission’s proposal on depositions reflects more whim than anything else.  The level of analysis of the issue and reasoned consideration of the options is pathetic.  The retention of an inherently unfair process that favors the SEC staff and undermines the defense is so clear that one can only assume it was intended.  If adopted by the Commission in a final rule, it should be challenged, and should be overturned by the court of appeals.

In Part III of our analysis of the SEC proposal, we will examine some of the other respects in which the Commission’s proposed rule changes assure that the SEC staff will continue to have a distinct advantage over respondents in the SEC’s administrative proceedings.

Straight Arrow

November 5, 2015

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On “Merger Tax” Cases, Mark Twain, Abe Vigoda, and Other Premature Death Reports

Mark Twain is famously reported as saying “Reports of my death are greatly exaggerated.”  Well, in that respect, he may have been like Yogi Berra (RIP), whose autobiography was titled “I Really Didn’t Say Everything I Said.”  A little research yielded Mark Twain’s original note, which was less pithy: “the report of my death was an exaggeration.”

Mark Twain on His Reported Death

“The report of my death was an exaggeration.”

Yogi Berra Autobiography

Mark Twain was not alone.  Samuel Taylor Coleridge overheard someone talking about a coroner’s inquest into his suicide (by hanging), and responded: “it is a most extraordinary thing that he should have hanged himself, be the subject of an inquest, and yet that he should at this moment be speaking to you.”  Many other folks have been the subject of premature death reports, including, many of us remember vividly, Paul McCartney.  This seems to be common among musicians — it also happened to Madonna, Lou Reed, Bob Seger, John Mellencamp, Lena Horne, Fats Domino, Alice Cooper, Neil Young (three times), and Gordon Lightfoot (who was at the dentist when he heard of his death).  Others in this club include Pope John Paul II (three times), Queen Elizabeth II, Ernest Hemingway (who reportedly read his obituaries every morning with a glass of champagne), P.T. Barnum (at his request, so he could see what people would say about him), Alfred Nobel (who is said to have read in his obit that he was a “merchant of death” and then decided to fund the Nobel Prize), Joe DiMaggio, Bob Hope (twice),  James Earl Jones (mistakenly identified when James Earl Ray died), Sean Connery, Steve Jobs, George Soros, Russell Crowe, Ken Kesey (who faked his own suicide to avoid criminal charges), and William “The Refrigerator” Perry (who was watching a Chicago Bears game when he saw a ticker message glide by announcing his death).  And don’t forget Abe Vigoda, whose death was reported on at least two occasions, and who, as of today, is 94 years old and has a website devoted to reporting that he remains alive: http://www.abevigoda.com/.

What do Mark Twain and all of these people have to do with securities law?  The reports of their deaths were, indeed, premature, as may be the reported death of one of the most enduring securities litigation scams – the “merger tax” litigation.

If you read this blog, you may have seen several discussions of “merger tax” litigation, that cynical sham in which virtually every merger or acquisition is met by a legal challenge regardless of whether there is any reasonable basis for doing so.  The legal challenge is not calculated to protect shareholders or increase shareholder value – in fact, it most likely victimizes them and diminishes that value.  Instead, it is calculated to delay the completion of the proposed transaction sufficiently to convince the parties to pay the plaintiffs’ lawyers to go away by settling the case for attorneys’ fees and otherwise meaningless non-monetary relief, supposedly for the benefit of shareholders, but actually worthless or even a net cost to them.

This long-standing charade is high on the list of lawyer chicanery that leads the public to view lawyers as among the least honest and most unethical professionals around.  In 2013, lawyers were ranked as having high honesty and ethical standards by only 20% of those polled, falling above only TV reporters, advertising practitioners, State officeholders, car salespeople, Members of Congress, and lobbyists, and below 15 other professions (including nursing home operators, who beat lawyers handily).  See http://www.gallup.com/poll/166298/honesty-ethics-rating-clergy-slides-new-low.aspx.

The practice of paying the “merger tax” to get rid of worthless legal challenges is the product of greed by unscrupulous plaintiffs’ lawyers, cynical deal-making by defense lawyers and their corporate clients, and “go along, get along” judges, who ultimately have to approve these sham transactions in their role of supposedly protecting the interests of the absent real parties in interest, the shareholders.  Unfortunately, most judges in this situation act like potted plants. For reasons that are hard to determine, they accept the sham and, worse, place their judicial imprimatur on the transaction.

In recent months, however, we have reported on repeated judicial decisions to say “No Mas.” We reported on Judge Melvin Schweitzer’s decision to reject a merger tax settlement in Gordon v. Verizon Communications in our Commentary on Abusive State Law Actions Following M&A Deals, which was followed by a post discussing a welcome judicial discussion of the impropriety of “merger tax” cases in City Trading Fund v. Nye: NY Court Flexes Muscles in Rejecting Bogus “Merger Tax” Settlement.  And the securities law world has taken note of several recent Delaware Chancery Court cases that excoriate the practice.  See Delaware Judge Tells Plaintiff Lawyers: The M&A ‘Deal Tax’ Game Is Over; Game Over?: Del. Chancery Court Rejects Disclosure-Only Settlement in H-P/Aruba Networks Merger Objection Lawsuit; and Transcript of Del. Chancery Court Hearing in Aruba Networks Stockholder Litigation.

On the basis of these developments, we reported that “this sordid practice may be on the wane because judges finally are doing their jobs.”  Alas, as with Mark Twain and his comrades in faux-death mentioned above, our reports of the possible impending death of “merger tax” litigation may have been premature.

Witness the settlement proposed just last week in McGill v. Hake, a case brought in the Southern District of Indiana by plaintiffs’ law firms Faruqi & Faruqi and Robbins Orroyo, with local firm Riley Williams & Pyatt.  Complicit in this legal atrocity are the defense lawyers — from Sullivan & Cromwell, Jones Day, and Taft, Stettinius & Hollister — as well as their client, Harris Corporation and its directors, but at least they have the excuse that they view themselves as acting in the short term interest of their clients or shareholders.

The complaint in McGill, filed February 12, 2015, was purportedly brought for the benefit of all shareholders of Exelis Inc., and alleged that the acquisition of 100 percent of the shares of Exelis by Harris Corp. was a breach of fiduciary duty because the value offered to Exelis shareholders ($23.75 per share) was “insufficient, as it fails to account for the Company’s significant future earning potential and falls below the premium other defense contractors have recently sold for.”  The complaint sought to enjoin the transaction or, if the transaction were completed, damages suffered by the shareholders as a result of the alleged breaches of fiduciary duty.  The claims were allegedly “based on information and belief, including the investigation of counsel and review of publicly-available information.”  The complaint can be reviewed here: Complaint in McGill v. Hake.

Fast forward to last week.  Plaintiff’s counsel filed a motion for court approval of a settlement of the claims.  The terms of the settlement: the plaintiff’s lawyers get a payment of $410,000; the shareholders get nothing of value.  Instead, the plaintiff’s lawyers negotiated for the defendants “to make certain supplemental disclosures” in a Form 8-K which purportedly “provided Exelis’ shareholders with material information concerning the fairness of the Merger and the Merger Consideration.”  Notice that there was no adjustment to the value received by the Exelis shareholders, despite the original contention that the $23.75 value per share was “insufficient.” Instead, more information was provided that supposedly allowed the shareholders to confirm that the value offered was indeed adequate.  In short, although the case was supposedly brought to remedy the “insufficient” value given to Exelis shareholders, the only pecuniary benefit provided in the settlement goes to the plaintiff’s lawyers.  The motion for approval of the settlement can be reviewed here: Plaintiff’s Motion for Approval of Merger Tax Settlement in McGill v. Hake.

This is a quintessential “merger tax” “disclosure only” settlement.  Supposedly convinced that the alleged unfair value was not in fact unfair, the lawyers walk away from the case pocketing the only money transferred.  How were they convinced that the value was sufficient?  By reviewing materials provided to them that confirmed the fairness of the valuation, and performing so-called “confirmatory discovery” after the deal was done to “confirm” the fairness of the deal.  So-called “confirmatory discovery” of a settlement deal is a transparently fictitious way to generate time and effort by the plaintiff’s lawyers that they then present to the court as a justification for the dollar fee payment the parties previously agreed would be paid to the lawyers.  Trust me on this – I’ve negotiated many such settlements.  Settlements that fail to go forward after “confirmatory discovery” are a non-existent species.

So, here we are in October 2015, following a series of cases touted as the death-knell for the “merger tax” “disclosure only” settlement, looking at precisely such a settlement proposal.  District Judge Tanya Walton Pratt, relatively new to the bench, will conduct a hearing on February 16, 2016 to consider whether to approve the proposed settlement.  See Scheduling Order in McGill v. Hake.

Judge Tanya Walton Pratt

Judge Tanya Walton Pratt

We can only hope that Judge Pratt follows the lead of her brethren on New York and Delaware and continues the process by which the lawyers’ cottage industry of “merger tax” litigation can be eliminated by judges simply doing their jobs.

Straight Arrow

October 27, 2105

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New Developments in Gordon v. Verizon Communications Class Action

There seem to be a good number of people trying to figure out what is going on in the securities class action suit in the New York State Supreme Court Gordon v. Verizon Communications, Inc., Index No. 653084/2013.  That is the case in which Judge Melvin Schweitzer famously rejected a proposed “merger tax” settlement in an opinion that received some attention.  It was a matter of some interest that a member of the New York State Bar, Gerald Walpin, filed successful papers in the case objecting to the settlement on policy grounds when the defense lawyers from the Wachtell Lipton firm stood mute in the effort to pay off the plaintiff’s counsel to allow the merger to proceed.  See Commentary on Abusive State Law Actions Following M&A Deals.

Some time ago I provided an update on developments in that case (Update on Status of Proposed Settlement in Gordon v. Verizon Communications, Inc.),  in which I noted that the plaintiff filed a notice of appeal, and that attorney Walpin sought to intervene in the case to pursue a motion for summary judgment, arguing that the defense lawyers in the case were conflicted by having agreed to the settlement.

Here is another update.  I provide this because it seems like a lot of class members are floundering around with no understanding of what is happening.

On August 3, 2015, Judge Anil Singh rejected several motions in the case, including the motion by Mr. Walpin to intervene and seeking summary judgment on behalf of the defendants, and a motion by by the plaintiff to introduce a new expert report addressing the proposed settlement and for reconsideration of Judge Schweitzer’s December 19, 2014 order denying the motion to approve that proposed settlement.  A copy of that decision is available here: Decision on motions in Gordon v. Verizon Communications.  On September 14, 2015, the plaintiff filed a Notice of Appeal of that order.  See Notice of Appeal in Gordon v. Verizon Communications.

That is pretty much all that the case docket sheet reveals.  By all outward appearances, the case is otherwise in stasis.

Since Judge Schweitzer’s decision, the “disclosure only” settlements of merger challenges — referred to by Judge Schweitzer as “merger tax” settlements — have come under attack and disrepute in a number of court decisions.  Most recently, several decisions in the Delaware Chancery Court have rejected such proposed settlements.  See Delaware Judge Tells Plaintiff Lawyers: The M&A ‘Deal Tax’ Game Is Over; Game Over?: Del. Chancery Court Rejects Disclosure-Only Settlement in H-P/Aruba Networks Merger Objection Lawsuit; and Transcript of Del. Chancery Court Hearing in Aruba Networks Stockholder Litigation, in which Vice Chancellor Laster addressed a proposed disclosure-only settlement in the H-P/Aruba merger challenge.

It seems that this sordid practice may be on the wane because judges finally are doing their jobs.  But in the meantime, the supposed beneficiaries of these cases — the shareholders — are kept totally in the dark about these developments.  Plaintiff’s counsel should be keeping these putative clients informed but, at least in this case, are obviously failing to do so, presumably because they see no vigorish in it.  What a “profession”!

Straight Arrow

October 16, 2015

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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

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SEC Proposes Amended Rules of Practice in Recognition of Unfair Procedures

Today, September 24, 2015, the SEC issued proposed amendments to the Rules of Practice governing SEC administrative proceedings.  You can read them here.

This comes 15 months after the SEC’s General Counsel Anne Small noted that the existing rules were archaic, and insufficient to handle the complex cases being sent to the SEC’s administrative courts.  See SEC Administrative Case Rules Likely Out Of Date, GC Says.  (Ms. Small said it was fair for attorneys to question whether the SEC’s rules for administrative proceedings were still appropriate, with the rules last revised “quite some time ago” when the SEC’s administrative proceedings dealt with different kinds of cases than the more complex administrative matters it now takes on or expects to take on — given the commission’s expanded authority under the Dodd-Frank Act — such as insider-trading actions.  It was “entirely reasonable to wonder” if those rules should be updated to reflect the changed situation, for instance by allowing more flexibility on current limits to trial preparation time or allowing for depositions to be taken.  “We want to make sure the process is fair and reasonable, so [changing] procedures to reflect the changes makes a lot of sense.”)

Since then, the challenges to SEC administrative proceedings have been fast and furious.  Some arguments that alleged that the appointment of the ALJs themselves was constitutionally invalid under the Constitution’s Article II Appointments Clause have been received favorably by some courts.  See SEC Hit with Double Whammy Rulings Barring It from Commencing Challenged Administrative Proceedings.  Others that made more fundamental challenges to the entire fairness of the administrative proceeding process have not yet gained judicial footholds.  But the disparate treatment of alleged violators in federal court and the SEC courts was so obvious, and became the focus of so much criticism, that some action was required.  See Former SEC Enforcement Leaders Urge SEC To Reform Administrative Enforcement Process.  The repeated statements by SEC Enforcement officials that the existing process was fair and provided no disadvantages to alleged violators were transparently wrong (see Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions).  The Commission was forced to act when the Wall Street Journal reported on the plain advantage that the SEC had when it sent cases to its administrative court.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal (credit to WSJ reporter Jean Eaglesham for playing a major role in moving the SEC toward reform).  Then, judges like N.D. Ga. Judge Leigh Martin May and SDNY Judge Richard Berman began to note in their opinions on the Appointments Clause issue that there were overall fairness issues raised that went beyond the alleged Article II violations.  Thank goodness the Commission saw that a stonewalling strategy that lasted almost two years had to be revised.

We now need to examine these proposals, and see if they adequately handle the procedural problems in the administrative court that give the SEC staff an unacceptable advantage in prosecutions that place respondents’ assets, and ability to do business and earn a living, at issue.  Not having reviewed the proposal yet, I can’t comment on the extent to which they address those problems.  But my bet is that there are at least some key advantages held by the SEC staff that are not yet addressed (since the staffers drafting the changes have been arguing for months that respondents are not really at a disadvantage).  That will be the subject of future blog posts, and, of course, what are likely to be voluminous responses during the comment period.

Straight Arrow

September 24, 2015

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SEC Hit with Double Whammy Rulings Barring It from Commencing Challenged Administrative Proceedings

On the afternoon of September 17, 2015, the SEC was rebuffed by two federal courts in separate cases challenging the constitutionality of the SEC’s administrative law enforcement proceedings.  As reported here, the Court of Appeals for the Second Circuit granted Lynn Tilton an order barring the SEC from proceeding with an administrative trial on charges against her, pending that court’s resolution of a dispute over whether the federal courts have jurisdiction to consider her complaint that the administrative proceeding would violate Article II of the Constitution.  At roughly the same time, New York federal district court Judge Richard Berman rejected a motion by the SEC to allow it to proceed with an administrative action against Barbara Duka while it appealed (to the Second Circuit) Judge Berman’s preliminary injunction barring that proceeding from moving forward, on the very same constitutional grounds.  Judge Berman’s preliminary injunction order can be read here: Order Issuing Preliminary Injunction in Duka v. SEC; and his order denying the SEC’s stay motion can be read here: Decision and Order in Duka v. SEC.

The result is that two more administrative proceedings are now barred by court orders, joining two others that were barred by orders of Judge Leigh May in the federal district court in Atlanta.  See Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding, and Order Enjoining SEC in Gray Financial Group v. SEC.

The Second Circuit order was brief and straightforward.  But Judge Berman’s denial of the SEC’s application for a stay is filled with meaty discussions of key issues, including reiterating that several of the SEC’s positions on jurisdiction and the merits are wrong, suggesting that the SEC plays a little fast and loose with the positions it argues, and emphasizing that the SEC might want to be more proactive in addressing allegations of potential bias in its administrative court.

Judge Richard Berman - NYLJ/Rick Kopstein 100614

Judge Richard Berman – NYLJ/Rick Kopstein

On the jurisdictional issue, Judge Berman restated his belief that his court does have jurisdiction over the Duka constitutional challenge (“The Court is, respectfully, convinced that it made the correct finding of subject matter jurisdiction,” slip op. at 3), and took the time to address the contrary position recently reached by the Seventh Circuit in Bebo v. SEC, 2015 WL 4998489 (7th Cir. Aug. 24, 2015) (see 7th Circuit Rules for SEC, Affirming Dismissal of Bebo Case on Jurisdictional Grounds).  He openly disagreed with the Seventh Circuit’s view that the Supreme Court decision in Elgin v. Dep’t. of the Treasury, 132 S. Ct. 2126 (2012), was on point because the factual circumstances differed significantly.  See slip op. at 8-9.

Judge Berman also made pointed statements elsewhere in his opinion arguing that immediate consideration of the consitutional issue was consistent with Second Circuit law and the public interest.  For example: “The SEC argues unconvincingly that a party in Ms. Duka’s shoes ‘must patiently await the denouement of proceedings within the [administrative agency],” . . . .  But Second Circuit precedent appears to refute such a notion.  See Touche Ross & Co. v. S.E.C., 609 F.2d 570, 577 (2d Cir. 1979) (‘[T]o require appellants to exhaust their administrative remedies would be to require them to submit to the very procedures which they are attacking.’).”  Slip op. at 15-16 (some cites omitted).  And: “With respect to the public interest, the Court submits that it is of the utmost importance to the public that complex constitutional questions be resolved at the outset, with finality, and by application of the expertise of the federal courts.  See, e.g., Massaro v. United States, 538 U.S. 500,504 (2003); see also Pappas v. Giuliani, 118 F. Supp. 2d 433, 442 (S.D.N.Y. 2000) affd, 290 F.3d 143 (2d Cir. 2002) (‘Although often highly competent in their designated area of law, administrative decision-makers generally have neither the training nor the experience to adjudicate complex federal constitutional issues.’); Austin v. Ford, 181 F.R.D. 283, 286 (S.D.N.Y. 1998) (‘Public interest in finality of judgment encompasses the development of decisional law, the importance of the opinion to nonparties, and the deterrence of frivolous litigation.’).”  Slip op. at 16 (some cites and footnote omitted).

All of these points could be impactful as the Second Circuit considers the same jurisdictional issue in the Tilton v. SEC appeal.

On the merits, Judge Berman restated his belief that Supreme Court case law leaves little doubt that the SEC’s administrative law judges are “inferior officers” within the meaning of that term in Article II, and, as a result, their appointments are subject to limitations in Article II’s Appointments Clause.  His finding that the High Court reasoning and holding in Freytag v. Commissioner, 501 U.S. 868 (1991), yields the conclusion that SEC ALJs are inferior officers because they exercised “significant authority pursuant to the laws of the United States” was not new – as he noted, he previously reached the same conclusion when he issued the preliminary injunction.  Slip op. at 9.  But it came within two weeks of the SEC reaching the opposite conclusion in its recent decision on the petition for review in In the Matter of Raymond J. Lucia Cos., Inc., File No. 15006 (see SEC Declares All Is Okay Because Its ALJs Are Just Employees and Not “Inferior Officers”), without even mentioning that decision or its analysis, suggesting Judge Berman found the SEC reasoning unpersuasive and sees no reason to defer to SEC views on the issue.  No doubt with knowledge of the specific analysis of the SEC in Lucia, he still wrote: “the SEC will not, in the Court’s view, be able to persuade the appellate courts that ALJs are not “inferior officers.”  Slip op. at 11.  Judge Berman’s bottom line: “Duka’s constitutional (Appointments Clause) challenge is (very) likely to succeed.”  Id. at 10.

On the SEC’s nimble willingness to revise its arguments to fit the circumstances, Judge Berman noted the “irony” of the SEC’s new-found emphasis on the compelling importance of judicial efficiency after it scoffed at Ms. Duka’s similar arguments in the original preliminary injunction hearing.  He wrote: “The Court’s reference to ‘irony’ [in an earlier ruling] refers to the fact that conservation of Duka’s resources was a core argument that she raised in objecting to participating in the SEC’s administrative proceedings prior to resolution of her constitutional challenge in federal court.  The SEC flatly opposed that argument, which it now appears firmly to embrace.”  He quoted his own statement during the oral argument that “I don’t understand why you reject that argument when Ms. Duka makes it but then at the same time in this Court you make the very same argument.”  Slip op. at 3 n.2.

And Judge Berman was surely making a point when he dwelled, without any apparent need, on the SEC’s opaque handling of publicly-disclosed evidence that its own administrative court could have a latent, or even intentional, bias in favor of the prosecution.  His opinion includes the following striking paragraph:

The Court is aware of recent allegations of undue pressure said to have been applied to an SEC ALJ to cause her to make SEC-favorable rulings.  “Lillian McEwen, who was an SEC judge from 1995 to 2007, said she came under fire from [Chief Administrative Law Judge Brenda] Murray for finding too often in favor of defendants.”  See Jean Eaglesham, SEC Wins with In-House Judges, The Wall Street Journal, May 6, 2015. . . .  And, in In the Matter of Timbervest, respondents allegedly sought to depose presiding ALJ Cameron Elliot, who was then allegedly invited by the SEC “to file by July I, 2015 an affidavit addressing whether he has had any communications or experienced any pressure similar to that alleged in the May 6, 2015 The Wall Street Journal article.”. . .  On June 9, 2015, ALJ Elliot emailed the following response: “I respectfully decline to submit the affidavit requested.”  See Jean Eagelsham, SEC Judge Declines to Submit Affidavit of No Bias, The Wall Street Journal, June 11, 2015. . . .  On July 24,2015, Chief Administrative Law Judge Murray issued an Order Redesignating Presiding Judge, designating Administrative Law Judge James E. Grimes “in place and stead of the Administrative Law Judge [ALJ Cameron Elliot] heretofore designated, to preside at the hearing in these proceedings and to perform other and related duties in accordance with the Commissioner’s Rules of Practice.”  See In the Matter of Barbara Duka, File No. 3-16349 (SEC).

During the September 16, 2015 hearing, the Court noted that it was “aware that there is some sort of flap at the SEC with respect to some of the ALJs,” that it “want[ed] to get further clarification about that matter,” and that “in this very case, [ALJ] Cameron Elliot . . . has been reassigned because he was not able or would not submit an affidavit.”. . .  While acknowledging that ALJ Elliot was removed from the Duka matter, Ms. Lin contended that “Judge Elliot has a very busy docket . . . and there is no suggestion, no connection whatsoever about [The Wall Street Journal article], about that particular former ALJ’s accusations to Judge Elliot’s reassignment in this case. . . .  And it’s not true that there would be any kind of connection.”. . .  The Court assumes that the SEC will want fully to investigate these matters.

Slip op. at 14-15 (citations omitted and emphasis added).

Apparently Judge Berman is as perplexed as yours truly when the Commission seems more insouciant than concerned in its reaction to serious public questioning of the fairness of its own administrative judicial process.  See SEC Bumbles Efforts To Figure Out How Its Own Administrative Law Judges Were Appointed; and SEC “Invites” ALJ Cameron Elliot To Provide Affidavit on Conversations “Similar” to Those Described by Former ALJ.  Indeed — although Judge Berman made no mention of this — it is downright embarrassing that 15 months ago the SEC’s General Counsel acknowledged that the Rules of Practice governing SEC administrative proceeding are archaic and need revamping and nothing has yet been done to address that issue.  See SEC Administrative Case Rules Likely Out Of Date, GC Says.  (Ms. Small said it was fair for attorneys to question whether the SEC’s rules for administrative proceedings were still appropriate, with the rules last revised “quite some time ago” when the SEC’s administrative proceedings dealt with different kinds of cases than the more complex administrative matters it now takes on or expects to take on — given the commission’s expanded authority under the Dodd-Frank Act — such as insider-trading actions.  It was “entirely reasonable to wonder” if those rules should be updated to reflect the changed situation, for instance by allowing more flexibility on current limits to trial preparation time or allowing for depositions to be taken.  “We want to make sure the process is fair and reasonable, so [changing] procedures to reflect the changes makes a lot of sense.”)

Anne Small -- SEC General Counsel

Anne Small — SEC General Counsel

When all of the dust settles on the Appointments Clause and other Article II constitutional challenges to these administrative courts, we will still be left with what every practicing securities litigator knows are vastly diminished due process rights in the SEC’s administrative courts as compared to the federal courts.  Judge Berman certainly seemed concerned about this in his opinion.  He said: “during the September 16, 2015 hearing, the SEC argued that administrative proceedings would serve the public interest because ‘it is a much faster process and it expedites the consideration and the determination of whether the underlying security violations had actually occurred and, more importantly, to impose the kind of remedy that would then help to prevent future harm.’. . .  The Court responded that ‘faster is [not] necessarily better because faster means no juries, no discovery, no declaratory relief.  In federal court you can get that . . . there’s a whole lot of protections, Ms. Duka argues, that are available in federal courts that are not available before the Commission.'”  Slip op. at 16.

If the SEC continues to be empowered to exercise effectively uncontrolled discretion over which cases are directed to the administrative courts (as a result of the expanded jurisdiction of those courts under the Dodd-Frank Act), and it continues to ignore obvious needs to modernize and balance the procedures for those proceedings to eliminate their “Star Chamber” similarities, the controversy over these actions will be unabated.

Straight Arrow

September 18, 2015

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SEC ALJ Jason Patil Stings Enforcement Division with Dismissal in Ruggieri Case

SEC Administrative Law Judge Jason Patil’s September 14, 2105 Initial Decision in In the Matter of Bolan and Ruggieri, File No. 3-16178, represents a milestone is SEC administrative jurisprudence in several respects.  The decision is available here: Initial Decision in In the Matter of Bolan and Ruggieri.

First, coming as it did in the midst of controversy over questionable fairness, and allegations of bias, in the SEC’s administrative enforcement process, ALJ Patil’s opinion, which rules against the SEC Division of Enforcement in a publicized insider trading case, shows that SEC ALJs are capable of giving serious scrutiny to the Division’s often overblown charges and questionable evidentiary support in support them.  ALJ Patil, a recent arrival at the SEC, has already shown a judicial temperament and backbone that is needed to assure a more level playing field in these cases.  We previously noted some high quality work by Mr. Patil.  See Some SEC Administrative Law Judges Are Thoughtful and Even Judicious.

Second, ALJ Patil’s decision itself was solid and thoughtful.  His analysis was mostly independent and well-reasoned.  The main exception was a not-very-thoughtful rejection of several constitutional challenges, which was presented in brief paragraphs that showed little of the painstaking analysis he gave to the evidence and the law in the remainder of his opinion.  He devoted fewer than two pages to dismiss five distinct constitutional arguments.  See Initial Decision at 2-4.  I chalk this up to a recognition that the constitutional issues were pretty much beyond his pay-grade, a point he even used in response to one of them (“I do not have authority to adjudicate this claim” (referring to a delegation doctrine argument)).  Id. at 3.  The treatment of the Appointments Clause issue now before several courts completely deferred to the SEC’s decision in In the Matter of Raymond J. Lucia Cos. (id.), and on the related issue of the double layer of ALJ tenure protection, he speciously argued that the Supreme Court footnote in its decision regarding the PCAOB in Free Enterprise Fund v. PCAOB meant that it “did not support” applying the same analysis to SEC ALJs.  Id.  That, of course, evades the argument, it does not address to it.  And the one sentence on the Seventh Amendment jury trial issue fails to consider the key point – whether a process that allows solely the SEC to require a jury trial (by choosing the forum) but deprives a respondent of any comparable right could be consistent with the Seventh Amendment. Id. at 6.

ALJ Patil was wrong to give these issues scant treatment because they were a side show.  If he didn’t want to take them seriously, he should have declined to address them because they were, as it turned out, unnecessary to consider in light of his decision on the merits.  Knowing his decision on the merits made this discussion superfluous, the correct approach was simply to decline to rule on those constitutional issues.

But in the overall picture, this may be just a quibble.  When it came to doing the hard work of evaluating the evidence and applying the law to the evidence, ALJ Patil did excellent work.  There were some flaws in his description of insider trading law, but he eventually got to the right place.

Third, ALJ Patil took on some key aspects of the implementation of insider trading law pursuant to Dirks v. SEC and United States v. Newman, and showed the fortitude to adopt positions – which I believe to be correct – that conflict with current SEC and Government arguments being made in Newman itself and in other insider trading cases.  That takes some cojones, and ALJ Patil should be commended for taking an independent view.

In particular, ALJ Patil rejected the argument now being made by the Government in the Newman cert. petition that the Newman decision breaks with Supreme Court precedent in Dirks v. SEC: “In its petition for a writ of certiorari, the government contends that Newman conflicts with Dirks and erroneously heightened the burden of proof.  See Pet. Writ Certiorari, United States v. Newman, No. 15-137 (July 30, 2015); 17 C.F.R. § 201.323 (official notice).  I do not, however, read Newman as conflicting with Dirks, but rather as clarifying the standard where proof of a personal benefit is based on a personal relationship or friendship.  See 773 F.3d at 452.”  Initial Decision at 35.  He also rejected the Division’s concerted argument that the “personal benefit” requirement for tipper liability adopted in Dirks, and further developed in Newman, has no place in insider trading violations based on the “misappropriation” theory, rather than a “classical” insider trading violation.  We will discuss his analysis on this point below, but his bottom line was that the personal benefit requirement plays the same important role in misappropriation cases as it does in classical cases.  See id. at 28-32.  Finally, he rejected multiple arguments by the Division that the personal benefit requirement was satisfied by the evidence when it was plain that the evidence did not support any such inference.  See id. at 33-49.

The Facts

Unlike many recent tippee cases, including the Newman/Chiasson case, the facts here are relatively straightforward.  Bolan and Ruggieri both worked for Wells Fargo.  Bolan was a researcher and analyst covering healthcare companies; Ruggieri was a senior trader of healthcare stocks who traded for Wells Fargo clients and also in a Wells Fargo proprietary account.  Unpublished Wells Fargo research and ratings analysis was proprietary and confidential company information.  Wells Fargo mandated that analysts not share ratings changes with traders before they were made public. Ruggieri knew that he was prohibited from trading based on nonpublic information from a forthcoming research report.

The SEC alleged that Bolan tipped Ruggieri to imminent Wells Fargo ratings changes he was about to make for specific stocks, and that Ruggieri took advantage of that knowledge on six occasions to trade in advance of publication and profit when the stock prices moved after the ratings change was announced.

Bolan settled the SEC’s case against him.  Ruggieri did not.  He was charged with violations of section 17(a) of the 1933 Act and section 10(b) of the 1934 Act and Rule 10b-5 thereunder.

The Findings

Much of the opinion addresses the evidence surrounding Ruggieri’s trades involving six stocks.  There apparently was little dispute that Bolan provided Ruggieri advance information about his views on these six companies.  But the evidentiary issues were complicated because Ruggieri argued that his decisions in all of these cases were based on his own knowledge of these companies and the market for their stocks, not on Bolan’s incipient ratings changes.  After all, much of the data available to Bolan was also available to Ruggieri, and in addition to that, Ruggieri had independent sources of information through the institutional investors he serviced for Wells Fargo, who often were the source of information about investor views about these companies.

After reviewing the extensive record, ALJ Patil concluded that the Division did not satisfy its burden of proving that Ruggieri’s trades in two of the six stocks were founded on tips from Bolan, but that he did rely on Bolan’s tips on four of the trades.

ALJ Patil’s Overview of Insider Trading Law Was Not Quite Right

ALJ Patil’s decision includes extensive discussion of his understanding of unlawful insider trading.  His Overview of the law (Initial Decision at 8-9) is mostly correct, but reflects some errors that, while not determinative in this case, suggest a less than complete understanding of the law.

ALJ Patil starts out with a summary statement about the law that is half right and half almost-right: He says that section 17(a) and section 10(b) “do not require equal information among market participants; the mere act of trading on insider information is not fraud. . . .  Rather, insider trading constitutes fraud within the meaning of these provisions when it involves a market participant’s breach of a fiduciary duty owed to a principal for a personal benefit.”  Id. at 8.  The first part is right – the Supreme Court has repeatedly rejected the theory that trading on material nonpublic information is itself unlawful.  The second part is half-right because it omits an important element – insider trading is “fraud within the meaning of these provisions when it involves a market participant’s breach of a fiduciary duty owed to a principal for a personal benefit” if, and only if, that breach of duty is undisclosed.  Trading on information that breaches a fiduciary duty to a principal is not “fraud” under these provisions if it is disclosed.  The importance of the fiduciary duty is that it creates a duty to disclose the breach to the principal, and the failure to do so in the context of a fiduciary relationship constitutes fraud.  That is why it is always said that the trader has the choice to “disclose or abstain from trading” to avoid violating the law.

ALJ Patil goes on to describe that this case involves the “misappropriation” theory of insider trading, since the critical information was not confidential information owned by the issuer of the traded stock, but confidential analytic information about various issuers owned by Wells Fargo: “The Division alleges that Bolan tipped Ruggieri with confidential information . . . in breach of a duty to Wells Fargo for a personal benefit and Ruggieri traded based on such tips.”  Id.  In such cases, the duty is owed to the owner of the information – here, Wells Fargo – and a fraud occurs if “[a] fiduciary who pretends loyalty to the principal while secretly converting the principal’s information for personal gain.”  United States v. O’Hagan, 521 U.S. 642, 653-54 (1997) (emphasis added).  As discussed above, what makes this conduct fraudulent is the failure to disclose the misuse of information stolen from the principal (“secretly converting”).

ALJ Patil notes that under Dirks, Ruggieri’s liability as a tippee “is derivative of Bolan’s alleged breach.”  Initial Decision at 8.  He states: “To establish Ruggieri’s liability, the Division must therefore show that: 1) Bolan tipped material non-public information to Ruggieri in breach of a fiduciary duty owed to Wells Fargo for a personal benefit to himself; 2) Ruggieri knew or had reason to know of Bolan’s breach, that is, he knew the information was confidential and divulged for a personal benefit; and 3) Ruggieri still used that information by trading or by tipping for his own benefit.”  Id. Actually, as discussed above, there is a fourth requirement, which is that Ruggieri knew that the breach of duty remained undisclosed to the principal at the time he traded.

ALJ Patil’s discussion of “materiality” is also not quite right, although his error seems of no consequence here.  He says there is no dispute that Bolan’s ratings were material because “ratings changes typically moved stock prices,” and Bolan’s ratings changes “had a statistically significant impact on the stock prices of the securities being rated.”  Id. at 9.  That would be correct if the disclosure duty at issue here were a duty to company shareholders, as in a case based on the classical insider trading theory.  But, as discussed above, the fraud in a misappropriation case is on the owner of the information, not any investor.  The correct materiality analysis must look for materiality to the owner – not investors.  If the owner of the information could care less whether the information was used or not – i.e., did not treat the confidentiality of the information as important – then even if it were highly material to certain investors there would be no fraud by the employee’s failure to disclose the use of it for his own benefit.  In this case, the information Bolan gave to Ruggieri was material because Wells Fargo made it plain in its internal policies that it was important to keep this information confidential from investors and from other employees outside of the research department.  That would be true even if it was not clear whether disclosing the information would or wouldn’t impact the stock price of the companies researched.  Because the secret ratings information was material to Wells Fargo, ALJ Patil’s finding of materiality was correct, albeit for the wrong reason.

Fortunately, these analytic shortcomings in ALJ Patil’s overall statement of the law did not prevent him from getting to the right decision based on the theory pursued by the Division and the evidence placed before him.

ALJ Patil’s Analysis of Dirks and Newman Was Spot On

ALJ Patil’s best work in this opinion is his discussion of the Dirks “personal benefit” requirement, as further developed by the Second Circuit in Newman.  In pages 28 to 32, he explains why the personal benefit requirement must apply to a misappropriation case, and in pages 33 to 50, he rejects every Division argument that the evidence presented adequately showed that Bolan obtained a personal benefit as part of his communication of impending ratings changes to Ruggieri.  Because there was no such benefit proved, Bolan’s tip was not fraudulent and Ruggieri could not have tippee liability derived from a fraud by Bolan.

ALJ Patil first addressed whether the Division was required to prove a personal benefit. Dirks “rejected the premise that all disclosures of confidential information are inconsistent with the fiduciary duty that insiders owe to shareholders.”  Initial Decision at 29.  He noted that the key element of a violation is “manipulation or deception”: “As Dirks instructs, mere disclosure of or trading based on confidential information is insufficient to constitute a breach of duty for insider trading liability.  Not every breach of duty, and not every trade based on confidential information, violates the antifraud provisions of the federal securities laws.  Rather, such conduct must involve manipulation, deception, or fraud against the principal such as shareholders or source of the information.”  He quoted both O’Hagan (521 U.S. at 655) (section 10(b) “is not an all-purpose breach of fiduciary duty ban; rather, it trains on conduct involving manipulation or deception”) and Dirks (463 U.S. at 654) (“Not all breaches of fiduciary duty in connection with a securities transaction, however, come within the ambit of Rule 10b-5.  There must also be manipulation or deception.”).  Id.  This led to the conclusion: “the Court identified the personal benefit element as crucial to the determination whether there has been a fraudulent breach.”  Id. at 30.  This is how Dirks separated communications not designed to deceive shareholders from those with an element of deception.  Otherwise, “If courts were to impose liability merely because confidential information was disclosed to a non-principal, this would potentially expose a person to insider trading liability ‘where not even the slightest intent to trade on securities existed when he disclosed the information.’”  Id. (quoting SEC v. Yun, 327 F.3d 1263, 1278 (11th Cir. 2003).

He then expressly rejected the Division’s contention that the Dirks personal benefit requirement did not carry over to misappropriation cases by pointing out that O’Hagan, which first accepted the misappropriation theory, equally focused on the need for deceptive conduct:

Contrary to the Division’s position, the alleged breach committed by a misappropriator is not any more “inherent” than the alleged breach committed by an insider in a classical case.  In both scenarios, confidential information was leaked and/or used to trade in securities.  The harm to the principal—the source of the information in a misappropriation case or the shareholders in a classical case—is the same, if “not more . . . egregious” in a classical case. Yun, 327 F.3d at 1277.  “[I]t . . . makes ‘scant sense’ to impose liability more readily on a tipping outsider who breaches a duty to a source of information than on a tipping insider who breaches a duty to corporate shareholders.”  Id.

It is true that Dirks was decided in the context where an insider leaked confidential information to expose corporate fraud, which put the Court in the unenviable position of either finding insider trading liability when there was no objective evidence of an ill-conceived purpose, or crafting a standard to ensure that the securities laws were of no greater reach than intended.  The Division contends that Dirks required a benefit in classical cases to differentiate between an insider’s improper and proper use of confidential information.  The Division asserts that “use of confidential information to benefit the corporation (or for some other benevolent purpose consistent with the employee’s duties to his employer) cannot logically breach a fiduciary duty to the corporation’s shareholders.”  Div. Opp. to Motion for Summary Disposition at 21.  But the same rationale applies in an alleged misappropriation case.  An outsider might just as well divulge information for purposes that he believes might be in the best interest of the source to which a fiduciary duty is owed.

Courts cannot simply assume that a breach is for personal benefit.  See Newman, 773 F.3d at 454 (“[T]he Supreme Court affirmatively rejected the premise that a tipper who discloses confidential information necessarily does so to receive a personal benefit.”).  And the breach in a misappropriation case has not been defined by the Supreme Court as inherent, but as connected to personal benefit.  The misappropriation theory “holds that a person commits fraud ‘in connection with’ a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”  O’Hagan, 521 U.S. at 652.  “Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.”  Id. (emphasis added).  In contrast to a classical case premised “on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.”  Id.

It is with this view that the Supreme Court “agree[d] with the Government that misappropriation, as just defined, satisfies § 10(b)’s requirement that chargeable conduct involve a ‘deceptive device or contrivance’ used ‘in connection with’ the purchase or sale of securities.”  O’Hagan, 521 U.S. at 653.  The Court “observe[d] . . . that misappropriators, as the Government describes them, deal in deception.  A fiduciary who pretends loyalty to the principal while secretly converting the principal’s information for personal gain . . . dupes or defrauds the principal.” Id. at 653-54 (emphasis added). . . .  The Court analogized misappropriation to the scenario where “an employee’s undertaking not to reveal his employer’s confidential information ‘became a sham’ when the employee provided the information to his co-conspirators in a scheme to obtain trading profits,” which constituted “fraud akin to embezzlement—‘the fraudulent appropriation to one’s own use of the money or goods entrusted to one’s care by another.’” Id. at 654. . . .  Thus, the O’Hagan Court accepted the government’s misappropriation theory on the premise that the breach was committed secretly for self-gain, not on the assumption that this element is inherent.

Initial Decision at 30-31 (footnotes and some cites omitted).

ALJ Patil then rejected the Division’s reliance on other cases in support of its argument, finding that though they may have used loose language, they did not need or intend to address the personal benefit issue in this context.  He concluded:

Neither the Supreme Court nor any federal court of appeals has drawn the curtain between classical and misappropriation cases that the Division urges.  Rather, courts have emphasized that the two theories are complementary, not mutually exclusive. . . .  In fact, “nearly all violations under the classical theory of insider trading can be alternatively characterized as misappropriations.”  Yun, 327 F.3d at 1279; see id. at 1276 n.27.  By requiring personal benefit to be proved in a misappropriation case, respondents are judged under similar standards.  Liability should not vary according to the theory under which the case is prosecuted.

At bottom, the Division’s position here, as the one advanced in Dirks, would have “no limiting principle.”. . .  The proposition that an alleged misappropriator violates his duty to a source, in violation of the antifraud provisions, by the mere disclosure of confidential information would improperly revive the notion that the antifraud provisions require equal information in the market, which has been rejected by the Supreme Court. . . .  [Dirks, 463] at 666 n.27 (rejecting similar arguments that “would achieve the same result as the SEC’s theory below, i.e., mere possession of inside information while trading would be viewed as a Rule 10b-5 violation” and reemphasizing that “there is no general duty to forgo market transactions based on material, nonpublic information.” . . .  I therefore adhere to my ruling that the Division must prove personal benefit.

Id. at 31-32.

ALJ Patil then turned to examining the evidence of the alleged personal benefits Bolan received from his tips.  I will not go through the details of the analysis of this evidence, which goes on for 14 pages.  The Division presented multiple claims of “personal benfit,” but the evidence showed that all of them were not in fact benefits related to providing tips but the internal operations of Wells Fargo in the normal course.  Purported “personal benefits” from the tips included “career mentorship” (found to be the norm at Wells Fargo); “positive feedback” (found to be no different for Bolan and others except as his performance justified); “friendship” with Ruggieri (found not be especially strong); a good “working relationship” (again found to be consistent with the Wells Fargo norm); and an intended gift by Bolan (found unproved – the Division did not even call Bolan as a witness).  As a nail in the coffin, ALJ Patil found that the evidence suggested Bolan simply accorded little weight to Wells Fargo’s policies, as reflected in recidivist violations of Wells Fargo confidentiality rules with others as well as Ruggieri (for which he was fired by Wells Fargo).

Why Did the Division of Enforcement Try Ruggieri as a Tippee?

This review of the facts and law of the case leaves a strange question.  What was the point of charging Ruggieri as a tippee rather than for his direct misappropriation of confidential Wells Fargo information?  He received Bolan’s information as a Wells Fargo employee and was obligated to keep that information confidential.  If he knowingly used that information improperly (in violation of his duties to Wells Fargo), in order to gain a benefit for himself (the Division contended the successful trades increased his compensation), and failed to disclose this to Wells Fargo, he violated section 10(b) regardless of whether Bolan did as well.  The Division would not have been stymied by a personal benefit requirement because the lack of a benefit to Bolan wouldn’t matter – the alleged increased compensation to Ruggieri would be sufficient to support a fraud claim.

I’m guessing the Division voluntarily made its case against Ruggieri harder because it wanted to stick it to both Bolan and Ruggieri.  Bolan, who agreed to a settlement (and had already been fired by Wells Fargo), could not be charged with fraud if he were not alleged to be a tipper, and the SEC staff always wants to charge fraud.  So, the ultimate irony of the case may be that in a case centered on greed, it may have been the Division’s own greed for multiple fraud judgments that pushed it to charge a case it lacked sufficient evidence to prove.  It would not be the first time the Division lost a case because, like Johnny Rocco (Edward G. Robinson) in Key Largo, it was motivated simply by wanting “more.”

Johnny Rocco

Johnny Rocco (Key Largo)

(“There’s only one Johnny Rocco.”

“How do you account for it?”

“He knows what he wants.  Don’t you, Rocco?”

“Sure.”

“What’s that?”

“Tell him, Rocco.”

“Well, I want uh …”

“He wants more, don’t you, Rocco?”

“Yeah. That’s it. More. That’s right! I want more!”

“Will you ever get enough?”

“Will you, Rocco?”

“Well, I never have. No, I guess I won’t.”)

Like Johnny Rocco, the SEC staff almost always wants “more.”

Straight Arrow

September 15, 2015

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SEC Declares All Is Okay Because Its ALJs Are Just Employees and Not “Inferior Officers”

On September 3, 2015, the SEC issued its first ruling addressing the constitutionality of its administrative law judges, in In the Matter of Raymond J. Lucia Cos., Inc., File No. 15006.  The opinion can be read here: SEC Opinion in In the Matter of Raymond J. Lucia Companies.  In substance, the SEC argued that its ALJs are “employees,” not “inferior officers” within the meaning of Article II of the Constitution.  In that respect, it disagreed with two federal courts that have addressed the merits of that issue, each of which found it “likely” that the ALJs are inferior officers, and therefore subject to Article II’s Appointments Clause.  See SDNY Court Ups the Ante, Allowing Duka Injunctive Action To Proceed on Appointments Clause Issue, and Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding.

The SEC now says “no,” arguing that its ALJs are sufficiently like the FDIC ALJ’s that were found not to be inferior officers in a split D.C. Circuit opinion in Landry v. FDIC, 204 F.3d 1125 (D.C. Cir. 2000).  That was an argument rejected by the two courts.  The SEC wrote:

Our consideration of this question is guided by the D.C. Circuit’s decision in Landry v. FDIC, which addressed whether ALJs should be deemed inferior officers or employees.  Landry held that, for purposes of the Appointments Clause, ALJs at the Federal Deposit Insurance Corporation (“FDIC”) who oversee administrative proceedings to remove bank executives are employees rather than inferior officers. Landry explained that the touchstone for determining whether adjudicators are inferior officers is the extent to which they have the power to issue “final decisions.”  Although ALJs at the FDIC take testimony, conduct trial-like hearings, rule on the admissibility of evidence, have the power to enforce compliance with discovery orders, and issue subpoenas, they “can never render the decision of the FDIC.”  Instead, they issue only “recommended decisions” which the FDIC Board of Directors reviews de novo, and “[f]inal decisions are issued only by the FDIC Board.”  The ALJs thus function as aides who assist the Board in its duties, not officers who exercise significant authority independent of the Board’s supervision.  Because ALJs at the FDIC “have no such powers” of “final decision,” the D.C. Circuit “conclude[d] that they are not inferior officers.”

The mix of duties and powers of the Commission’s ALJs are very similar to those of the ALJs at the FDIC. Like the FDIC’s ALJs, the Commission’s ALJs conduct hearings, take testimony, rule on admissibility of evidence, and issue subpoenas.  And like the FDIC’s ALJs, the Commission’s ALJs do not issue the final decisions that result from such proceedings. Just as the FDIC’s ALJs issue only “recommended decisions” that are not final, the Commission’s ALJs issue “initial decisions” that are likewise not final.  Respondents may petition us for review of an ALJ’s initial decision, and it is our “longstanding practice [to] grant[] virtually all petitions for review.”  Indeed, we are unaware of any cases which the Commission has not granted a timely petition for review.  Absent a petition, we may also choose to review a decision on our own initiative, a course we have followed on a number of occasions.  In either case, our rules expressly provide that “the initial decision [of an ALJ] shall not become final.”  Even where an aggrieved person fails to file a timely petition for review of an initial decision and we do not order review on our own initiative, our rules provide that “the Commission will issue an order that the decision has become final,” and it “becomes final” only “upon issuance of the order” by the Commission.  Under our rules, no initial decision becomes final simply “on the lapse of time” by operation of law; instead, it is “the Commission’s issuance of a finality order” that makes any such decision effective and final.  Moreover, as does the FDIC, the Commission reviews its ALJs’ decisions de novo.  Upon review, we “may affirm, reverse, modify, set aside or remand for further proceedings, in whole or in part,” any initial decision.  And “any procedural errors” made by an ALJ in conducting the hearing “are cured” by our “thorough, de novo review of the record.”  We may also “hear additional evidence” ourselves, and may “make any findings or conclusions that in [our] judgment are proper and on the basis of the record.”  For this reason, although ALJs may play a significant role in helping to shape the administrative record initially, it is the Commission that ultimately controls the record for review and decides what is in the record.  As we have explained before, we have “plenary authority over the course of [our] administrative proceedings and the rulings of [our] law judges—before and after the issuance of the initial decision and irrespective of whether any party has sought relief.”

Opinion at 30-31 (footnotes omitted).

The SEC rejected the argument, which the two courts found convincing, that the Supreme Court decision in Freytag v. Commissioner, 501 U.S. 868 (1991), supported the opposite conclusion, arguing that the “special trial judges” at issue in Freytag were more important than the SEC ALJs: “The far greater role and powers of the special trial judges relative to Commission ALJs, in our view, makes Freytag inapposite here.”  Opinion at 32.  The reasons for this view were:

First, unlike the ALJs whose decisions are reviewed de novo, the special trial judges made factual findings to which the Tax Court was required to defer, unless clearly erroneous.  Second, the special trial judges were authorized by statute to “render the [final] decisions of the Tax Court” in significant, fully-litigated proceedings involving declaratory judgments and amounts in controversy below $10,000.  As discussed above, our ALJs issue initial decisions that are not final unless the Commission takes some further action. Third, the Tax Court (and by extension the court’s special tax judges) exercised “a portion of the judicial power of the United States,” including the “authority to punish contempts by fine or imprisonment.”  Commission ALJs, by contrast, do not possess such authority.

Based on the foregoing, we conclude that the mix of duties and powers of our ALJs is similar in all material respects to the duties and role of the FDIC’s ALJs in Landry.  Accordingly, we follow Landry, and we conclude that our ALJs are not “inferior officers” under  the Appointments Clause.

Id. at 32-33 (footnotes omitted).

The reasoning is minimalist.  It ignores the decisions of the two federal courts.  It does not address the array of powers the SEC ALJs have that may differ from FDIC ALJs.  It does not explain why it believes that the differences it found between the “special trial judges” in Freytag and its own ALJs are of sufficient importance to warrant a different result.  And it does not discuss other Supreme Court decisions addressing when adjudicative officials should be considered to be “inferior officers.”  See Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit.

None of this is surprising.  There was zero chance the SEC was going to rule against its own appointments of ALJs.  That is one reason why decisions of several federal courts that the SEC should be given the chance to address the issue before the courts did, while perhaps lawyerly, seem so pointless.  But nothing about this opinion presents a compelling argument that the ALJs are mere employees, given the broad array of powers they have in determining how administrative cases are litigated and ultimately decided.  And, because the SEC essentially chooses to adopt the rationale of the majority in Landry v. FDIC rather than address the hard issues itself, it is unlikely that any appellate court outside of the D.C. Circuit, where Landry was decided, should, or would, be swayed by what the Commission had to say on the issue.

Straight Arrow

September 4, 2015

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Supreme Court Filings in U.S. v. Newman and Chiasson Leave Serious Doubts on Grant of Certiorari

With all of the publicity, hubbub, and hype surrounding the Second Circuit’s decision in United States v. Newman and Chiasson, a grant of writ of certiorari at the Government’s request is a foregone conclusion, right?  In a word, “no.”  The filings on the Government’s motion seeking certiorari make it pretty clear that if you remove the publicity, hubbub, and hype – and consider what the Newman opinion says, and not just what the Government portrays it as saying – the Supreme Court’s normal standards for hearing a case simply are not satisfied.  Let me explain.

(The filings on the petition for certiorari can be read here: Petition for Writ of Certiorari in US v. Newman; Newman Opposition to Cert. Petition; Chiasson Opposition to Cert. Petition.

The Government’s entire push for Supreme Court review turns on two arguments: (1) the Second Circuit amended the Supreme Court’s decision in Dirks v. SEC by mandating that a tippee exchange tangible value for tipped material nonpublic information from the tipper, when Dirks says that “gifts” of such information by the tipper to the tippee can be sufficient to create liability; and (2) the Second Circuit’s revision threatens the integrity of the securities markets by undermining investors’ belief in the fairness of those markets.  The briefing on certiorari, however, leaves little doubt that the Government cannot (or at least does not) provide support for either of these arguments.  Instead, these arguments are based on (i) a reading of the opinion that ignores what the court said, and is not how the courts have treated the Newman opinion since it was issued; and (ii) ipse dixit assertions by the Government about the terrible consequences of Newman on markets and law enforcement, which lack any substantiation.

But beyond this, the briefing makes it clear that Newman simply is not the kind of case that the Supreme Court normally would review, for three reasons: (1) the ruling the Government asks for would not, in fact, change the result – Messrs. Newman and Chiasson will be not be prosecutable in any event because the Government does not seek review of determinative aspects of the Second Circuit opinion that prevent any conviction; (2) the aspect of the Newman decision that the Government does challenge is an evidentiary issue – not an important issue of law – that is limited in its impact, other than in support of the view that the actual evidence presented in a case matters, which the Supreme Court is unlikely to countermand; and (3) the ruling the Government asks for would make it difficult for investors and their advisers to gather and use information in ways the Dirks court sought to protect as critical to the functioning of an efficient marketplace.

The Supreme Court Usually Doesn’t Review Cases To Provide an Advisory Opinion

Let’s start with what should be the most important issue for a cert. petition: will Supreme Court review actually make a difference in the case.  The answer here plainly is that it would not.  Why? Well, the Government presents for review only a single question: “whether the court of appeals erroneously departed from this Court’s decision in Dirks by holding that liability under a gifting theory requires ‘proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.’”  Cert. Pet. at (I).  But the Second Circuit reversed the convictions of Messrs. Newman and Chiasson for another, totally independent reason: that because this is a criminal case, a conviction required proof that the defendants knew that the information they used to trade securities was obtained through a breach of duty by an insider, and there was no evidence from which a reasonable juror could make such a finding.  Because of this, even if the Supreme Court were to agree with the Government on its question presented, the defendants’ convictions would still be overturned.  The Supreme Court typically does not accept cases in which its opinion, in effect, becomes an advisory opinion on the law and does not impact the determination of the case before it.

Here is how the Newman cert. opposition discusses this point:

The central legal holding in the court below was that insider trading liability requires a tippee to know that the tipper received a personal benefit.  While the government opposed such a requirement in the trial court and on appeal, it does not challenge that ruling now. Instead, the Petition seeks review of a single, fact-based sufficiency determination regarding whether there was a personal benefit in the first place.  Notably, the government’s articulation of the question presented addresses only the type of evidence required to prove a personal benefit; it does not implicate the court of appeals’ independent holding that Newman committed no crime because he did not know of the benefit.  Accordingly, even if this Court were to agree with the government that the Second Circuit misstated the type of evidence required to support an inference of a benefit, the decision dismissing the indictment on the independent ground that Newman did not know of any benefit would stand.

The government understands, of course, that the Supreme Court does not grant review to issue advisory opinions.  To overcome that obstacle, the government proposes that this Court “correct” the Second Circuit’s analysis of what evidence may be used to prove a personal benefit and then remand to the Second Circuit for reconsideration of both the sufficiency of whether there was a benefit and whether Newman knew of the benefit.  Pet. 29-31.  This attempted sleight of hand is unconvincing.  The Second Circuit determined that, “[e]ven assuming that the scant evidence . . . was sufficient to permit the inference of a personal benefit,” the proof was insufficient to establish knowledge of any benefit because the defendants “knew next to nothing” about the insiders or the circumstances of their disclosures, and the government “presented absolutely no testimony or any other evidence that Newman and Chiasson knew . . . that those insiders received any benefit in exchange for such disclosures . . .” . . . .  This conclusion was not based on a nuanced view of how personal benefit should be defined; it was based on the utter lack of evidence that the defendants knew of any benefit, however defined, or even the basic circumstances under which the disclosures were made.  No decision by this Court on the narrow issue presented for review would change the ultimate disposition of this case.

Newman Cert. Opp. at 1-3.

The Second Circuit Decision Is Inaccurately Portrayed by the Government

Let’s turn now to the guts of the Government argument, and show why it fails because it is founded on a reading on the Newman opinion that is inaccurate and misleading.

The Government’s core argument is that the Second Circuit broke from Dirks by refusing to allow a “gift” from the tipper to the tippee to be considered a basis for the required breach of duty to support an insider trading violation:

The court of appeals’ decision is irreconcilable with Dirks.  In the guise of interpreting this Court’s opinion, the court of appeals crafted a new, stricter personal-benefit test, stating that “[t]o the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades ‘resemble trading by the insider himself followed by a gift of the profits to the recipient,’ *** we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” . . .

That new “exchange” formulation erases a form of personal benefit that this Court has specifically identified.  Under Dirks, an inference of a personal benefit to the insider arises in two situations: when the insider expects something in return for the disclosure of the confidential information, or when the insider freely gives a gift of information to a trading friend or relative without any expectation of receiving money or valuables as a result. . . .  The Second Circuit purported to recognize that second form of personal benefit . . . but then rewrote the concept of a “gift” so as to eliminate it.  The court held that an insider cannot be liable on a gift theory unless he receives something from the recipient of information “that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” . . .  But such an “exchange” is, by definition, not the same thing as a “gift”; rather, it is a quid pro quo, “something for something.”

Cert. Pet. at 18-19.

This argument should fail because the Supreme Court Justices – and their clerks – should easily see that the Second Circuit decision does not say what the Government argument describes.  The Government accepts that the entire discussion of “personal benefit” occurred as the Second Circuit “considered the sufficiency of the evidence that the . . . insiders personally benefitted from disclosing confidential corporate information,” and that in doing so, the court of appeals “acknowledged that in [Dirks, the Supreme] Court stated that ‘personal benefit’ includes reputational benefit and ‘the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.’”  Cert. Pet. at 11 (emphasis added).

The problem was that the Government introduced no evidence showing that in either of the two instances of alleged tipping (involving communications between insiders at Dell and NVIDIA with industry analysts they knew), the tipper either (a) received a tangible benefit in return, or (b) provided the information as a “gift.”  Instead, the Government relied on the mere circumstances of the relationship between the alleged tippers and the alleged tippees to provide a sufficient inference of a “gift” to satisfy the breach of duty requirement laid out in Dirks.  The Second Circuit rejected this effort because a review of the evidence showed no meaningful relationships between these people that would suggest that the insiders transferred information as an intended “gift” to the analysts.

The actual evidence showed that the relationship between the Dell insider and the analyst he spoke to was no more than that they knew each other at business school, spoke on limited occasions when they both worked at Dell, and that the analyst gave career advice to the insider that was not terribly meaningful.  The evidence also showed that the communications between them were consistent with the insider’s job responsibilities to develop relationships with financial firms that could be a source for possible investors, and the insider was never told anyone was trading on information he provided.  The NVIDIA insider attended the same church as the analyst he spoke to and sometimes had lunch with him.  While the analyst said he sometimes traded NVIDIA stock, he never said he would use information they discussed to trade.

Based on this evidence, the Second Circuit proceeded to try to implement the Dirks duty standard, not revise that standard.  As the Newman cert. opposition says: “the Second Circuit’s refusal to accept the mere fact of friendship as per se evidence that a tipper intended to bestow a gift on a tippee is consistent with, and indeed compelled by, Dirks.”  Newman Cert. Opp. at 20.

Dirks said that “there may be a relationship between the insider and the recipient that suggests a quid pro quo . . . or an intention to benefit the particular recipient,” but said no more about the parameters of such a relationship.  See Dirks, 463 U.S. at 663.  The Dirks Court also said that an inference of personal gain to the tipper that would evidence the required breach of duty could flow “when an insider makes a gift of confidential information to a trading relative or friend” (id.), but said nothing about how to determine if such an inference is reasonable, except that such a circumstance could “resemble trading by the insider himself followed by a gift of profits to the recipient.”  Id.  The Dirks Court left it to lower courts to figure out how best to implement these principles.  See id.  The Second Circuit plainly was trying to work out when it might be reasonable to conclude that a communication of information is intended as a “gift” based solely on the nature of the parties’ relationship.

The Government’s argument turns on the appellate court’s use of the term “exchange”:

The court reinterpreted this Court’s holding that an insider personally benefits when he “makes a gift of confidential information to a trading relative or friend,” . . . to require “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” . . .  That holding cannot be reconciled with Dirks, which did not require an “exchange” to find liability for a gift of inside information and did not impose amorphous standards for the relationships that can support liability.

. . . .

Under Dirks, an inference of a personal benefit to the insider arises in two situations: when the insider expects something in return for the disclosure of the confidential information, or when the insider freely gives a gift of information to a trading friend or relative without any expectation of receiving money or valuables as a result. . . .

The Second Circuit purported to recognize that second form of personal benefit . . . but then rewrote the concept of a “gift” so as to eliminate it.  The court held that an insider cannot be liable on a gift theory unless he receives something from the recipient of information “that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” . . . .  But such an “exchange” is, by definition, not the same thing as a “gift”; rather, it is a quid pro quo, “something for something.” . . .  If the personal-benefit test cannot be met by a gift-giver unless an “exchange” takes place, then Dirks’s two categories of personal benefit are collapsed into one—and the entire “gift” discussion in Dirks becomes superfluous.

Cert. Pet. at 14.

This argument intentionally ignores the gist, and the actual language, of the Newman opinion.  It begins by ignoring the paragraphs leading up to the quoted passage, which emphasize that the intent to gift confidential information to another person can be sufficient, but there needs to be evidence proving it.  If that evidence is nothing more than the nature of the relationship between the parties, then that relationship has to be strong enough to warrant a reasonable inference that the information exchange was intended as a gift.  Here is what the court said:

The circumstantial evidence in this case was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips.  As to the Dell tips, the Government established that Goyal and Ray were not “close” friends. . . .  The evidence also established that Lim and Choi were “family friends” that had met through church and occasionally socialized together.  The Government argues that these facts were sufficient to prove that the tippers derived some benefit from the tip.  We disagree.  If this was a “benefit,” practically anything would qualify.

We have observed that “[p]ersonal benefit is broadly defined to include not only pecuniary gain, but also, inter alia, any reputational benefit that will translate into future earnings and the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.” . . .  This standard, although permissive, does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature.  If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity.  To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades “resemble trading by the insider himself followed by a gift of the profits to the recipient,” see 643 U.S. at 664, we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.  In other words . . . this requires evidence of “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].”. . .

United States v. Newman, slip op. at 21-22 (emphasis added and some cites omitted).

This quote makes it apparent that to justify its argument, the Government badly, and misleadingly, truncates the Second Circuit discussion on this issue.  The Government’s argument ignores language that makes it clear that the Second Circuit did not limit the “gift” concept to a tangible “exchange.”  Instead, in the very paragraph the Government quotes, the court twice says that evidence showing a tipper’s intent to gift information to a tippee would be sufficient to satisfy the Dirks personal benefit standard — (i) including “the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend” as sufficient to show a personal benefit, and (ii) using the disjunctive “or” in describing the need for evidence of “a relationship . . . that suggests a quid pro quo . . . or an intention to benefit the [tippee].”

This makes it plain that the court was not excluding from the range of potentially sufficient evidence an “exchange” in which the tipper’s value received was consummating an “intention to benefit” the tippee.  But there still needs to be evidence of that intention to benefit, and if that evidence is solely the relationship between the parties, proof of a “meaningfully close relationship” is important because relying solely on evidence of a “friendship . . . of a casual or social nature” would undermine the Dirks “personal benefit requirement” by making it an effective “nullity.”

(By the way, this explains why the Second Circuit reached a different result in Newman than the Ninth Circuit did in U.S. v. Salman.  In Salman, there was direct evidence that the transfer of information was made with an intent to benefit the tippee, and even beyond this, the tipper and tippee where brothers, which is well beyond the kind of “casual” friendships at issue in Newman.  In truth, Salman is not even a close case under the Newman standard.  See In U.S. v. Salman, Judge Rakoff Distinguishes Newman in 9th Circuit Opinion Affirming Insider Trading ConvictionThe Government’s argument that this represents a split in the Circuits is, with respect, laughable.)

This is how the Newman cert. opposition addressed this key point:

Dirks recognized that “[d]etermining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts.” 463 U.S. at 664.  By characterizing the inquiry as “a question of fact” the Court appreciated that lower courts would need to formulate rules for weighing the evidence in the particular circumstances before them.  That is exactly what the Second Circuit did here.  The court of appeals’ assessment of what kind of proof would support a factual inference is the type of evidence-based analysis that Dirks recognized would be within the province of the lower courts to develop.

Dirks also recognized that a personal benefit in the form of a gift is not simply a matter of whether a tipper gives inside information to a friend or relative.  The Court repeatedly emphasized that it is the purpose of the disclosure that is determinative.  E.g., 463 U.S. at 662 “Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure.”). . . .  The Court’s focus on the purpose of a disclosure would be undermined if a jury were permitted to infer a personal benefit from the bare fact that two people knew each other.  That is because it is not reasonable to presume that the purpose of communicating financial information between casual acquaintances is to provide a gift.  Casual acquaintances typically do not give each other the kind of gifts contemplated by Dirks, i.e. the equivalent of the insider trading stock and gifting the proceeds to someone else.  On the other hand gifts, especially of money, are much more likely among people who take a deep personal interest in each other’s lives, such as close friends or relatives.  The Second Circuit’s evidentiary formulation is thus consistent with the gift theory as articulated in Dirks because it limits the inference of an intentional gift of trading proceeds to circumstances that reasonably support that conclusion.

Newman Cert. Opp. at 20-21.

So, what the Government cert. petition comes down to is a request that the Supreme Court re-examine the evidentiary record to determine whether the agreed-upon Dirks standard was satisfied in this case, even though that issue is not even case-determinative.  That’s not the resolution of an important securities law issue, it is an effort to get the High Court to relieve the Justice Department of the embarrassment of being shot down for an overly-aggressive prosecution fueled more by ambition than evidence.  That’s not cert.-worthy in my book.

There Is No Basis To Expect Harmful Market Consequences from the Newman Decision

The Government’s last argument in support of certiorari – that absent Supreme Court reversal the securities markets and securities law enforcement will be devastated by the purportedly “new,” limited scope of the insider trading prohibition adopted in Newman – fails for multiple reasons.

First, as discussed above, The Newman court did not limit the scope of the law as stated by Dirks.  It tried its best to articulate an evidentiary standard for satisfying the Dirks “personal benefit” standard in the narrow circumstances where there was no quid pro quo from tippee to tipper, and there was no evidence of an intended “gift” from the tipper to the tippee apart from the nature of their relationship.

Second, the Government cited no empirical data even suggesting that requiring evidence of a “meaningfully close relationship” between tipper and tippee to prove insider trading fraud in such cases would harm investor confidence or undermine the overall integrity or efficiency of the securities markets.  Both the Newman and Chiasson cert. oppositions lay out the facts showing that since the Newman decision, Government insider trading cases have not failed because of Newman.  See Newman Cert. Opp. at 27-30; Chiasson Cert. Opp. at 30-33.  Such unsupported “sky is falling” predictions are hardly the grounds for granting certiorari.  In fact, Dirks itself undermines this Government argument, because the Dirks opinion warned against low standards for proving insider trading fraud based on communications with securities analysts, whose purpose is to ferret out information and incorporate it into the market:

Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market.  It is commonplace for analysts to ‘ferret out and analyze information,’ . . . and this often is done by meeting with and questioning corporate officers and others who are insiders.  And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation’s securities.  The analyst’s judgment in this respect is made available in market letters or otherwise to clients of the firm.  It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation’s stockholders or the public generally.

Dirks, 463 U.S. at 658-59 (footnotes and cites omitted).  Dirks makes it clear that “objective facts and circumstances” must provide evidence of misconduct, especially when we are dealing with communications of information between businesses and analysts.  The Newman opinion is a step in the direction Dirks espoused, made with due regard for the fact that communications of the nature involved in Newman provide the foundation for efficient securities markets.

In Contrast, the Government’s Proposed Rule Would Undermine the Securities Markets

As we have written before, it has long been the Government’s view that the securities laws should be interpreted to mandate equal access of information to all investors, even though that concept is inconsistent with market efficiency, and even market fairness.  (Market efficiency depends on dissemination of information.  Market fairness is undermined when preventing the dissemination of information causes securities transactions to be completed on the basis of incomplete information, and the consequential mispricing of the securities traded.)  See The Myth of Insider Trading Enforcement (Part I), and SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.  The Government’s cert. petition continues to reflect this bias, notwithstanding the fact that the Supreme Court has rejected this view repeatedly, including this quote from Dirks itself:

Here, the SEC maintains that anyone who knowingly receives nonpublic material information from an insider has a fiduciary duty to disclose before trading.  In effect, the SEC’s theory of tippee liability in both cases appears rooted in the idea that the antifraud provisions require equal information among all traders.  This conflicts with the principle set forth in Chiarella that only some persons, under some circumstances, will be barred from trading while in possession of material nonpublic information.  Judge Wright correctly read our opinion in Chiarella as repudiating any notion that all traders must enjoy equal information before trading: ‘[T]he ‘information’ theory is rejected. Because the disclose-or-refrain duty is extraordinary, it attaches only when a party has legal obligations other than a mere duty to comply with the general antifraud proscriptions in the federal securities laws.’ . . .  We reaffirm today that “[a] duty [to disclose] arises from the relationship between parties . . . , and not merely from one’s ability to acquire information because of his position in the market.”

Dirks, 463 U.S. at 656-58 (footnotes and cites omitted).

This bias is reflected in the Government’s revisionist view that Dirks was consistent with the view that communications between what the Second Circuit called “casual” friends should be sufficient to satisfy the “breach of duty” requirement, and suggesting that in such cases, the burden should shift to the accused to show that “selective disclosures” had “a valid business purpose” or were a “mistake.”  That view, if accepted, would greatly impact the nature of communications between and among securities analysts, and would undermine market efficiency and fairness by presuming every communication of information between acquaintances is unlawful absent their ability to prove otherwise.  This is what the Government says:

Dirks recognizes that not all selective disclosures of confidential information trigger the disclose-or-abstain-from-trading rule. . . .  It explains that if an insider has a valid business purpose for selective disclosure (for instance, supplying data to another company in the course of merger talks), or mistakenly believes that information is not material or is already in the public domain, disclosure does not violate the insider’s fiduciary duties. . . .  The fact that analysts (or others) may be friends with company insiders does not automatically preclude such a legitimate business reason for disclosure.”

Cert. Pet, at 21.

In fact, Dirks makes it crystal clear that the burden falls on the Government to prove that even communications between friends or acquaintances rise to the level of a breach of duty that could support an insider trading fraud finding.  The Chiasson cert. opposition addresses this attempted Government sleight-of-hand:

Finally, at the close of its discussion of Dirks, the Government tips its hand. The Government’s problem is not really with the decision below; it is with Dirks itself.  The Government asserts (at 21) that an insider violates his fiduciary duty by disclosing information unless the insider “has a valid business purpose for selective disclosure” or “mistakenly believes that information is not material or is already in the public domain.” But that turns Dirks on its head. Dirks does not require the insider to prove some “legitimate” reason for his disclosure to avoid liability. . . .  To the contrary, under Dirks, an insider is not liable unless the Government proves that “the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.” . . .  And the circumstances under which an insider may disclose information without receiving a personal benefit are hardly limited to the two scenarios the Government acknowledges. The Court in Dirks made clear that mistaken disclosures were only an “example” of the type of disclosure that would not constitute a breach. . . .  Even disclosures that violate company policy or confidentiality obligations are not necessarily made for the insider’s personal benefit. . . .  The Government may wish to pursue prosecutions that go beyond what Dirks contemplated, but that is no reason to revisit precedent that has been on the books since the Burger Court.

Chiasson Cert. Opp. at 19-20.

It seems especially strange that the Government is pursuing this argument in the context of a case with facts that seem so close to the kind of communications that Dirks wanted to protect.  The evidence here is that securities analysts were discussing company performance with company officials.  That’s what analysts are supposed to do.  The evidence is also that for at least one of these companies — Dell — the insider’s job was to stay in touch with, and develop relationships with, market analysts who could ultimately be a source of investors.  The communications were not known to be for the purpose of trading.  This strikes me as precisely the kind of communications between company insiders and outside analysts that Dirks wanted to enshrine, not attack.  It truly seems like it is the Government that is trying to alter Dirks, not the Second Circuit.

*                      *                      *

The flaws in the Government’s argument in support of granting the writ of certiorari are manifold and serious.  One normally expects the Justices and their clerks to recognize this, even when the proponent of the writ is the Government.  Yet, it remains possible that all of the brouhaha over the Newman decision – much of which can be traced to the Government’s own hissy fit over losing these cases (which are certainly marginal at best) – will drive the Court towards granting cert.  This person’s view is that if this happens, the Government will regret the decision to elevate this case.  There is much more potential for downside for the Government than upside, because when the Court further specifies the elements of insider trading fraud under section 10(b) and Rule 10b-5, the Government’s discretion to pursue its favored “equality of information” policies is likely to become more, rather than less, constrained.

Straight Arrow

September 3, 2015

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7th Circuit Rules for SEC, Affirming Dismissal of Bebo Case on Jurisdictional Grounds

On August 24, 2015, the Seventh Circuit handed the SEC a major victory in the ongoing battle over alleged constitutional infirmities of the SEC’s administrative judicial process.  It agreed with the lower court that Laurie Bebo’s federal court challenge to her administrative proceeding cannot be heard in the case filed by her seeking injunctive relief against an SEC administrative proceeding.  The court found that the circumstances of Bebo’s case were such that she was required to wait to present her constitutional objections before a federal appellate court on review of whatever action the SEC might ultimately take against her.  The opinion can be read here: 7th Circuit Decision in Bebo v. SEC.

The court found that the Bebo case — and presumably others like hers — was not like the PCAOB case in which the Supreme Court decided the constitutional challenge could be heard immediately, in Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010).  The court summarized: “It is ‘fairly discernible’ from the statute that Congress intended plaintiffs in Bebo’s position ‘to proceed exclusively through the statutory review scheme’ set forth in 15 U.S.C. § 78y.  See Elgin v. Dep’t of Treasury, 567 U.S. —, 132 S. Ct. 2126, 2132–33 (2012).  Although § 78y is not ‘an exclusive route to review’ for all types of constitutional challenges, the relevant factors identified by the Court in Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477, 489 (2010), do not adequately support Bebo’s attempt to skip the administrative and judicial review process here.  Although Bebo’s suit can reasonably be characterized as ‘wholly collateral’ to the statute’s review provisions and outside the scope of the agency’s expertise, a finding of preclusion does not foreclose all meaningful judicial review. . . .  And because she is already a respondent in a pending administrative proceeding, she would not have to ‘‘bet the farm … by taking the violative action’ before ‘testing the validity of the law.’’ . . .  Unlike the plaintiffs in Free Enterprise Fund, Bebo can find meaningful review of her claims under § 78y.”

The court then addressed the arguments in greater detail:

The statutory issue here is a jurisdictional one: whether the statutory judicial review process under 15 U.S.C. § 78y bars district court jurisdiction over a constitutional challenge to the SEC’s authority when the plaintiff is the respondent in a pending enforcement proceeding.  Where the statutory review scheme does not foreclose all judicial review but merely directs that judicial review occur in a particular forum, as in this case, the appropriate inquiry is whether it is “fairly discernible” from the statute that Congress intended the plaintiff “to proceed exclusively through the statutory review scheme.” Elgin v. Dep’t of Treasury, 567 U.S. —, 132 S.Ct. 2126, 2132–33 (2012). 

This inquiry is claim-specific.  To find congressional intent to limit district court jurisdiction, we must conclude that the claims at issue “are of the type Congress intended to be reviewed within th[e] statutory structure.”  Free Enterprise Fund, 561 U.S. at 489, quoting Thunder Basin Coal Co. v. Reich, 510 U.S. 200, 212 (1994).  We examine the statute’s text, structure, and purpose. . . .

. . . .  Our focus in this appeal is whether Bebo’s case is sufficiently similar to Free Enterprise Fund to allow her to bypass the ALJ and judicial review under § 78y.  Based on the Supreme Court’s further guidance in Elgin, we believe the answer is no.

. . . .

Read broadly, the jurisdictional portion of Free Enterprise Fund seems to open the door for a plaintiff to gain access to federal district courts by raising broad constitutional challenges to the authority of the agency where those challenges (1) do not depend on the truth or falsity of the agency’s factual allegations against the plaintiff and (2) the plaintiff’s claims do not implicate the agency’s expertise.  That’s how Bebo reads the case.  She argues that Free Enterprise Fund controls here because her complaint raises facial challenges to the constitutionality of the enabling statute (§ 929P(a) of Dodd-Frank) and to the structural authority of the agency itself, and the merits of those claims do not depend on the truth or falsity of the SEC’s factual claims against Bebo or implicate the agency’s expertise.  While Bebo’s position has some force, we think the Supreme Court’s more recent discussion of these issues in the Elgin case undermines the broader reading of the jurisdictional holding of Free Enterprise Fund.

. . . .

[T]he Elgin Court specifically rejected the plaintiffs’ argument, advanced by Bebo in this appeal and by the dissent in Elgin, that facial constitutional challenges automatically entitled the plaintiffs to seek judicial review in the district court. . . .

The Elgin Court also read the jurisdictional portion of Free Enterprise Fund narrowly, distinguishing it on grounds directly relevant here. . . .  [In Elgin, b]ecause the [controlling statute] provided review in the Federal Circuit, “an Article III court fully competent to adjudicate petitioners’ claims [of unconstitutionality],” the statutory scheme provided an opportunity for meaningful judicial review.

. . . .

Elgin established several key points that undermine Bebo’s effort to skip administrative adjudication and statutory judicial review here.  First, Elgin made clear that Bebo cannot
sue in district court under § 1331 merely because her claims are facial constitutional challenges.  Second, it established that jurisdiction does not turn on whether the SEC has authority to hold § 929P(a) of Dodd-Frank unconstitutional, nor does it hinge on whether Bebo’s constitutional challenges fall outside the agency’s expertise.  Third, Elgin showed that the ALJ’s and SEC’s fact-finding capacities, even if more limited than a federal district court’s, are sufficient for meaningful judicial review.  Finally, Elgin explained that the possibility that Bebo might prevail in the administrative proceeding (and thereby avoid the need to raise her constitutional claims in an Article III court) does not render the statutory review scheme inadequate.

. . . .  We think the most critical thread in the case law is the first Free Enterprise Fund factor: whether the plaintiff will be able to receive meaningful judicial review without access to the district courts.  The second and third Free Enterprise Fund factors, although relevant to that determination, are not controlling, for the Supreme Court has never said that any of them are sufficient conditions to bring suit in federal district court under § 1331.  We therefore assume for purposes of argument that Bebo’s claims are “wholly collateral” to the administrative review scheme.  Even if we give Bebo the benefit of that assumption, we think it is “fairly discernible” that Congress intended Bebo to proceed exclusively through the statutory review scheme established by § 78y because that scheme provides for meaningful judicial review in “an Article III court fully competent to adjudicate petitioners’ claims.”

. . . .

Bebo’s counter to this way of synthesizing the cases is that the administrative review scheme established by § 78y is inadequate because, by the time she is able to seek judicial review in a court of appeals, she will have already been subjected to an unconstitutional proceeding. The Supreme Court rejected this type of argument in FTC v. Standard Oil Co., 449 U.S. 232, 244 (1980), holding that the expense and disruption of defending oneself in an administrative proceeding does not automatically entitle a plaintiff to pursue judicial review in the district courts, even when those costs are “substantial.”

This point is fundamental to administrative law. Every person hoping to enjoin an ongoing administrative proceeding could make this argument, yet courts consistently require plaintiffs to use the administrative review schemes established by Congress. . . .  It is only in the exceptional cases, such as Free Enterprise Fund and McNary, where courts allow plaintiffs to avoid the statutory review schemes prescribed by Congress. This is not
such a case.

Although several courts have now reached differing conclusions on this jurisdictional issue (see In Duka v. SEC, SDNY Judge Berman Finds SEC Administrative Law Enforcement Proceedings Constitutional in a Less than Compelling Opinion, and Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding), the Seventh Circuit is the first appellate court to do so, and that alone is likely to carry weight elsewhere.  But this is also a strongly-stated opinion, which examines seriously and in depth the somewhat varying Supreme Court precedent.  The fact that the court takes on Ms. Bebo’s arguments directly and rejects them on the basis of its interpretation of the Supreme Court precedent makes it even more likely to be influential.

The D.C. and Eleventh Circuits may be the next appellate courts to consider the jurisdictional issue.  The D.C. Circuit heard argument on this jurisdictional issue in Jarkesy v. SEC, and it may issue the next appellate opinion.  See Appeals panel considers SEC’s use of in-house courts.  And the 11th Circuit has already received the SEC’s brief on appeal in Hill v. SEC, which it appealed from the preliminary injunction issued by Judge Leigh May in the Northern District of Georgia.  See SEC 11th Circuit Appeal Brief in Hill v. SEC.  Because Judge May decided her court had jurisdiction, and then went on to find a likely constitutional violation, The 11th Circuit briefs will address both the jurisdictional issue and the merits of some of the constitutional arguments.  If the 11th Circuit agrees with the 7th Circuit that there is no jurisdiction to bring these cases, however, it will vacate the preliminary injunction and not address the merits of Mr. Hill’s claim.

Depending on what these appellate courts do, and whether they concur in the 7th Circuit’s analysis, the door to injunctive relief in the federal courts for these alleged constitutional violations may slam shut.  That would focus attention on the merits of the claims in cases decided by the SEC on a petition for review from an administrative decision.  The case likely to be the first such SEC decision that could be appealed would seem to be In the Matter of Timbervest, LLC, in which the SEC is still receiving supplemental briefing addressing constitutional and discovery issues.  See SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case and Division of Enforcement Continues To Refuse To Comply with SEC Orders in Timbervest Case.

Stay tuned.

Straight Arrow

August 24, 2015

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Supreme Court Should Take Action To Rehabilitate Brady Rule in Georgiou v. United States

Justice requires that the Supreme Court shore up the foundations of one of its landmark due process cases, Brady v. Maryland, 373 U.S. 83 (1963).  Otherwise, Brady, one of the seminal due process cases of the 20th Century, will be “more honor’d in the breach than the observance.”

In Brady, the Court ruled that prosecutors could not hide material exculpatory evidence from defendants. It is founded on the simple concept that a fair trial requires that a jury be presented with unbiased evidence, and the Government cannot, consistent with due process, prevent important exculpatory evidence from reaching the jury.

Over the years, prosecutors have largely resisted the concept that they share evidence in their possession that could assist the defense.  This reflects a fundamentally flawed approach to the criminal justice process – too many prosecutors view winning a prosecution as the ultimate goal, when in fact achieving justice – win or lose – is the sine qua non of the criminal justice system of which they are part and parcel.

It is well-known that obtaining exculpatory evidence from prosecutors can be like pulling their teeth, and it has been documented that the failure to follow the simple Brady mandate is a common occurrence.  The courts, which are entrusted to assure the Brady rule is followed, have been unduly neglectful of this key oversight role, showing an unseemly willingness to accept Brady violations under a range of rationalizations.

One of the key rationalizations for permitting Brady violations has been the so-called “due diligence” rule adopted by some courts, under which even the intentional failure of the prosecution to share important exculpatory evidence is ignored if the court develops a hindsight theory of how defense counsel could have uncovered similar information through its own investigations.  The “due diligence” concept finds no support in Brady or other Supreme Court decisions, and, as is readily apparent, flies in the face of the very concept of Brady, which is about the State’s duty to assure a fair trial, not the relative diligence or acumen of the defense lawyers.

This issue has now been placed squarely before the Court in a petition for certiorari in Georgiou v. United States, No. 14-1535.  Some time ago we wrote about some ill-conceived decisions by the Third Circuit in United States v. Georgiou, 777 F.3d 125 (3d Cir. 2014).  The 3rd Circuit first misapplied the Supreme Court decision in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), by ruling that transactions that touched the United States in only the most ephemeral way were subject to extraterritorial jurisdiction.  See Third Circuit Adopts “Craven Watchdog” Standard for Extraterriorial Reach of Securities Laws in U.S. v. Georgiou.  Then, the court sunk a spear into the heart of Brady by ruling that the prosecutors’ intentional withholding from the defense of key exculpatory evidence was not a Brady violation because the defense lawyers could have figured out how to gain access to that information themselves.  See U.S. v. Georgiou: 3rd Circuit Panel Decision Makes a “Mockery” of Brady Disclosures and Jencks Act Compliance.  The Third Circuit opinion is available here: US v Georgiou.

It is well-documented that prosecutorial violations of the Brady rule – which is critically important to both actual and apparent fairness in criminal prosecutions – are common.  This is one of the shameful aspects of our current criminal justice system that most courts blithely ignore.  It is bad enough that non-compliance with Brady is rife; it is even worse that our courts not only conjure up reasons to allow prosecutors to get away with this, but also, like the Third Circuit in Georgiou, create new rules to provide non-compliant prosecutors with a safe harbor to avoid the appropriate consequences – reversal and retrial – for deciding not to comply with the core fairness principles Brady endorsed and imposed.

The cert. petition in Georgiou and three supporting amicus briefs show (i) the Brady rule is often circumvented by prosecutors, mostly with no consequences; (ii) that is what happened in the Georgiou prosecution; and (iii) the post-hoc absolution of prosecutorial misconduct by focusing on hypothetical defense failures to cure that violation is contrary to Supreme Court precedent, antithetical to Brady, and fosters a prosecutorial mindset that the risk of such due process violations is worth taking in order “win” a conviction.

The Georgiou cert. petition is available here: Cert. Petition in Georgiou v. US.  The three amicus briefs in support of that petition are available here: Georgiou v. US Amicus Brief of Former Prosecutors; Georgiou v. US Center on Administration of Criminal Law Amicus Brief; and Georgiou v. US Amicus Brief of California Attorneys for Criminal Justice.

The Georgiou cert. petition presents these key facts relating to the Brady issue:

The charges arose out of an alleged scheme to artificially inflate the prices of several stocks on the over-the-counter securities market. . . .  According to the indictment, Georgiou and his co-conspirators caused the stocks’ prices to rise by engaging in manipulative trading. . . .

. . . . The Government’s star witness was Kevin Waltzer, an alleged coconspirator.  Waltzer was the only witness who could provide what the Government described as “an insider[’]s view into this stock ring by one of its participants.” . . .  And during the trial, Waltzer testified directly to Georgiou’s mens rea, telling the jury that Georgiou “basically” admitted to him that Georgiou “kn[ew] that the public is going to get fleeced.” . . .

Following trial, Georgiou obtained critical material from Waltzer’s own criminal proceedings. Waltzer himself had been charged with wire fraud and other federal crimes. . . .  [M]ore than a year before the start of Georgiou’s trial . . . a [bail report] regarding whether Waltzer should be released on bail . . . stated that Waltzer had “been diagnosed in the past with Anxiety Disorder, Panic Disorder and Substance Abuse Disorder.” . . .  And it noted that he had been taking Paxil for the last ten years for his anxiety. . . .  Georgiou obtained a copy of this bail report for the first time after the end of his trial.

Georgiou also obtained, for the first time following his trial, a copy of the transcript of Waltzer’s arraignment and guilty plea hearing.  During that hearing, in the presence of an assistant U.S. attorney, Waltzer acknowledged “see[ing] a psychiatrist, psychologist or mental health provider * * * in connection with depression and anxiety.”

The Government had failed to disclose either the bail report or the plea transcript prior to Georgiou’s trial, even though Georgiou had requested “any and all evidence” that “a government witness or prospective government witness * * * is or was suffering from any mental disability or emotional disturbance.” . . .  Georgiou had also requested any “[i]nformation concerning Mr. Waltzer’s * * * current or past psychiatric treatment or counseling.”

Cert. petition at 4-8.

The petition also describes how the availability of that evidence would have permitted the defendant to learn that this key witness was an admitted drug addict, and that his medication had known side-effects of memory impairment.  Id. at 6-7 & notes 2-3.  The Third Circuit ruled that the prosecutors’ intentional withholding of this evidence about the state of mind of the Government’s star witness was not a Brady violation because with greater diligence, the defense could have obtained those materials themselves.  It also found they were not “material” evidence under Brady.

The Georgiou case struck a nerve among both defense lawyers and prosecutors.  This is reflected in the three amicus briefs filed in support of granting the writ of certiorari and reversing Georgiou. One was filed by the California Attorneys for Criminal Justice, one by the Center on the Administration of Criminal Law, and one by an unusual, large group of former federal prosecutors, Department of Justice, and other Government officials.  Those officials include: a former Attorney General and federal district judge, two former Acting Attorneys General, a former White House Counsel, four former Deputy Attorneys General, five former U.S. Attorneys, and an assortment of other former high-level federal criminal justice officials.

These three amicus briefs agree that the exception to the Brady rule adopted by the Third Circuit is wrong as a matter of law under Supreme Court precedent, and dangerous as a matter of policy because of its harmful effects on due process.  They also agree that the documented trend of prosecutors ignoring Brady will continue and worsen if the Supreme Court fails to step in to make it clear that the rule is not just a heuristic concept with no serious consequences if (actually, when) it is ignored, but is mandated by principles of fundamental fairness, due process, and the administration of justice, and must be enforced vigorously and without exception.

The impressive group of former DOJ leaders, prosecutors, and government officials wrote:

As the Supreme Court recognized in Brady v. Maryland, the failure to disclose favorable evidence “violates due process … irrespective of the good faith or bad faith of the prosecution.” 373 U.S. 83, 87 (1963); see also United States v. Nixon, 418 U.S. 683, 709 (1974) (“The very integrity of the judicial system and public confidence in the system depend on full disclosure of all the facts, within the framework of the rules of evidence.”).  While this affirmative duty is above and beyond the demands of the “pure adversary model,” United States v. Bagley, 473 U.S. 667, 675 n.6 (1985), it is grounded in an understanding of the prosecutor’s “‘special role … in the search for truth in criminal trial,’” Banks v. Dretke, 540 U.S. 668, 696 (2004).  From their years of combined experience, amici appreciate the challenging judgment calls prosecutors face on a daily basis, but they also deeply believe that fundamental fairness and public confidence in our justice system relies on prosecutors taking their disclosure obligations seriously and fulfilling this duty capaciously.

Amici do not believe that Supreme Court precedent recognizes an exception to the Brady rule for lack of diligence by the defense and are concerned that the decisions of several federal circuits, including the Third Circuit, have undermined Brady by shifting focus away from the prosecutor’s affirmative obligation to disclose. We submit this brief to emphasize that the introduction of an antecedent “due diligence” inquiry focused on the defendant is inconsistent not only with Supreme Court precedent but also principles codified in the codes of ethical conduct for prosecutors.

Petitioner George Georgiou’s case presents a straightforward question about the appropriateness of conditioning Brady disclosures on a defendant’s exercise of due diligence.  According to the government, Georgiou and his co-conspirators engaged in a scheme that inflated the prices of four securities through various trading strategies and then fraudulently used those manipulated securities as collateral to obtain large loans. . . .  The prosecution relied on the testimony of Kevin Waltzer, Georgiou’s former business partner and alleged co-conspirator. . . .  Waltzer’s testimony corroborated certain physical evidence collected by the government . . . and undergirded the government’s contention that Georgiou acted “wilfully” and had the “intent to defraud.”. . .

Recognizing the importance of Waltzer’s testimony, Georgiou made a pre-trial request that the government turn over any Brady information that would “reflect upon the credibility, ompetency, bias or motive of government witnesses,” including with respect to any mental health problems or substance abuse issues Waltzer might have had. . . .  The government provided limited information regarding Waltzer’s drug use responsive to this request. . . .

Yet the government had been aware from Waltzer’s own criminal proceedings that he had an extensive history of substance abuse and mental health problems, and possessed two pieces of evidence at issue on appeal that it failed to disclose: A Bail Report provided to the government a year before Georgiou’s trial by pretrial services . . . and the transcript of Waltzer’s arraignment and guilty plea hearing . . . .  Both documents contained specific information about the timeline of Waltzer’s mental health and substance abuse issues, as well as the medication and treatment he was receiving in the period leading up to his testimony.  This information might have informed Georgiou’s defense strategy and advanced his efforts to undermine Waltzer’s credibility. . . .

The Third Circuit affirmed the conviction. The court held that the evidence had not been suppressed because Georgiou failed to exercise “reasonable diligence” in seeking evidence of Waltzer’s mental health history. . . .  In particular, the court reasoned that the Bail Report and the Minutes, as public records, were equally available to Georgiou and the prosecution.  . . .

By adopting this circumscribed view of a prosecutor’s obligations under Brady, the Third Circuit has joined a growing list of courts departing in this way from Supreme Court precedent and the fundamental principles that undergird the Brady doctrine.  Where prosecutors are aware of this sort of information, they should disclose it to the defense, and their obligations to the truth-seeking process and principles of fairness are not discharged on the theory that the defendant could seek it out for himself.  Such an approach contributes to a harmful notion that the criminal justice system is a game, and that victory rather than justice is a prosecutor’s goal.

. . . . The Third Circuit has diminished this constitutional and ethical requirement by introducing a rule that excuses a prosecutor from fulfilling her obligation if the defendant could have but did not find the favorable evidence himself.  Rather than ask whether the prosecution has withheld from the defendant evidence that, “if made available, would tend to exculpate him or reduce the penalty,” Brady, 373 U.S. at 87-88, the Third Circuit asks whether the defendant could have obtained the evidence “from other sources by exercising reasonable diligence,” United States v. Perdomo, 929 F.2d 967, 973 (1991).  Such a rule is tantamount to saying that a “‘prosecutor may hide, defendant must seek,’” which this Court in Banks v. Dretke made clear “is not tenable in a system constitutionally bound to accord defendants due process.”  540 U.S. 668, 696 (2004) . . . .  It is also at odds with standards of prosecutorial conduct.

Brief of Former Prosecutors and Officials at 2-7.

The Center for the Administration of Criminal Law (CACL) provided similar views, and focused on the harmful impact of fashioning rules that allow departures from Brady obligations:

Prosecutors’ duty under Brady to disclose exculpatory evidence to defendants is a core component of prosecutors’ ethical duty to seek justice rather than victory.  Nonetheless, many prosecutors fail to live up to the obligations that Brady imposes on them.  Because of the public perception that prosecutorial misconduct is widespread, public confidence in prosecutors’ integrity and the overall fairness of the criminal justice system is in decline.

The Third Circuit’s recognition of a “due diligence” exception to Brady not only undermines defendants’ constitutional right to due process, but also fosters conditions likely to further erode public confidence in the system.  While a legal doctrine excusing Brady violations might appear to be an attractive option for prosecutors, in fact it harms both prosecutors and defendants.  It muddies an otherwise clear ethical obligation to disclose exculpatory information, which is central to prosecutors’ duty to seek justice.  It burdens prosecutors by requiring speculation about information available to their adversaries through due diligence – a determination that prosecutors are ill-equipped to make for myriad reasons.  By undermining defendants’ confidence in the information they receive from prosecutors, it discourages plea bargaining, which is essential to the efficient functioning of today’s criminal justice system.  By undercutting public confidence in prosecutors generally, it hampers their ability to obtain the cooperation of witnesses and the trust of jurors.  And ultimately, it undermines the public’s interest in ensuring that the guilty are convicted and the innocent exonerated, because those outcomes depend on a robust adversarial system in which both sides have actual knowledge of the material facts.

CACL Brief at 3-4.

The CACL brief also focused on the growing problem of non-compliance with Brady:

Unfortunately, Brady’s promise of full disclosure often has not been realized in practice.  In a recent frank opinion, Chief Judge Alex Kozinski of the U.S. Court of Appeals for the Ninth Circuit observed that “Brady violations have reached epidemic proportions in recent years, and the federal and state reporters bear testament to this unsettling trend.”  United States v. Olsen, 737 F.3d 625, 631 (9th Cir. 2013) (Kozinski, J., dissenting from denial of reh’g en banc) (collecting cases).  Some commentators are even more critical.

Empirical studies confirm that Chief Judge Kozinski’s statement was no exaggeration.  According to a study by the Veritas Initiative, prosecutors withheld or delayed disclosing favorable evidence in roughly one-third of the cases sampled.  [Citation omitted.]  Yet in 2001, “[a] nationwide study of all reported cases involving discipline for prosecutorial misconduct found only twenty-seven instances in which prosecutors were disciplined for unethical behavior that compromised the fairness of a trial.”  [Citations omitted.]  Recognizing a due diligence exception, and thereby increasing uncertainty about Brady’s scope, threatens to exacerbate these problems by suggesting judicial sanction for prosecutors’ noncompliance.

. . . .

Disclosing exculpatory evidence helps to “justify trust in the prosecutor,” and supplies legitimacy enabling the prosecutor to fulfill his or her mandate. . . .  By excusing failures to disclose Brady material that might be discovered through “reasonable diligence” . . ., the exception both weakens prosecutors’ disclosure obligations and reduces transparency.  In short, it undermines trust in prosecutors by minimizing their duty to disclose exculpatory evidence.

Id. at 6-7, 10.

The CACL brief goes on to discuss at length why presenting prosecutors with the option to game the Brady rule by speculating about what defense “due diligence” might reveal – thus negating their own obligation to reveal exculpatory evidence they know exists – undermines the rule, and places even good faith prosecutors in an untenable position to make decisions based on guesses or suppositions that they are ill-fitted to make.  Id. at 13-18.

The California Attorneys for Criminal Justice likewise argue that removing the uncertainty of the products of “due diligence” from the Brady disclosure equation is necessary to achieve Brady’s key fairness goals:

The “due diligence” exception adopted by the Third Circuit in this case, and by other circuits and state courts around the country, should be rejected because it undermines the animating principle of Brady and imposes on prosecutors and courts the unavoidably speculative analysis of whether a particular piece of evidence would be meaningfully “available” to a diligent defendant.  The exception also invites prosecutorial mischief, as complex rules that rest on speculative inquiries are far more vulnerable to mistakes, or abuse, than clear and simple commands.  The exception also imposes onerous and inefficient limitations on counsel to indigent defendants, who often do not have resources to conduct fulsome investigations.

. . . .

As Brady itself recognized, “[s]ociety wins not only when the guilty are convicted but when criminal trials are fair; our system of the administration of justice suffers when any accused is treated unfairly.”  373 U.S. at 87. . . .  The “due diligence” rule applied by the Third Circuit in this case undermines these goals. . . .  The due diligence exception has no place in the Brady analysis, and in fact operates only to undermine the promise of fair trials.  As applied by the Third Circuit and other courts, the exception affects the outcome of the Brady analysis only when the defendant has established the failure to disclose evidence that has a reasonable probability of affecting the outcome of a case.  That is, it preserves a conviction precisely, and only, when there is substantial doubt that the defendant was “convicted on the basis of all the evidence which exposes the truth.”

. . . .

The Third Circuit’s opinion in this case relied on the assumption that the undisclosed evidence “could have been accessed through his exercise of reasonable diligence.” . . .  Even if that assumption were warranted here, in many cases a prosecutor’s determination whether evidence is reasonably accessible to defendants will require speculation regarding both the availability of evidence and the resources available to the defendant and his counsel.  And more importantly, even when a defendant might have access to information via rumors or innuendo, a prosecutor might well have access to reliable, admissible documents with far more persuasive value.  Due Process cannot condone withholding admissible, exculpatory evidence on the grounds that a defendant, through the exercise of due diligence, could have had access to inadmissible hearsay.

. . . .

If speculation as to the fruitfulness of “pre-trial depositions and other discovery” is sufficient to establish the “availability” of evidence in an undisclosed police report, and is therefore sufficient to excuse a Brady violation, the result will be that Brady violations, including intentional suppression of exculpatory evidence, will be excused.  And on a practical level, such a rule invites a prosecutor to engage in the same speculation in seeking to determine whether to disclose plainly exculpatory evidence under Brady.  The question of “availability” of evidence therefore becomes yet another opportunity for subjective analysis by prosecutors creating a corresponding risk of error—or temptation into gamesmanship.

California Attorneys for Criminal Justice Brief at 3-5, 8, 10.

Ironically, the lack of equivalence the California Attorneys point to between actual exculpatory evidence known to prosecutors, and the hypothetical prospect that defense counsel might obtain access to some form of similar information in the exercise of so-called “due diligence,” is one that is often addressed under the securities laws — the same laws under which Mr. Georgiou was convicted.  Under the securities laws, however, the availability of material information through exercise of due diligence by investors does not relieve companies or company officials of duties they may have to disclose that same information.  That rule applies for good reason, because obtaining hard information from a reliable company source with a duty to disclose it is different from ferreting out what may be the same information by means that may lack the same provenance.  It is a bizarre world where the duties of corporate officers to disclose business information could be more onerous and inflexible than the duties of public prosecutors to maintain a fair criminal process.

The Georgiou case gives the Supreme Court an opportunity to stem the growing trend of Brady non-compliance, and the creation of exceptions to the Brady rule that ignore its core message and effectively impede its goals.  The fairness of criminal proceedings is not a discretionary concept to be toyed with by aggressive prosecutors or judges unwilling to put teeth behind core due process requirements.  The Georgiou cert. petition should be granted, and the Supreme Court should send a clear message to the lower courts that some concepts are sacred.

Among those concepts is the admonition in Berger v. United States, 295 U.S. 78, 88 (1935), that the federal prosecutor “is the representative not of an ordinary party to a controversy, but of a sovereignty … whose interest, therefore, in a criminal prosecution is not that it shall win a case, but that justice shall be done.”  The prosecutor’s duty is not to win, but to “ensure that a miscarriage of justice does not occur,” and that includes complying with Brady by disclosing “evidence favorable to the accused that, if suppressed, would deprive the defendant of a fair trial.”  United States v. Bagley, 473 U.S. 667, 675 (1985).  In Brady, the Court made it clear that it is in society’s broader interest “when criminal trials are fair,” and that “our system of the administration of justice suffers when any accused is treated unfairly.”  373 U.S. at 87.  A vague, unverifiable, and poorly-conceived “due diligence” exception to the Brady rule – which excuses even intentional prosecutorial efforts to prevent a fair trial — eviscerates that paramount need and requirement.

Straight Arrow

August 20, 2015

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What Is the SEC Backup Plan if It Loses the ALJ Constitutionality Issue in Court?

The saga of challenges to the constitutionality of the SEC’s administrative law proceedings — and in particular the appointments and removal protections of the administrative law judges — has played out over many months in both court and commentary.  After some early SEC victories on jurisdictional challenges, the Commission seemed content to try to fend off the court cases on such procedural grounds, and fight the merits by deciding the issue in its own favor on a petition for review of one of these proceedings (like the one now before it in the Timbervest case), with perhaps an upper hand once the case reached a federal appeals court.

If that was the early strategy, it now seems to be in need of reconsideration.  Two federal district court judges found jurisdiction over cases making such challenges in four separate cases, and ruled on preliminary injunction motions that the plaintiffs will likely succeed on the merits.  In three of those four cases, involving proceedings against Charles Hill, Gray Financial Group, and Barbara Duka, the SEC is now preliminarily enjoined from moving forward with its administrative proceedings.  (In the other, against Timbervest, the preliminary injunction was denied because the case had already been tried and was now before the SEC for review.)  See Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding; N.D. Ga. Judge Leigh May Issues Injunction for Gray Financial and Denies One for Timbervest; SDNY Court Ups the Ante, Allowing Duka Injunctive Action To Proceed on Appointments Clause Issue; Order Issuing Preliminary Injunction in Duka v. SEC.  The merits of the constitutionality issue now can no longer be dismissed as fringe advocacy.  The main issue in these cases — whether the SEC ALJs are “inferior officers” under Article II of the Constitution — has now been substantially vetted by two courts, which found they were, indeed, inferior officers under closely analogous Supreme Court decisions.  Beyond this, the SEC made embarrassing errors in court submissions about how its ALJs were appointed, and at a minimum seems incompetent at figuring out and reporting to the courts on this simple factual issue.  Indeed, even in the SEC’s own proceeding in Timbervest, the Enforcement Division refused to comply with an adjudicative order from the Commission to provide the Commissioners with a description of how the ALJs were appointed.  Whether it was because they couldn’t do so, or just didn’t want to do so, is not clear.  See SEC Bumbles Efforts To Figure Out How Its Own Administrative Law Judges Were Appointed.  In this context, the SEC itself will have difficulty writing an opinion in Timbervest upholding the constitutionality of the ALJs that would not be in significant danger of being overturned.

But the SEC continues to take a “business as usual” approach in its administrative court proceedings.  Many of these are ongoing, and more are assigned each day (or at least each week).  Any defense lawyer could be committing malpractice by failing to challenge a pending or new case on grounds of unconstitutionality.  Indeed, I question why the ALJs themselves don’t make clear in each such case that the constitutionality of their appointments is now at issue, and stating sua sponte that each respondent would be deemed to have challenged the proceeding on that ground, in the event the argument was ultimately upheld in the courts.

So, what happens if the SEC’s stonewalling defense posture fails; if the constitutionality challenge is ultimately upheld?  If the status quo prevails, my guess is near chaos.  To be sure, the ruling is likely to be applied prospectively, and stayed for some time to allow for some remedial steps to be taken, akin to the approach taken when the bankruptcy courts were ruled unconstitutional.  See Northern Pipeline Co. v. Marathon Pipe Line Co., 458 U.S. 50, 87-88 (1982).  But I don’t see how every case currently pending, or instituted between now and when such a decision occurs, in which such a challenge is made, would not be vacated.  See D.C. Circuit Invalidates Appointment of Former Acting GC for Labor Board (DC Circuit holds in SW General, Inc. v. NLRB, No. 1107, that NLRB action by Acting General Counsel serving unlawfully must be vacated).  That could be a lot of cases that need to be retried (or reconsidered or settled).  Perhaps the Commission is counting on the appellate courts (and the Supreme Court) to blanche at the prospect of vacating such a large number of prosecuted cases.

Even a Commission confident in its arguments needs to consider how to proceed in a way that minimizes chaos if it loses.  What could it do now to protect against that future result?  Two steps immediately come to mind.  First, at least for now, while the constitutionality issue remains in doubt, reverse its new policy of bringing more of its complex cases in the administrative court and go back to the model in which those cases were brought in federal court.  To save face, this need not be announced; it can be effected sub silentio.  The Commission seems to prefer secrecy over sunshine, although a little more open discussion of how it approaches these issues would probably do a lot more good than harm.  An open statement of this discretionary decision would evidence more good faith than we’ve seen over the past year.  Second, obtain a waiver of the constitutionality issue from fully informed respondents before commencing new proceedings, or continuing pending proceedings.  I haven’t researched the issue, but my bet is that the SEC and an opposing party can, by mutual consent, agree to any forum to resolve cases, and a fortiori, an agreement to use the administrative court with its current ALJs likely would be enforceable.  At a minimum, a party that agreed to proceed on this basis would likely be estopped from making a future challenge on this ground.  The SEC might have to make some concessions to get such an agreement — probably involving fairer rules for discovery and scheduling in these cases — but by now they should recognize that this might not be a bad thing.  Many respondents with limited defense resources could well prefer, and agree to, this approach.  That would take a lot of potential future vacated results off the table.

No doubt there are other steps that can be taken to avoid a potential future quagmire.  The important thing is that the Commission and its staff should be thinking about, and implementing, these kinds of steps, because, like it or not, the Commission may find itself on the losing end of the constitutional question.

Straight Arrow

August 12, 2015

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SEC Inspector General Reveals Investigation into Possible Bias of SEC ALJs

The Inspector General of the SEC issued an Interim Report on August 7, 2015 which indicated that he is in the midst of an inquiry into allegations that SEC administrative law judges may have been subjected to pressure from other in the performance of their duties.  According to the Interim Report, the “investigation was initiated on June 30, 2015, based on information provided by Erica Williams, Deputy Chief of Staff, Office of the Chair, concerning alleged potential issues of fairness and bias in the SEC’s administrative proceedings, including those introduced in the Timbervest, LLC (Timbervest) matter.”  On receipt of this information, the “OIG determined it would investigate allegations of bias on the part of Administrative Law Judges (ALJ) in the Commission’s administrative proceedings.”

The information that stirred the inquiry included the May 6, 2015 Wall Street Journal article by Jean Eaglesham, which reported that the SEC’s Division of Enforcement prevailed in about 90% of the cases sent to the SEC administrative law judges (see SEC Wins With In-House Judges: Agency prevails against around 90% of defendants when it sends cases to its administrative law judges), and a Securities Diary June 30, 2015 blog post entitled “SEC Bumbles Efforts To Figure Out How Its Own Administrative Law Judges Were Appointed.”  The Interim Report also referenced another, May 7, 2015 Securities Diary post “Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal,” which reported on the content of the May 6 Wall Street Journal article.

Ms. Williams told the OIG that “Chair Mary Jo White requested an OIG investigation of the alleged bias issue because the identified concerns could impact all ALJs and the SEC administrative proceedings.  The Interim Report can be read here: Interim Report of Investigation by SEC Office of Inspector General into Possible SEC ALJ Bias.

The Interim Report says:

The OIG reviewed the Securities Diary and WSJ news articles that Williams identified, which included the following statements attributed to former ALJ McEwen: she thought the system was slanted against defendants at times; she came under fire from Chief ALJ Murray for finding too often in favor of defendants; Chief ALJ Murray questioned McEwen’s loyalty to the SEC; McEwen retired as a result of the criticism; and SEC judges were expected to work on the assumption that “the burden was on the people who were accused to show that they didn’t do what the agency said they did.”

The Interim Report discussed an OIG interview with ALJ Cameron Elliot, who presided over the Timbervest administrative trial, and described that interview as follows:

The OIG interviewed ALJ Elliot concerning allegations of potential issues of fairness and bias in the SEC’s administrative proceedings.  Elliot denied bias during his reviews and rulings and stated that he independently made his decisions.  Concerning his decision not to provide an affidavit after being invited to do so by a Commission order, Elliot said he received the invitation to provide an affidavit from the Office of the Secretary.  He said that he informed Chief ALJ Murray of the existence of the invitation.  However, he said he adhered to the instructions in the order which requested him to “not consult with anyone at the Commission in the preparation of his affidavit concerning the substance thereof.”  Elliot said that he strictly followed those instructions and that he informed Chief ALJ Murray of the existence of the instructions.  At an office meeting, he informed everyone in the Office of ALJ that he had responded to the order.  When asked, Elliot said he did not receive any direction or guidance from anyone, including Chief ALJ Murray, on how he should respond to the invitation.  Elliot said he had declined to provide an affidavit, stating he had “multiple reasons why [he] decided not to provide a response” but declined to provide any of those reasons to the OIG.  Furthermore, Elliot denied being influenced by anyone on “how to decide [his] cases or suggest or make [him] biased in any fashion.”

The OIG also interviewed ALJ Brenda Murray, who “denied influencing matters before the ALJs and explained that she is responsible only for assigning the ALJs’ workload.”  She also “stated that there was no merit to the allegations of bias as alleged in the WSJ article.”

Regarding the status of the investigation, the OIG reports that it “remains ongoing,” and it “is still gathering additional facts and completing investigative steps, and new information will be reported accordingly.”  At this point, however, “the OIG has not developed any evidence to support the allegations of bias in ALJs’ decisions in the Commission’s administrative proceedings.”

It is troubling, however, that there is no reference to any effort to interview former ALJ Lillian McEwen, who made the troubling statements to the Wall Street Journal.  Ms. McEwen later reportedly said that she would be willing to be interviewed on this matter by the Commissioners.  It is important for the OIG to lay out precisely what efforts have been made to flesh out her views on this issue before issuing any clean bill of health for the SEC’s administrative process.

In addition, the statistics showing an unusually high success rate for the Enforcement Division should be confirmed or rejected through a thorough analysis, and if a statistically significant higher success rate is found for administrative proceedings over the Division’s federal court prosecutions, it is essential that the OIG make every effort to determine that the source of that differential is not, even in part, attributable to inherent biases in either the ALJs themselves or the process they use to reach their results.  Anything short of this will not put the serious due process and fairness issues to rest.  The courts — including the Supreme Court in a key employment discrimination case this past term — often accept that a statistically provable disparate impact can provide evidence of underlying concerns.  That is certainly not a precise analogy for what may be happening here, but if there is a compelling statistical case (and a 90% win rate, or even 100% for some judges, suggests there may be), it should not be ignored.

This being said, it is encouraging that Chair Mary Jo White has seen fit to cause this inquiry to occur.  The apparent determination not to make the existence of the inquiry public is a little perplexing, given the publicity surrounding the accusations.  Nevertheless, she should get credit where it is due.  Those facing prosecution in a possibly biased forum argue, however, that it is not enough to turn to an in-house IG to investigate possible in-house bias.  Lynn Tilton, who is challenging the constitutionality of her administrative enforcement action, tweeted in response: “This defendant feels no comfort that the SEC’s Internal IG investigates bias by its own Judges in its own Courts.”  This skepticism that the SEC’s IG can perform a truly independent investigation must be met by an investigative process so thorough and informed that it is beyond reproach.

Straight Arrow

August 10, 2015

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N.D. Ga. Judge Leigh May Issues Injunction for Gray Financial and Denies One for Timbervest

Events are flowing fast and furious on the continuing litigation of the constitutionality of the SEC’s administrative enforcement proceedings.  We previously reported that S.D.N.Y. Judge Richard Berman issued a favorable ruling to Barbara Duka and withheld deciding whether to issue a preliminary injunction for seven days pending possible SEC action.  See SDNY Court Ups the Ante, Allowing Duka Injunctive Action To Proceed on Appointments Clause Issue.  Now, N.D. Ga. Judge Leigh May, who was the first to rule that the appointment of SEC administrative law judges was likely to be in violation of Article II of the Constitution in Hill v. SEC (see Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding), has issued another preliminary injunction based on the same analysis in Gray Financial Group, Inc. v. SEC.  See Order Enjoining SEC in Gray Financial Group v. SEC.

But the respondents in the administrative proceeding In the Matter of Timbervest, LLC et al.were denied a preliminary injunction by Judge May.  See Order Denying Preliminary Injunction in Timbervest v. SEC.  Unlike the Hill and Gray Financial cases, the administrative trial in the Timbervest administrative proceeding was already completed — and petitions for review from both the Timbervest respondents and the Division of Enforcement were in the midst of consideration by the Commission — when the Timbervest parties commenced their action seeking preliminary relief after Hill v. SEC was decided.  The fact that the case was at a different stage was critical to Judge May, who find that becuase the burden of an extensive administrative trial could no longer be avoided, the justification for a preliminary injunction was far less compelling for Timbervest as compared to the other cases.

Judge May still found that, like the other cases, Timbervest was likely to succeed on the merits of its case, but that was not enough to support the issuance of the preliminary injunction.  Here is what she said on that:

The Court finds that Plaintiffs have not satisfied the remaining preliminary injunction factors as Plaintiffs have failed to meet their burden that they will be irreparably harmed if this injunction does not issue.  Plaintiffs seek limited relief: they request the Court enjoin the SEC’s ability to publish its decisions or enforce those decisions against them until this matter is resolved; they do not seek to enjoin the proceeding or prevent the SEC from issuing its final order. However, unlike the procedural posture in the Court’s prior decisions in Gray and Hill, Plaintiffs waited until the ALJ had issued his initial decision and this case was before the SEC itself before filing this motion.  Plaintiffs have already gone through the entirety of the administrative procedure before the ALJ—thus, no injunction will cure or prevent Plaintiffs’ prior obligation to defend itself before
the ALJ.  And any harm which Plaintiffs have already suffered by virtue of the initial decision being published has already been experienced; removing the ALJ’s initial decision from the website would not prevent a future harm.

Plaintiffs argue that by virtue of the initial decision being posted, they are subject to the results of an unconstitutional procedure. . . .  But even if the Court were to order the initial decision to be taken down, the initial decision has been publicly available since August 2014 and articles have been published about it.  Reality dictates that the results of the initial decision will still be available in the public domain even if the decision is removed, albeit not in its most formal version.

Plaintiffs also argue that they may be subject to additional harm if the SEC publishes a final order or imposes additional future action against them while their appeal from the SEC’s final order is pending.  The Court finds that any future harm as to the judgment is speculative at this point as it has not yet been imposed.  See Winter v. Natural Res. Def. Council, Inc., 555 U.S. 7, 22 (2008) (noting that plaintiffs must show “irreparable injury is likely in the absence of an injunction” and stating that “[i]ssuing a preliminary injunction based only on a possibility of irreparable harm is inconsistent with our characterization of injunctive relief as an extraordinary remedy that may only be awarded upon a clear showing that the plaintiff is entitled to such relief.”) (emphasis in original).  And the SEC stated at the hearing that the SEC often stays its final orders pending appeal, so even if the SEC decides to impose future action against Plaintiffs, the SEC could agree to stay that harm (e.g., any bars, fines, or suspensions) pending appeal.  Therefore, the Court DENIES Plaintiffs’ Motion.

Slip op. at 27-29.

Finally, in connection with the appeal of the preliminary injunction issued in Hill v. SEC, Judge denied the SEC’s request for a stay of her order pending appeal.  See Order Denying SEC Stay Motion in Hill v. SEC.  She said:

The Court finds that a stay of the preliminary injunction pending appeal is not warranted. First, for the reasons stated in this Court’s Order in this case, . . . and the reasons the Court has since stated in two other very similar cases, Gray Financial Group, Inc. v. SEC, No. 1:15-cv-492-LMM, and Timbervest, LLC v. SEC, 1:15-cv-2106, the Court finds that the SEC has not made a strong showing it is likely to succeed on the merits.  As well, the Court notes that the SEC is only foreclosed from conducting an administrative proceeding in front of an ALJ who was not appointed by the SEC itself—the SEC Commissioners may conduct the hearing against Plaintiff at any time or appoint the SEC ALJ directly.  They may also elect to bring their claims in district court. Thus, the Court does not find the SEC is irreparably injured or the public interest is affected as the SEC still has a channel to pursue Plaintiff—even through an administrative proceeding if it chooses.  However, if the stay is lifted, Plaintiff would have to participate in a likely unconstitutional proceeding which would cause a substantial injury. Thus, the SEC’s Motion to Stay is DENIED.

Order at 4.

In showing she is willing to parse through the different factors in these cases and reach varying decision based on the applicable standards, Judge May gains credibility for a reasoned approach to this volatile issue.

Straight Arrow

August 6, 2015

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SDNY Court Ups the Ante, Allowing Duka Injunctive Action To Proceed on Appointments Clause Issue

Today, August 3, 2015, Judge Richard Berman rules that Barbara Duka’s action to enjoin an SEC administrative proceeding against her could proceed in his court.  In doing so, he endorsed the reasoning of Judge Leigh May in SEC v. Hill, on the issues of jurisdiction and whether the SEC ALJs are “inferior officers” for purposes of the Appointments Clause of Article II of the Constitution.  Judge Hill’s decision is discussed here: Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC ProceedingJudge Berman’s decision can be read here: Decision & Order in SEC v. Duka.  Judge Berman previously addressed the jurisdiction issue, ruling in Ms. Duka’s favor, but nevertheless denied her request for a preliminary injunction because he found she was unlikely to succeed in showing that the removal limitations protecting SEC administrative law judges from removal by the President violated the separation of powers.  See In Duka v. SEC, SDNY Judge Berman Finds SEC Administrative Law Enforcement Proceedings Constitutional in a Less than Compelling Opinion.  That decision can be read here: Order Denying Relief in Duka v. SEC.  The issue in this case, and others filed since then, has turned to whether the appointment of SEC ALJs violates Article II’s Appointments Clause.  Judge Berman was not prepared to dismiss an action on that issue, and seemed to be leaning in favor of Ms. Duka on the merits of the violations and the issue of relief.

Today, he did not address Ms. Duka’s motion for a preliminary injunction; he simply denied the SEC’s motion to dismiss the action.  The courts are badly split on the jurisdictional dispute over whether an SEC enforcement respondent may bring a court action to enforce a proceeding alleged to be unconstitutional, rather than litigation the case to completion and raising the constitutionality issue before the SEC and, eventually, likely years later, before a court of appeals.  On the other hand, the courts that have addressed the issue of whether SEC administrative law judges are “inferior officers” from a constitutional standpoint — and therefore subject to the constitution’s Article II appointment (and presumably other) restrictions — seem to be less divided.  The decisions seem to favor the view that these ALJs are to be treated as “inferior officers” under binding Supreme Court precedent.  They generally appear to favor the analysis laid out in our earlier discussion of this issue here: Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit.

Judge Berman’s decision was short and direct.  He reiterated that he found no reason to alter the jurisdictional analysis in his April 15 Order, despite the later differing views of SDNY judges expressed in other cases (Tilton v. SEC and Spring Hill Capital Partners, LLC v. SEC): “This Court confirms the reasoning and conclusions set forth in its Decision & Order.  The Court perceives no new facts or legal authorities that would warrant reconsideration, including, most respectfully, two recent decisions in the Southern District of New York in Tilton v. S.E.C., No. 15-CV-2472 RA, 2015 WL 4006165 (S.D.N.Y. June 30, 2015) and Spring Hill Capital Partners, LLC, et al. v. SEC, 1 :15-cv-04542, ECF No. 24 (S.D.N.Y June 29, 2015).”  Slip op. at 2.  Instead, he endorsed the reasoning of Judge May in Hill v. SEC: “The Court finds persuasive the reasoning in Hill v. S.E.C., No. 1 :15-CV-1801-LMM, 2015 WL 4307088, at *6 (N.D. Ga. June 8, 2015) (“Congress did not intend to . . . prevent Plaintiff from raising his collateral constitutional claims in the district court.”).”

On the Appointments Clause issue he wrote:

The Court stated in its Decision & Order that “[t]he Supreme Court’s decision in Freytag v. Commissioner, 501 U.S. 868 (1991), which held that a Special Trial Judge of the Tax Court was an ‘ inferior officer’ under Article II, would appear to support the conclusion that SEC ALJs are also inferior officers.” . . .  The Court here concludes that SEC ALJs are “inferior officers” because they exercise “significant authority pursuant to the laws of the United States.”  Freytag, 501 U.S. at 881. . . .  The SEC ALJs’ positions are “established by [l]aw,” including 5 U.S.C. §§ 556, 557 and 15 U.S.C. § 78d-1(a), and “the duties, salary, and means of appointment for that office are specified by statute.” . . .  And, ALJs “take testimony, conduct trials, rule on the admissibility of evidence, and have the power to enforce compliance with discovery orders.”  Freytag, 501 U.S. at 881.  “In the course of carrying out these important functions, the [ ALJ s] exercise significant discretion.” Id.; see also Hill, 2015 WL 4307088, at *17 (“like the STJs in Freytag, SEC ALJs exercise ‘significant authority.”‘).  The Court is aware that Landry v. FDIC, 204 F.3d 1125 (D.C. Cir. 2000) is to the contrary.

The Appointments Clause in Article II provides: “[T]he Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts ofLaw, or in the Heads of Departments.”  Constitution, Art. II,§ 2, cl. 2.  It is well-settled that the Appointments Clause provides the exclusive means by which inferior officers may be appointed. . . .  For purposes of the Appointments Clause, the SEC is a “Department” of the Executive Branch, and the Commissioners function as the “Head” of that Department. . . .

There appears to be no dispute that the ALJs at issue in this case are not appointed by the SEC Commissioners. . . .

As noted above, after thoroughly reviewing facts quite similar to those presented here, United States District Judge Leigh Martin May concluded that “Freytag mandates a finding that the SEC ALJs exercise ‘ significant authority’ and are thus inferior officers” and that, because SEC ALJs are “not appropriately appointed pursuant to Article II, [their] appointment is likely unconstitutional in violation of the Appointments Clause.”

Slip op. at 4-5.

Judge Berman also addressed a question that has been studiously avoided by the SEC — whether the infirmity in the appointments of ALJs can be easily remedied: “Judge May also determined that ‘the ALJ’s appointment could be easily cured by having the SEC Commissioners issue an appointment or preside over the matter themselves.’ . . .  Plaintiffs counsel in the instant case reached the same conclusion at a conference held on June 17, 2015, stating that ‘I think that [having the Commissioners appoint the ALJ s] is one of [the easy cures] .’ . . .  And, it appears that the Commission is reviewing its options regarding potential ‘cures’ of any Appointments Clause violation(s).” . . .  The SEC has generally declined to address this issue, noting a quick fix may not be available, and preferring instead to focus on beating back the court challenges.

Judge Berman, however, gave the SEC a chance to address the issue in his court before deciding the preliminary injunction motion: “The Court reserves judgment on Plaintiffs application for a preliminary injunction and/or imposition of such an injunction for 7 days from the date hereof to allow the SEC the opportunity to notify the Court of its intention to cure any violation of the Appointments Clause.  The parties are directed not to proceed with Duka’ s SEC proceeding in the interim.”  Slip op. at 6.

The SEC is unlikely to change course in response to this invitation (which also came up previously with him in the course of oral argument).  Judge Berman’s decision. however, adds fuel to the fire.  It seems unlikely that the issue will be resolved until it gets through the appellate courts, and possibly the Supreme Court.  That’s a long time to wait and see whether judges current adjudicating SEC administrative cases are doing so lawfully.  It also creates a risk that adjudicative decisions made in the interim may have to be vacated in the future if the appointment of these ALJs is ultimately found invalid.  There could be a better, less wasteful, and less risky approach if the SEC would address the issue as a problem to be solved rather than a challenge to be rebuffed.

Straight Arrow

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Chamber of Commerce Report Details Concerns with SEC Enforcement and Proposed Reforms

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).

And later:

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.

Straight Arrow

July 16, 2015

 

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SEC Bumbles Efforts To Figure Out How Its Own Administrative Law Judges Were Appointed

The SEC’s handling of the controversy over whether its administrative law judges were properly appointed under the Appointments Clause of Article II of the Constitution continues to amuse, or horrify, depending on your point of view.  Putting aside the actual substance of the Appointments Clause issue itself, which will work its way through the courts, when it comes to the mere disclosure of the underlying facts at issue about the appointment of the SEC’s ALJs, the SEC staff has acted with questionable competence, and apparent insubordination.  That’s a strong statement, so you can decide for yourself, based on recent events in the In the Matter of Timbervest, LLC administrative proceeding.

You may recall that the Timbervest administrative enforcement action was tried to SEC ALJ Cameron Elliot, who issued an Initial Decision finding for the Division of Enforcement in all respects except that he concluded two of the individual respondents lacked the scienter required for aiding and abetting the firm’s violations, and that the five-year statute of limitations in 28 U.S.C. § 2462 precluded the associational bars sought against the individuals and the revocation of Timbervest’s adviser’s license.  Both sides petitioned for review by the Commission, which was granted.  Before the Commission itself, the respondents pressed their constitutional challenges to the administrative proceeding, and the Commission asked for further briefing on those issues.  See Briefing of ALJ Constitutionality Before SEC Leaves Resolution in Doubt.

Then the Wall Street Journal published a blockbuster article discussing potential issues of fairness in the SEC’s administrative court, including statements by former SEC ALJ Lillian McEwen that she had been pressured to issue rulings more favorable to the SEC staff.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.  On the basis of that article, the Timbervest respondents sought to pursue additional discovery to obtain evidence relevant to its constitutional challenges.  The precise request made is not clear from the record because the SEC failed to post this motion on its docket.  But it is apparent that the information sought included data about SEC ALJs Cameron Elliot and Brenda Murray (who was the original ALJ designated to hear the case before it was transferred to Mr. Elliot), as well as information about the allegations made by Ms. McEwen.  The Commission responded with an Order Requesting Additional Submissions and Additional Briefing, stating that “The Commission’s consideration of the Appointments Clause challenge would be assisted by the submission of additional material for inclusion in the record and by the submission of additional briefing.”  It then “ORDERED that the Division of Enforcement shall . . . file . . . an affidavit from an appropriate Commission staff member, with supporting exhibits if appropriate, setting forth the manner in which ALJ Cameron Elliot and Chief ALJ Brenda Murray were hired, including the method of selection and appointment.”

A week later, the Commission issued another Order Concerning Additional Submission and Protective Order, in which it “invited” ALJ Elliot to provide an affidavit addressing whether he was ever aware of ALJs being subjected to such pressures.  See SEC “Invites” ALJ Cameron Elliot To Provide Affidavit on Conversations “Similar” to Those Described by Former ALJ.

The responses to these Orders were remarkable.  In response to the second Order, Mr. Elliot declined to provide the affidavit “invited” by the Commission.  That certainly raised the possibility that the content of such an affidavit would be problematic.  See SEC ALJ Cameron Elliot Declines To Submit Affidavit “Invited” by the Commission.  But that at least was consistent with the SEC’s Order, which made it clear it was not mandating that ALJ Elliot provide the affidavit.

The Division of Enforcement’s response to the first Order was even more extraordinary.  It refused to provide the ordered “affidavit . . . setting forth the manner in which ALJ Cameron Elliot and Chief ALJ Brenda Murray were hired, including the method of selection and appointment,” instead providing an affidavit only containing “the factual information the Division believes legally relevant to resolving Respondents’ Article II-based constitutional claims,” which said only that “ALJ Elliot was not hired through a process involving the approval of the individual members of the Commission.”  In further explanation, the Division justified failing to comply with the Commission’s Order because “the Division believes that the facts set forth in the affidavit — i.e., facts relating to ALJ Elliot’s hiring — are sufficient for the Commission’s consideration of Respondents’ Appointments Clause challenge.”  The precise language of the affidavit was: “Based on my knowledge of the Commission’s ALJ hiring process, ALJ Elliot was not hired through a process involving the approval of the individual members of the Commission.”  See Division’s Notice of Filing, with Attached Affidavit of Jayne L. Seidman.

The Division described “the hiring process for Commission ALJs,” as administered by OPM, and told the Commission: “It is the Division’s understanding that the above process was employed as to ALJ Elliot, who began work at the agency in 2011.  As for earlier hires, it is likely the Commission employed a similar, if not identical, hiring process.  But the Division acknowledges that it is possible that internal processes have shifted over time with changing laws and circumstances, and thus the hiring process may have been somewhat different with respect to previously hired ALJs. For instance, Chief ALJ Murray began work at the agency in 1988 and information regarding hiring practices at that time is not readily accessible.”

This submission was a stunning act of insubordination, bordering on contempt.  It plainly declined to address the specific issues ordered by the Commission, and did so on the presumptuous basis that “the Division believes” the information ordered by the Commission was not necessary for the Commission to decide the issues raised by the respondents.  If the Division wanted relief from the Order, it should have moved for it to be revised.  It was impermissible to ignore the command based on what the Division — at this point simply a party in the proceeding — believed should have been requested.  But even beyond this, the affidavit the Division provided was misleading.  It did not even attempt to state the facts of Mr. Elliot’s hiring.  Instead, it was only “based on” “knowledge of the Commission’s ALJ hiring process,” and the Division’s Notice was founded on an unsupported “understanding” that the normal process was used.  So, even in the single respect the Division responded to the Order, it did so based on presumption, not investigation.  The combination of brazenly ignoring the Order, and then providing an affidavit not founded on facts, is conduct that should be reprimanded, if not sanctioned.  If a respondent had acted this way in response to a Commission Order, there would be more than silence from the Commission.

That isn’t the end of the story, because it turns out the assumption used to support the affidavit, and the Division’s purported “understanding” of what occurred, was unfounded, which could have been learned with only a modicum of effort.  ALJ Elliot is now presiding over another case being challenged on constitutional grounds, In the Matter of Laurie Bebo and John Buono.  In that case, at a hearing on June 18, 2015, ALJ Elliot raised the issue of the circumstances of his hiring, and the Division’s filing in Timbervest,  and noted the “the Division’s description of how I was hired was erroneous.”  He went on, “The crucial language is in the first full paragraph on page 2. . . .  I have informed the chief ALJ.  I brought it to her attention that it was wrong.  Of course she knew because she hired me, so she already knew that it was wrong.  I also informed Jayne Seidman, who is the woman who gave the affidavit.”  He went on, “I certainly don’t want the Division to be, you know, embarrassing themselves by saying things that are wrong. . . .”

The next day, the parties asked that ALJ Elliot state “what you believe the inaccuracies to be.”  He explained that the SEC’s affidavit assumed he was newly hired as an ALJ by the SEC, but that was not correct because he had been an ALJ in the Social Security Administration.  That meant that he was hired “through the process that essentially everyone else goes through,” responding to a posting on the federal government’s job-posting website.  “I saw a posting on USA Jobs when I was at Social Security.  I sent in my resume, I had an interview, I got an offer; it’s as simple as that.  What’s described in the Division’s notice of filing in Timbervest is if you’ve never been an ALJ before.  And as I said, I did in fact go through that process, just not when I was hired by the SEC.”  He went on, “I think when I was hired by the SEC, the Office of Personnel Management did have to approve my transfer from Social Security to SEC. . . .  So OPM does actually get involved in every ALJ’s hiring, to my knowledge.”  When asked with whom he interviewed, he responded: “I interviewed with Judge Murray, with Jayne Seidman, . . . and an attorney with the general counsel’s office, whose name escapes me at the moment.”  He also said “I pulled out one of my forms that I got from HR, and it appears that someone in HR did sign off on my hiring. . . .  I’m not saying that the person who signed the paper itself was my appointment. . . .  Whether that constitutes my appointment or not, I don’t know.”  When asked if he knew who appointed him, or the actual act that constituted his appointment, he responded: “I would have to say no, I don’t know.  I have an educated guess, but it’s really just an educate guess.  No, I don’t know the answer.”

This response makes it clear that records available at the SEC, could have informed the Division that the affidavit it provided was inaccurate.  Numerous people knew that ALJ Elliot was initially hired to serve at the Social Security Administration, apparently including the affiant, Ms. Seidman, but this fact was ignored.  Presumably the Division did not find it convenient actually to search the SEC’s own HR records before submitting the erroneous affidavit.  The difference here may not be material, which was ALJ Elliot’s stated view, but that is surely not within the Division’s purview to decide.  When asked for the facts, the Division (a) declined to seek them out, and (b) made an inaccurate filing instead.

The Division finally corrected the record in the Timbervest case on June 23, with the filing of an additional Notice: SEC June 23 Notice in Timbervest Administrative Proceeding.  That Notice attached the transcript of comments made by ALJ Elliot in the Bebo hearing, but otherwise said the Division still had not taken steps to confirm whether these recollections were accurate, including, apparently, not even seeking to obtain documents that could clarify the record.  Interestingly, although the Division’s original, inaccurate, Notice is posted on the docket, the mea culpa corrective Notice, with the excerpted portions of the Bebo transcript, is strangely missing, just like Timbervest’s original motion for discovery.

Of course, as ALJ Elliot noted, at a minimum the Division of Enforcement is “embarrassing themselves by saying things that are wrong.”  If this weren’t the government seeking to impose major penalties and other sanctions, we could dismiss them as “The Gang That Couldn’t Shoot Straight” (credit to Jimmy Breslin, RIP).

Jimmy Breslin - The Gang That Couldn't Shoot Straight

Jimmy Breslin – The Gang That Couldn’t Shoot Straight

But what happened here is much worse.  The Commission, sitting in its adjudicatory capacity, ordered that the Division provide certain information.  The Division refused to do so, declined to seek relief from the order, and instead substituted erroneous information, which a modest amount of diligence would have shown was certainly incomplete, if not inaccurate.  If the Division were held to the standards of performance it routinely applies to those it investigates and prosecutes, there would be meaningful repercussions, if not outright accusations of reckless misconduct.

I won’t hold my breath.

Straight Arrow

June 30, 2015

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SEC Says It Will Appeal Hill v. SEC Decision, Seek To Stay the Case, and Try To Prevent Discovery

An SEC June 15, 2015 filing in Hill v. SEC, No. 15-cv-1801 (N.D. Ga.), informed Judge Leigh Martin May that the Commission will appeal her June 8 ruling that the administrative proceeding In the Matter of Charles L. Hill, Jr. violates the constitution because the appointment of the presiding administrative law judge, James Grimes, was unconstitutional.  See Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding.  The SEC also said it would seek a stay of the entire proceeding before Judge May, including any discovery the plaintiff intends to pursue as the Hill action moves beyond the preliminary injunction stage.  The SEC’s submission can be read here: SEC June 15 Filing in Hill v. SECThe submission on behalf of plaintiff Charles Hill can be read here: Hill June 15 Filing in Hill v. SEC.

These submissions were made in response to the portion of the June 8 ruling stating that the parties should “confer on a timetable for conducting discovery and briefing the remaining issues.”

Although Judge May’s preliminary injunction was narrowly drawn to halt only the single administrative action against Mr. Hill — and ALJ Grimes has since been appointed to preside over a new proceeding — the SEC still argues that the requirements for staying the Hill Order and litigation are satisfied.  The SEC wrote: “Defendant intends to appeal the preliminary injunction issued by this Court.  Defendant also intends to move to stay all proceedings in this Court pending appeal because the Eleventh Circuit’s ruling will have a significant impact on this case, and any further proceedings in this Court could prove largely superfluous and a waste of the parties’ and the Court’s resources.”  SEC Submission at 1-2.  Typically, however, the mere possibility of some wasted resources in the event of a reversal on appeal is insufficient to support a stay of proceedings.  Such a motion normally requires a showing that in the absence of a stay the status quo could be sufficiently altered that the moving party could suffer irreparable harm.  Because Judge May’s order does not go beyond the one proceeding, and the only harm to the SEC of the litigation going forward during the appeal would relate to discovery in the case itself, obtaining a stay should be an uphill battle.

Perhaps recognizing this, the SEC’s backup plan apparently is to slow play the Hill litigation.  It argued that if a stay is not issued, there is no urgency to resolve the matter.  Instead, the normal schedule for a civil action in the Northern District of Georgia should prevail: “There is no good cause for Plaintiff’s request that the parties begin discovery immediately.  First, this Court has already issued a preliminary injunction, and thus, there is no urgency for Plaintiff to proceed faster than the normal pace set by the Federal Rules and the Local Rules [under which] the government is entitled to have until July 20, 2015, to file its answer or other response to Plaintiff’s Amended Complaint.  There is no reason that the government should be deprived of the usual time that the Federal Rules provide for responding to the Amended Complaint nor that issues regarding whether discovery is warranted need to be resolved before the government has had that opportunity.  Moreover, under Local Rule 26.2(A), the discovery period does not commence until ‘thirty (30) days after the appearance of the first defendant by answer.'”  Id. at 2.

The SEC also said that plaintiff had not indicated the nature of discovery he intended to pursue, and argued that “no discovery is necessary because all of Plaintiff’s claims involve pure issues of law,” the “case can be resolved on dispositive motions without any factual development,” and “to the extent any facts are necessary, Plaintiff already has them in his possession.”  Id. at 2-3.  Accordingly, the SEC asks “that the Court should decide the case without permitting discovery.”  Id. at 3.

Plaintiff Charles Hill presented a different proposal.  After noting that counsel for the parties conferred “on multiple occasions” without reaching agreement on a proposed schedule, he proposed, without argument, simply that discovery begin “immediately,” end “90 days after Defendant files an answer, or, if Defendant files a Motion to Dismiss, 90 days after the Court denies the Motion to Dismiss,” and the deadline for motions for summary judgment be “30 days after the close of discovery.”  He presented no argument why the schedule should depart from local rules.

The best result probably lies somewhere between the two proposals.  The SEC’s notion that this should be treated as just another ordinary case seems a little tone-deaf, and strangely out of sync with the expectation that whatever the result, the Commission should want to avoid extending the period during which there is a cloud over its administrative proceedings.  It certainly seems in the public interest to expedite a case of this nature, and try to move quickly to a final result, while allowing the parties ample time to address complex issues.  On the other hand, it is the rare case that moves “immediately” to discovery when there is no pending deadline that causes the parties and the court to need to reach a quick result.  And the SEC has a point that the nature of discovery needed is unclear with respect to the appointments clause issue because the facts of ALJ Grimes’s appointment appear not to be in dispute.  (Although there could be a need for discovery or development of expert testimony on the equitable factors bearing on whether an injunction should issue, and, if so, what its scope should be.)  The same may not be true for the other Article II issue raised in the complaint — the alleged invalidity of the double layer of “for cause” protection for SEC ALJs against removal by the President — as to which Judge May’s opinion did not address the merits.  It is also not clear whether plaintiff will try to seek discovery on the two other theories in the complaint — the alleged improper delegation of legislative authority to SEC ALJs, and the denial of a 7th Amendment jury right — which Judge May found were not likely to succeed on the merits.

In any event, whether any discovery is appropriate, and if so what it would encompass, is not really a scheduling issue.  If the plaintiff wants to pursue discovery and the SEC objects, that dispute can be raised with the court.

The inability of the parties to reach a reasonable compromise on scheduling leaves it up to Judge May to decide what she believes is reasonable under these circumstances.  That probably should be something that allows the case to move forward expeditiously, but not quite at the breakneck pace Mr. Hill is suggesting.

In the meantime, as reported in Law 360 (SEC To Appeal District Judge’s Admin Court Injunction) the SEC informed Judge Richard Berman in a letter to the court in Duka v. SEC “that the agency has no plans to change the way it appoints its judges while it waits for the solicitor general to approve the appeal to the Eleventh Circuit it was not considering an effort to cure the appointments clause violation found by Judge May.”  The letter supports this position because “the SEC has over 100 litigated proceedings at various stages of the administrative process and the ALJ scheme has been in use for seven decades and is grounded in a highly-regulated competitive service system that Congress created for the selection, hiring and appointment of ALJs in the executive branch.”  That suggests that it may not be as straightforward as Judge May speculated that the appointments clause violation might be easily cured.

Straight Arrow

June 16, 2015

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Timbervest Files Complaint and TRO Motion To Halt SEC Proceeding

Today (June 12, 2015), Timbervest, LLC filed a complaint in federal court in the Northern District of Georgia seeking a halt to its ongoing SEC administrative proceeding, In the Matter of Timbervest, LLC at al.  We have previously discussed the Timbervest SEC proceeding, including recent developments involving Timbervest’s challenge to the constitutionality of the SEC administrative process and requests for discovery into possible systemic bias within the administrative court.  See Briefing of ALJ Constitutionality Before SEC Leaves Resolution in Doubt, SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case, SEC “Invites” ALJ Cameron Elliot To Provide Affidavit on Conversations “Similar” to Those Described by Former ALJ, and SEC ALJ Cameron Elliot Declines To Submit Affidavit “Invited” by the Commission.

With its efforts to pursue the constitutional challenge before the SEC meeting obstacles before the Commission, Timbervest opted to seek federal court intervention, commencing an action for injunctive relief, and moving for a temporary restraining order.  Those documents can be found here: Complaint in Timbervest v. SECMemorandum in Support of Motion for TRO in Timbervest v. SEC.

Because Timbervest is located in Atlanta, it filed its complaint in the federal district court for the Northern District of Georgia.  That is the same court that days ago halted a different SEC administrative proceeding, In the Matter of Charles L. Hill, Jr., in the action Hill v. SEC.  In that case, Judge Leigh Martin May found the appointment of ALJ James Grimes violated the appointments clause of Article II of the Constitution.  See Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding. And another case filed in that same court by yet another SEC respondent, Gray Financial Group v. SEC, was just assigned to Judge May as a related case.  See Ga. Judge Who Blocked SEC Admin Suit Gets Similar Case.  The new Timbervest complaint, which is case number 1:15-cv-02106-LMM, was also assigned to Judge May.

Judge May. an Obama appointee who is only in her first year of service as a judge, was active in the Democratic party before her appointment.  An article discussing her background can be read here: The Atlanta Judge Who Stuck A Thorn In The SEC’s Side.

In the Timbervest SEC proceeding, ALJ Cameron Elliot issued an Initial Decision as to which both the respondents and the SEC staff petitioned for Commission review, which was granted.  After briefing of the issues before the Commission, and supplemental briefing addressing constitutional issues, Timbervest sought discovery after the Wall Street Journal revealed possible pressures on SEC administrative judges to favor the SEC staff.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.  Only days ago, the Commission held oral argument on the petitions for review.  But after Judge May”s decision in the Hill case, and ALJ Elliot’s refusal to provide information about possible pressures requested by the Commissioners, Timbervest felt it had to seek relief in federal court, saying: “Plaintiffs have appealed the ALJ’s Initial Decision to the Commission, but it has become clear that the Commission should not hear these arguments.  First, the Commission itself did not properly appoint the ALJ.  Second, the Commission has argued in other cases that its administrative forum is constitutional.  Thus, Plaintiffs’ appeal to the Commission is nothing more than an exercise in futility.”  Complaint ¶ 8.

The Timbervest complaint reveals an interesting issue about the handling of its case by the SEC’s ALJs.  The case was originally assigned to Chief Administrative Law Judge Brenda Murray, but then handed over to ALJ Elliot.  (ALJ Murray is the person identified by former ALJ Lillian McEwen as having told Ms. McEwen that she “questioned her loyalty to the SEC” because she did not treat the SEC staff sufficiently favorably.)  ALJs Murray and Elliot allegedly made a critical decision preventing Timbervest from using Brady material (material tending to show the respondents were innocent):

Given the age of the case, the primary evidence presented in support of the Division’s alleged violations was the faded and inconsistent memories of two Division witnesses.  As to one of those witnesses, Plaintiffs argued that the SEC had in its possession Brady material that the Commission’s staff disagreed with and argued was inadvertently produced.  The Brady material consisted of notes of two interviews the Commission’s staff conducted with that witness.  The Plaintiffs argued that the notes were exculpatory and, at the very least, were inconsistent statements that were required to be produced.  Pursuant to the SEC’s own administrative proceeding rules, it is required to produce Brady material.  Even though the SEC conducted an investigation that lasted over three years,speaking to numerous individuals over that time, the Commission’s staff did not produce any documents or information that it identified as Brady to the Plaintiffs.  Ultimately, ALJ Elliot, as well as ALJ Murray, ruled in favor of the Commission’s staff that the notes were not Brady, even though the notes were clearly inconsistent and exculpatory.

Complaint ¶ 28.

The Timbervest complaint also revealed that the SEC staff acknowledged that “ALJ Elliot was not hired through a process involving the approval of the individual members of the Commission.”  The staff could not state how ALJ Murray was appointed because “Chief ALJ Murray began work at the agency in 1988 and information regarding hiring practices at that time is not readily available.”  Complaint ¶ 36.  At a minimum, then, if Judge May retains her view that the SEC’s administrative law judges are “inferior officers” of the Executive Branch, a finding that ALJ Elliot was improperly appointed may come soon.  The only thing that might prevent such a ruling is if Judge May concludes that because the Timbervest SEC proceeding has already gone through trial and is before the SEC on review of the Initial Decision — a different set of circumstances than she faced in the Hill case — a federal court should not take jurisdiction over the case.

The SEC’s pot is now boiling over in, of all places, Atlanta, Georgia.

Straight Arrow

June 12, 2105

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Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding

In a breakthrough development, Northern District of Georgia federal district judge Leigh Martin May found that Charles Hill, a respondent in a pending SEC administrative proceeding, had a “substantial likelihood of success” of showing that the proceeding against him is unconstitutional because the appointment of the administrative law judge presiding over his case violated the appointments clause of Article II of the Constitution.  That is one of several arguments that have been made against the legality of the SEC’s administrative enforcement proceedings, and this is the first court to treat any of those arguments seriously.

Judge May’s decision is here: Order in Hill v. SEC.

 

Judge Leigh May. Photo by John Disney/Daily Report.

Judge Leigh May. Photo by John Disney/Daily Report.

The opinion, while tempered, is an eye-opener for the SEC, which has so far convinced other courts (and no doubt themselves) either not to consider these arguments or give them short shrift.  The Commission now has no choice but to reconsider whether its recent determination to shift important enforcement cases from federal courts to its administrative courts still makes sense.  One can assume there will be every effort to appeal this decision and get this decision overturned on an expedited basis, but that could take months, even in an accelerated proceeding, and the Eleventh Circuit might end up agreeing with Judge May.  The availability of a stay pending appeal may be in doubt because the order only halts the one proceeding against Mr. Hill, making the need for a stay questionable.  Alternatively, the Commission could expedite its own consideration of this issue in the pending Timbervest administrative proceeding (see SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case), rule in its own favor, and possibly get the issue to an appellate court with an added argument that the SEC’s decision is entitled to some deference.  Since Timbervest is located in Atlanta, that may also end up before the Eleventh Circuit.  In the meantime, there is a cloud over the entire SEC administrative enforcement process, although, as noted, Judge May’s order itself only halts the impending adminsitrative trial of Mr. Hill.

Judge May’s opinion was careful and thorough.  In the end, it came down to a single issue: whether the SEC’s administrative law judges are “executive officers” subject to the appointments clause and other Article II limits on diminishing executive power.  Some time ago, we wrote that this was a serious issue on which Supreme Court precedent seemed likely create problems for the SEC.  See Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit.  Until now, however, no court has been willing to give the argument thorough consideration.  See In Duka v. SEC, SDNY Judge Berman Finds SEC Administrative Law Enforcement Proceedings Constitutional in a Less than Compelling Opinion.

The opinion begins with a discussion of many of the respects in which “SEC administrative proceedings vary greatly from federal court actions.”  Slip op. at 4.  These include: the rules of evidence do not apply; respondents “are generally barred from taking depositions”; “SEC administrative proceedings also occur much more quickly than federal court actions”; “[c]ounterclaims are not permissible”; there is no equivalent of Rule 12(b) motions “to test the allegations sufficiency”; and “there is no right to a jury trial.” Id. at 4-5.

It then discusses the respective powers of the ALJ and the SEC: the presiding ALJ is selected by the chief ALJ, presides over the matter and issues an initial decision; the SEC may order interlocutory review of any ALJ decision during the proceeding; the initial decision can be appealed by either party or reviewed by the SEC on its own initiative; a decision is not final until the SEC issues it, but if there is no appeal and the SEC does not review an ALJ decision “it is deemed the action of the Commission,” and the SEC issues an order making that decision final; SEC review is de novo and new evidence can be heard, but “the SEC will accept the ALJ’s ‘credibility finding, absent overwhelming evidence to the contrary.’”  An SEC decision can be appealed to a federal court of appeals (either the D.C. Circuit or the Circuit where the respondent resides).  On appeal, the “SEC’s findings of facts are ‘conclusive’ ‘if supported by substantial evidence.’” Id. at 5-7.

The court then describes that SEC ALJs “are ‘not appointed by the President, the Courts, or the [SEC] Commissioners.  Instead, they are hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions, and the Office of Personnel Management.’”  Id. at 7.  Congress authorized the SEC to delegate any of its functions to an ALJ, and the SEC promulgated regulations making ALJs responsible for the “fair and orderly conduct” of proceedings and giving them the authority to: “(1) Administer oaths and affirmations; (2) Issue subpoenas; (3) Rule on offers of proof; (4) Examine witnesses; (5) Regulate the course of a hearing; (6) Hold pre-hearing conferences; (7) Rule upon motions; and (8) Unless waived by the parties, prepare an initial decision containing the conclusions as to the factual and legal issues presented, and issue an appropriate order.”  Id. at 8.

The court then moved to the specifics of Mr. Hill’s prosecution, noting that he moved for summary disposition on constitutionality grounds but that ALJ James Grimes ruled that he lacked the authority to address two of the three grounds asserted: that “Congess’s delegation of authority to the SEC to pursue cases before ALJs violates the delegation doctrine in Article I of the Constitution,” and that “Congress violated his Seventh Amendment right to jury trial by allowing the SEC to pursue charges in an administrative proceeding.”  Id. at 10.  See SEC ALJ Says He Lacks Authority To Decide Key Constitutional Challenges.  Mr. Hill sought relief from the federal court to prevent the proceeding on these constitutionality grounds, and later amended his complaint to assert that the proceeding was also unconstitutional because “the SEC ALJ’s appointment violated the Appointments Clause of Article II as the ALJ is allegedly an inferior officer and he was not appointed by the President, the courts of law, or a department head.”  Slip op. at 10-11.

Turning to the legal determinations, Judge May first rejected the SEC’s contention that the court lacked jurisdiction to hear the case.  The SEC made this argument successfully in cases previously brought by other respondents, including Wing Chau and Laurie Bebo.  See SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding; Court Dismisses “Compelling and Meritorious” Bebo Constitutional Claims Solely on Jurisdictional Grounds.  The SEC argued “that its election to pursue claims against Plaintiff in an administrative proceeding, ‘channels review of Plaintiff’s claims through the Commission’s administrative process, with review in the courts of appeals,’” that is, “judicial review can only come from the courts of appeal following the administrative proceeding and the SEC’s issuance of a final order in Plaintiff’s case.”  Slip op. at 11-12.  The court found this “in tension with 28 U.S.C. § 1331, which provides that federal district courts ‘have original jurisdiction of all civil actions arising under the Constitution, laws, or treaties of the United States,’ and 28 U.S.C. § 2201, which authorizes declaratory judgments.”  Id. at 12.  The court rejected the SEC’s argument that “Congress declared its intent for the administrative proceeding to be the exclusive forum for judicial review for these cases by allowing the SEC to make the administrative proceeding its forum choice,” finding instead that “Congress’s purposeful language allowing both district court and administrative proceedings shows a different intent.  Instead, the clear language of the statute provides a choice of forum, and there is no language indicating that the administrative proceeding was to be an exclusive forum.”  Id. at 13.

Moving beyond this point to the issue addressed previously by two other courts in the SEC’s favor – whether Supreme Court precedent on the issue supports a finding that Congress did withdraw jurisdiction – Judge May found otherwise because:

(1) “If Plaintiff is required to raise his constitutional law claims following the administrative proceeding, he will be forced to endure what he contends is an unconstitutional process.”  Slip op. at 15.  Critically, Mr. Hill “does not challenge the SEC’s conduct in that proceeding or the allegations against him—he challenges the proceeding itself” (id. at 17).  “Waiting until the harm Plaintiff alleges cannot be remedied is not meaningful judicial review.”  Id. at 18.

(2) The constitutional challenge is “wholly collateral” to the merits of the proceeding itself.  “Plaintiff is not challenging an agency decision; Plaintiff is challenging whether the SEC’s ability to make that decision was constitutional.  What occurs at the administrative proceeding and the SEC’s conduct there is irrelevant to this proceeding which seeks to invalidate the entire statutory scheme.”  Id. at 20.

(3) The constitutional issues are outside the SEC’s expertise.  “Plaintiff’s constitutional claims are governed by Supreme Court jurisprudence, and ‘the statutory questions involved do not require technical considerations of agency policy.’”  Id. at 21.

This aspect of the opinion is consistent with Judge Richard Berman’s decision in Duka v. SEC (SDNY).  Judge Berman, however, went on to reject Ms. Duka’s constitutional argument, finding the she was “unlikely to succeed on the merits” of that claim.

Having likewise found her court had jurisdiction over Mr. Hill’s claim, however, Judge May went in a different direction on the merits of the preliminary injunction sought by Mr. Hill.  The critical issue was whether Mr. Hill had “a substantial likelihood to succeed on the merits” on his constitutional claims.

Judge May found no such likelihood of success for the argument that the power given to the SEC in the Dodd-Frank Act to bring these cases in its administrative court was an unconstitutional delegation of legislative power.  Instead, she found this authority was a form of prosecutorial discretion that is an executive power, not a delegated legislative power.  “When the SEC makes its forum selection decision, it is acting under executive authority and exercising prosecutorial discretion. . . .  Because Congress has properly delegated power to the executive branch to make the forum choice for the underlying SEC enforcement action, the Court finds that the Plaintiff cannot prove a substantial likelihood of success on the merits on his non-delegation claim.”  Slip op. at 23-29.

On the Seventh Amendment jury trial issue, the court likewise found no substantial likelihood of success.  Judge May found Supreme Court precedent on this controlling because SEC prosecutions involve “public rights,” since the SEC “is acting as a sovereign in the performance of its executive duties when it pursues an enforcement action.”  The controlling Supreme Court case, Atlas Roofing Co. v. Occupational Safety & Health Review Comm’n, 430 U.S. 442 (1977), rejected the jury trial argument in administrative enforcement actions brought by OSHA.

One might question whether this addresses the true jury trial issue in SEC cases.  Unlike the OSHA case, the SEC traditionally prosecuted alleged violations of the securities laws by unregulated persons in federal court actions, in which there is a jury trial right as to non-equitable claims.  Only after Dodd-Frank was enacted was the SEC permitted to commence the same actions in its administrative courts.  That means the SEC was given the power to deny a defendant what for many years has been a jury trial right, and, because there are no standards governing how to go about doing this, currently does so without any enforceable or predictable guidelines for the decision.  That raises a combination of jury trial, equal protection, and arbitrary and capriciousness arguments that the Atlas Roofing case does not begin to address.  I expect a more definitive consideration of the jury trial issue is yet to come.   

Judge May did ultimately find a substantial likelihood of success on one of Mr. Hill’s constitutional arguments, which raises the question of whether it was prudent to decide these first two constitutional issues when they did not, in the end, have a bearing on her decision.  Normally, a court strives to avoid constitutional issues if possible.

But the blockbuster part of the opinion is certainly the discussion of the alleged Article II violations.  Judge May did find a substantial likelihood of success on at least one of Mr. Hill’s alleged violations of Article II – whether the appointment of ALJ Grimes violated the appointments clause in Article II, section 2, clause 2.  (Having reached that conclusion, she found it unnecessary to decide the other Article II issue – whether the double layer of tenure protection for SEC ALJs unacceptably encroached on the President’s executive power.  Why was that given different treatment than the delegation and jury trial issues?)

The threshold question for each of these arguments was whether SEC ALJs are “executive officers” within the meaning of Article II.  We previously discussed this issue at length (in the aforementioned Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit), and expressed the view that Supreme Court precedent in Freytag v. Commissioner, 501 U.S. 868 (1991), strongly suggested that the SEC ALJs were, indeed, “inferior officers” within the meaning of Article II.  Judge May agreed that Freytag was effectively controlling, as follows:

The issue of whether the SEC ALJ is an inferior officer or employee for purposes of the Appointments Clause depends on the authority he has in conducting administrative proceedings. . . .  The Appointments Clause . . . creates two classes of officers: principal officers, who are selected by the President with the advice and consent of the Senate, and inferior officers, whom “Congress may allow to be appointed by the President alone, by the heads of departments, or by the Judiciary.” . . .  The Appointments Clause applies to all agency officers including those whose functions are “predominately quasi judicial and quasi legislative” and regardless of whether the agency officers are “independent of the Executive in their day-to-day operations.” . . .

“[A]ny appointee exercising significant authority pursuant to the laws of the United States is an ‘Officer of the United States,’ and must, therefore, be appointed in the manner prescribed by § 2, cl. 2, of [Article II].” . . .  By way of example, the Supreme “Court has held that district-court clerks, thousands of clerks within the Treasury and Interior Departments, an assistant surgeon, a cadet-engineer, election monitors, federal marshals, military judges, Article I [Tax Court special trial] judges, and the general counsel for the Transportation Department are inferior officers.” . . .

Plaintiff claims that SEC ALJs are inferior officers because they exercise “significant authority pursuant to the laws of the Unites States” while the SEC contends ALJs are “mere employees” based upon Congress’s treatment of them and the fact that they cannot issue final orders and do not have contempt power. . . .  The Court finds that based upon the Supreme Court’s holding in Freytag, SEC ALJs are inferior officers.

 In Freytag, the Supreme Court was asked to decide whether special trial judges (“STJ”) in the Tax Court were inferior officers under Article II. . . .  The Government argued, much as the SEC does here, that STJs do “no more than assist the Tax Court judge in taking the evidence and preparing the proposed findings and opinion,” id., and they “lack authority to enter a final decision.” . . .  The Supreme Court rejected that argument. . . .

The Court finds that like the STJs in Freytag, SEC ALJs exercise “significant authority.” The office of an SEC ALJ is established by law, and the “duties, salary, and means of appointment for that office are specified by statute.” . . .  ALJs are permanent employees—unlike special masters—and they take testimony, conduct trial, rule on the admissibility of evidence, and can issue sanctions, up to and including excluding people (including attorneys) from hearings and entering default. . . .

Slip op. at 35-38 (citations omitted).

Judge May went on to consider the divided decision of a D.C. Circuit panel in Landry v. Federal Deposit Insurance Corp., 204 F.3d 1125 (D.C. Cir. 2000), that ALJs at the FDIC were not executive officers.  She was convinced that the concurring minority opinion in that case was more true to Freytag than the majority of the panel, and, like the concurring judge in Landry, concluded “that the Supreme Court in Freytag found that the STJs powers—which are nearly identical to the SEC ALJs here—were independently sufficient to find that STJs were inferior officers.”  Slip op. at 40.

Judge May also rejected the SEC’s argument that the court “should defer to Congress’s apparent determination that ALJs are inferior officers” because “Congress is presumed to know about the Appointments Clause, and it decided to have ALJs appointed through OPM and subject to the civil service system,” and therefore “intended for ALJs to be employees.”  Id. at 41.  Because the appointments clause “prevents Congress from dispensing power too freely,” Judge May found that argument unacceptable: “Congress may not ‘decide’ an ALJ is an employee, but then give him the powers of an inferior officer; that would defeat the separation-of-powers protections the Clause was enacted to protect.”  Accordingly, the court found “that SEC ALJs are inferior officers.”  Id.  Moreover, because the SEC “concedes that Plaintiff’s ALJ, James E. Grimes, was not appointed by an SEC Commissioner,” he “was not appointed by the President, a department head, or the Judiciary” as the appointments clause requires.”  As a result, “[b]ecause he was not appropriately appointed pursuant to Article II, his appointment is likely unconstitutional in violation of the Appointments Clause.”  Id. at 42.

We might add that by all appearances ALJ Grimes’s treatment of the constitutional challenges to the proceeding before him has been handled responsibly, even to the point of granting a subpoena on the SEC sought by Mr. Hill relating to a due process challenge on the basis of possible systemic bias in the administrative court.  See SEC ALJ James Grimes Issues Important Discovery Order Against SEC.

Judge May went on to find the other requirements for a preliminary injunction satisfied (id. at 42-43), and ruled that “a preliminary injunction is appropriate to enjoin the SEC administrative proceeding and to allow the Court sufficient time to consider this matter on the merits.”  Id. at 44.

The judge’s final words addressed whether all of this was important enough to support potentially debilitating relief (and least in the short term):

The Court notes that this conclusion may seem unduly technical, as the ALJ’s appointment could easily be cured by having the SEC Commissioners issue an appointment or preside over the matter themselves.  However, the Supreme Court has stressed that the Appointments Clause guards Congressional encroachment on the Executive and “preserves the Constitution’s structural integrity by preventing the diffusion of appointment power.” Freytag, 501 U.S. at 878.  This issue is “neither frivolous or disingenuous.” Id. at 879. The Article II Appointments Clause is contained in the text of the Constitution and is an important part of the Constitution’s separation of powers framework.

In addition, the Appointments Clause may not be waived, not even by the Executive.  Id. at 880 (“Neither Congress nor the Executive can agree to waive this structural protection.”).  As this likely Appointment Clause violation “goes to the validity of the [administrative] proceeding that is the basis for this litigation,” id. at 879, it is hereby ORDERED that Defendant, the Securities and Exchange Commission, is preliminarily enjoined from conducting the administrative proceeding brought against Plaintiff . . . including the hearing scheduled for June 15, 2015, before an Administrative Law Judge who has not been appointed by the head of the Department.

Slip op. at 44.

The SEC is likely unprepared for this occurrence.  But, as we previously wrote, the case law strongly supported the view that SEC ALJs are, indeed, inferior executive officers, and serious constitutional issues flow from that, including the appointments clause issue now decided against the SEC.

As the court notes, there may be some tweaks that could clear up this issue, although they may well require action by Congress amending the statutory provisions governing the appointment of administrative law judges (an issue I’ve not looked at).  But even if a “cure” is possible with such tweaks, they would not address the more fundamental question of whether the SEC is doing the right thing by bringing serious prosecutorial actions like these against persons not subject to SEC regulatory oversight in the administrative court.  The lengthy list given by Judge May of the respects in which respondents are impeded from presenting a defense in the administrative forum, as compared to federal courts, should give a fair-minded Commission pause about whether its recent policy of increased administrative enforcement actions needs to be reconsidered.  See Former SEC Enforcement Leaders Urge SEC To Reform Administrative Enforcement Process.  The bottom line is that when unregulated persons are prosecuted for alleged violations and face debilitating demands for penalties and purported “disgorgement,” plus the usual SEC effort to bar these people from future employment as officers or directors of public companies, perhaps the “right” thing to do is allow them to defend themselves in a forum that provides a more level playing field.  Is it really that hard to “do the right thing”?

Straight Arrow

June 9, 2015

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SEC ALJ James Grimes Issues Important Discovery Order Against SEC

In In the Matter of Charles L. Hill, Jr., File No. 3-16383, SEC Administrative Law Judge James E. Grimes issued a subpoena requested by Mr. Hill requiring that the SEC produce materials relevant to Mr. Hill’s objections to using the SEC administrative law forum to pursue the enforcement action against him.  The Division of Enforcement and SEC Office of General Counsel (OGC) objected to the motion seeking the subpoena on what were plainly frivolous grounds.  ALJ Grimes properly rejected those objections and compelled the SEC to provide potentially important materials bearing on the fairness or constitutionality of the SEC’s administrative enforcement process.  See the order here: In re Hill Order Partially Granting Subpoena Request.

Recall that ALJ Grimes previously concluded that he lacked jurisdiction to consider some aspects of Mr. Hill’s constitutional challenge to the proceeding (see SEC ALJ Says He Lacks Authority To Decide Key Constitutional Challenges).  Following the issuance of that order, Mr. Hill commenced an action in federal court in the Northern District of Georgia to seek consideration of the constitutional issues the ALJ said he could not consider.  See Complaint in Hill v. SEC (N.D. Ga.).

The subpoena requested by Mr. Hill and opposed by the SEC covered a number of areas, but only two were addressed in yesterday’s order: (1) seeking documents identifying all SEC enforcement actions brought administratively against persons not subject to SEC regulatory oversight solely for alleged violations of section 14(e) of the Securities Exchange Act of 1934; and (2) seeking documents “that support, or reflect or are related to the allegations made by Lillian McEwen, a former SEC administrative law judge, as reported by the Wall Street Journal on May 6, 2015, that chief administrative law judge Brenda Murray ‘questioned [her] loyalty to the SEC’ as a result of finding too often in favor of defendants and that SEC administrative law judges are expected to work on the assumption that ‘the burden was on the people who were accused to show that they didn’t do what the agency said they did.'”  This second request relates to last week’s blockbuster Wall Street Journal article about the SEC’s possible unfair use of its administrative process to prosecute enforcement actions.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.

The objections raised to those aspects of the subpoena request were patently insufficient.  On the first request, the OGC argued the documents sought were “covered by attorney-client privilege and the work-product doctrine.”  Since the request on its face asked only for documents reflecting or reporting on public information (the actual filing of a proceeding), this objection was nonsensical (sanctionable, if the SEC can be sanctioned by its own ALJ).  ALJ Grimes appropriately gave the objection short shrift: “The identity of administrative proceedings is a matter of public record.  As such, documents that identify administrative cases . . . are not protected by the privileges asserted.”

On the second request, the OGC argued “‘[i]t is difficult to perceive how’ the requested documents could be relevant.”  Perhaps so if you are still in elementary school; but if you are a practicing lawyer, the relevance is obvious, since the information requested goes directly to a potential systemic bias imbued in SEC ALJs that would flout due process.  In response to the SEC’s perception problems, ALJ Grimes said no more than “I disagree,” and ordered production of any responsive materials.

The SEC OGC and Enforcement Division do themselves and the Commission no favors by making knee-jerk oppositions to discovery requests by respondents in administrative proceedings.  The very fact that the subpoenas must be approved by the ALJ before being served is a significant disadvantage for respondents as compared to federal court defendants (who can issue subpoenas to third parties, or make document requests of parties, without court approval).  It makes it worse that the SEC will routinely object to any attempt of a respondent to gather evidence through issuance of a subpoena.  It is obviously beyond the pale to do so on purely frivolous grounds.

Kudos to ALJ Grimes for his quick rejection of the SEC staff’s obstructive efforts.  The materials sought could have an important bearing on consideration of constitutional issues raised by Mr. Hill.  And, after the statements made by a former SEC ALJ, development of the record of possible misconduct relating to attempts to influence SEC ALJs to favor the SEC staff in administrative proceedings is essential.  Frankly, it is sad (but, unfortunately, not surprising) that in light of the charge made, the Commission itself has not already commenced an inquiry to assure that its own administrative proceedings have not been tainted by such bias.

Straight Arrow

May 22, 2015

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SEC ALJ Says He Lacks Authority To Decide Key Constitutional Challenges

On May 14, 2014, in In the Matter of Charles L. Hill, Jr., File No. 3-16383, SEC administrative law judge James Grimes ruled that he had no authority to decide that a portion of the Dodd-Frank Act allowing the SEC to commence civil actions against unregulated persons in its administrative law court was unconstitutional.  That could have a bearing on the issue of the standing of SEC administrative targets to bring federal court challenges to those proceedings.  ALJ Grimes did decide that he could address the constitutionality of the double layer of tenure protection provided to SEC ALJs against Presidential removal power, and, not surprisingly, ruled that he held his position constitutionally.  But he declined to offer any view on Mr. Hill’s arguments that the Dodd-Frank Act improperly delegated authority to the SEC, and that he had been denied a Seventh Amendment right to a jury trial.  The Order is available here: Order Denying Respondent’s Motion for Summary Disposition on Constitutional Issues.

On the issue of his authority to rule, he wrote:

After receiving Mr. Hill’s motion, I directed the parties to address “whether I have the authority to rule on Mr. Hill’s constitutional challenges.” . . .  The Division responded that I have authority to rule on Mr. Hill’s challenges. . . .  Mr. Hill disagrees. . . .

Subsequent to instructing the parties to address my authority to rule on Mr. Hill’s constitutional challenges, it came to my attention that the Commission has repeatedly held that it lacks the authority “to invalidate the very statutes that Congress has directed [it] to enforce.” . . .  It has recently reaffirmed this interpretation of its authority. . . .  The Commission thus operates on the assumption that its “governing statutes are constitutional” “[u]nless and until the courts declare otherwise.”

It follows from the foregoing that I lack the authority to rule on the constitutionality of particular provisions of the Exchange Act.

ALJ Grimes nevertheless concluded that he could address the issue of constitutionality of the double-layer of tenure protection afforded to SEC ALJs because that involved protections under 5 U.S.C. § 7521, which is not part of the Exchange Act.  He did so even though: “It would be incongruous . . . if I were unable to address the constitutionality of a provision of the Exchange Act, an Act I am regularly required to construe, but able to address the constitutionality of Section 7521, a provision I do not normally encounter.”

Turning to the double-layer of tenure protection, he “assumed” that ALJs are “inferior officers” of the Executive Branch, noting that “[b]oth parties have presented strong arguments in support of their positions.”  Nevertheless, he found that the double-layer of protection given to SEC ALJs against removal by the President does not make them unconstitutional because SEC ALJs “exercise only adjudicatory functions” that are “limited to a specific subject matter.”  In doing so, he relied almost exclusively on the Supreme Court’s decision in Morrison v. Olson, 487 U.S. 654 (1988), which addressed the constitutionality of the independent special prosecutor statute, and said “the real question is whether the removal restrictions are of such a nature that they impede the President’s ability to perform his constitutional duty, and the functions of the officials in question must be analyzed in that light.”  Id. at 691.  Because “the Commission’s administrative law judges exercise only adjudicatory functions,” and “their jurisdiction is limited to a specific subject matter and they ‘lack[] policymaking or significant administrative authority'” (quoting Morrison), “the dual-tenure protection afforded administrative law judges does not unconstitutionally impair the President’s ability to remove executive branch officials because those particular officials do not perform functions ‘central to the functioning of the Executive Branch'” (again quoting Morrison).

ALJ Grimes concludes: “Furthermore, taken to its logical end, Mr. Hill’s argument would mean that almost no independent agency could use administrative law judges.  If “‘a page of history is worth a volume of logic,’” however, it is unlikely this could be the case.”  Although he says that SEC ALJs are “not among ‘those who execute the laws,’” he does not address at all the critical role of SEC ALJs as part of what is probably the second most significant law enforcement agency in the federal government — the SEC — and the many respects in which SEC ALJs exercise significant discretion in the operation of that law enforcement process.

But ALJ Grimes chose not to offer any view on the other two constitutional challenges raised by Mr. Hill: (1) that “by giving the Commission the discretion to choose whether to seek civil penalties against unregulated individuals either administratively or in district court, Congress impermissibly delegated legislative power to the Commission”; and (2) that “by giving the Commission authority to bring an administrative action against an unregulated individual, Congress infringed on his Seventh Amendment right to a jury.”

On these issues, ALJ Grimes concluded that the limits on his authority to address constitutional issues preclude him from addressing those arguments.  Interestingly, in reaching this conclusion, he also implicitly holds that the SEC itself has no power to reach those issues, because the grounds for limiting his authority apply equally to the Commission.  That gives significant ammunition to those trying to get judicial review of these constitutional issues, because the standing to do so depends in part on whether the SEC has the power to address them as part of the normal administrative adjudication process.

Straight Arrow

May 15, 2015

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Court Dismisses “Compelling and Meritorious” Bebo Constitutional Claims Solely on Jurisdictional Grounds

On March 3, 2015, Eastern District of Wisconsin District Judge Rudolph Randa dismissed the action brought by Laurie Bebo, former CEO of Assisted Living Concepts, Inc., to enjoin the SEC’s administrative enforcement proceeding against her.  The opinion is available here: Order Dismissing Complaint in Bebo v. SEC.  We previously discussed Ms. Bebo’s complaint here: New Challenge to the Constitutionality of an SEC Administrative Proceeding Filed in Bebo v. SEC, and followed up with discussions of the merits of her claims here (In re Bebo Shows Why SEC Administrative Proceedings Have Fairness Issues) and here (SEC ALJ Cameron Elliot Shows Why In re Bebo Should Be in Federal Court).

The judge found that even if Ms. Bebo’s arguments have merit, she is required to defend the administrative action in the SEC’s administrative law court, present her arguments there, and if needed, seek review by the SEC itself, and ultimately by a federal court of appeals.  Judge Renda thus adopted the same approach as SDNY Judge Lewis Kaplan in Chau v. SEC, which is discussed here: SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding.  Judge Kaplan’s decision is now on appeal to the Second Circuit court of appeals.

Judge Randa concluded he was jurisdictionally bound to reject the Bebo action, but he didn’t stand totally mute.  He started out his opinion by saying: “The Court finds that Bebo’s claims are compelling and meritorious, but whether that view is correct cannot be resolved here.”  Slip op. at 3.  But, after whetting our appetite with that comment, he proceeded to explain why he believed Ms. Bebo is required to submit to the entire administrative enforcement process and make her arguments there, rather than seeking immediate intervention by a federal court.  He noted that the Securities Exchange Act of 1934 provides that “a ‘person aggrieved’ by a final SEC order ‘may obtain review of the order in the United States Court of Appeals for the circuit in which he resides or has his principal place of business'” (quoting 15 U.S.C. § 78y(a)(1)), and that such provisions “’generally preclude de novo review in the district courts, requiring litigants to bring challenges ‘in the Court of Appeals or not at all.’’”  Id. at 3-4 (quoting Altman v. SEC, 687 F.3d 44, 45-46 (2d Cir. 2012)).  Although the Supreme Court, in Free Enterprise Fund v. Pub. Co. Accounting Oversight Bd., 561 U.S. 477 (2010), found that a district court could properly exercise jurisdiction over an injunctive action to address the allegedly unconstitutional proceeding in that case, that did not apply here because in Free Enterprise Fund, no proceeding had yet commenced when the action was brought in federal court.  Slip op. at 5-6.  The judge also found that Ms. Bebo could make an adequate record during the administrative proceeding to allow a court of appeals a sufficient basis for considering her grounds for challenging the proceeding.  Id. at 6-9.

Judge Randa concluded by quoting Judge Kaplan’s decision in the Chau case:

Ultimately, Bebo’s argument regarding the lack of meaningful judicial review lies in her objection to being subject to a procedure that she contends is wholly unconstitutional.  But as one judge observed, district court jurisdiction “is not an escape hatch for litigants to delay or derail an administrative action when statutory channels of review are entirely adequate.”  Chau v. SEC, No. 14-cv-1903 (LAK), — F. Supp. 3d —-, 2014 WL 6984236, at *6 (S.D.N.Y. Dec. 11, 2014).  If the process is constitutionally defective, Bebo can obtain relief before the Commission, if not the court of appeals.  See, e.g., Landry v. F.D.I.C., 204 F.3d 1125 (D.C. Cir. 2000) (addressing Article II challenge to FDIC’s method of appointing ALJs on appeal from a final FDIC Order).  Until then, Bebo must “patiently await the denouement of proceedings within the Article II branch.” USAA Fed. Sav. Bank v. McLaughlin, 849 F.2d 1505, 1510 (D.C. Cir. 1988).

If other district courts hearing challenges to pending or threatened SEC administrative proceedings follow the same path as Judges Kaplan and Randa, it will take awhile to get any reasoned judicial analysis of the validity of the SEC’s expanded use of its administrative courts to impose sanctions under the 2010 authority provided in the Dodd Frank Act.  At this point, all we have is Judge Randa’s teasing dicta “that Bebo’s claims are compelling and meritorious.”

In the meantime, our own discussion of some of the issues raised by Ms. Bebo, and other cases challenging the constitutionality of the SEC administrative proceedings under the standard laid out in Free Enterprise Fund, can be found here: Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit.

Straight Arrow

March 4, 2015

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Let’s Get Real: When SEC “Disgorgement” Remedy Is Used as Punishment It Should Be Treated that Way

Virtually every SEC enforcement proceeding includes a request for so-called “disgorgement” relief.  Once upon a time, “disgorgement” meant that a wrongdoer should be denied benefits he or she gained from misconduct.  As a matter of justice or fairness, that seemed hard to argue about.  There seems no good reason why someone found liable for misconduct should be entitled to retain the benefits of that misconduct.  And there would seem to be good reasons why that shouldn’t happen: otherwise one could argue we leave in place an economic incentive to commit wrongdoing, if the proceeds of misconduct exceed penalties imposed once liability is found (plus other costs of the proceeding).

But where the rubber meets the road, things get more complex.  How exactly should we figure out what the “ill-gotten gains” really are?  How do we take into account potential ongoing civil liabilities for that conduct?  Is it really “disgorgement” of ill-gotten gains if victims of the misconduct can recover those amounts in civil actions, perhaps benefited by application of collateral estoppel against the wrongdoer on the issue of liability?  Is it “disgorgement” to cause multiple liabilities for the same “ill gotten gains”?  What about other possible governmental liability for the “ill-gotten gains”?  If another governmental entity has a claim to recover some or all of those amounts, how many times should the government get to recover the gains, plus impose “penalties”?  What if there are parallel criminal and civil government enforcement actions?  Is it “piling on” to impose a “disgorgement” on top of a  criminal fine, possible criminal forfeiture, and civil penalties, which together are much larger than any possible “ill-gotten gains”?

It gets even more complex.  What rights does an accused have when he faces government actions for “disgorgement,” on top of civil penalties and other possible forms of relief?  An accused has a right to a jury trial in any criminal action, but also has a Seventh Amendment right to a jury in many civil actions.  As a relic of history, there is no Seventh Amendment right to a jury in a civil action that would, in former days, have been tried in courts of “equity.”  Should disgorgement be treated as an “equitable” remedy for which there is no right to jury trial?  Does that seem right (might one say “equitable”?) if the “disgorgement” calculation proposed by the government could result in a liability that vastly exceeds any possible civil penalty that is permitted by statute?  Indeed, does it ever really make sense to allow a “disgorgement” theory that results in findings of liability that dwarf the statutory limits on penalties that can be awarded in a case?  And what about time limits on seeking disgorgement relief?  There are statutes of limitation for criminal and civil actions, but, again as a vestige of judicial history, those statutory time limits don’t apply to actions for so-called “equitable relief.”  If actions for civil penalties are time-barred, should it really be possible to pursue stale liability claims solely for “disgorgement”?  How about if the stale claims for “disgorgement” seek amounts that vastly exceed the possible penalties that are time-barred?

These are complicated and nuanced questions, which have multiple layers of issues of fairness and public policy.  Unfortunately, the SEC has little patience for any such considerations.  It not only takes a knee-jerk position that what it calls “disgorgement” should be pursued in every case, but it opposes any meaningful restriction on how it should calculate such “disgorgement,” and opposes allowing an accused procedural rights to fight disgorgement like other civil liabilities.  Not only that, the SEC has also decided that “disgorgement” doesn’t really mean that a wrongdoer must give up his or her ill-gotten gains; to the SEC, it means that the wrongdoer must also pay amounts gained and retained by other persons as a result of the misconduct.  (As an example, just look at the SEC’s most recent effort in SEC v. McGee to get an insider trader to be responsible for “disgorgement” that includes not only the $292,000 he earned in alleged illegal profits, but also more than $1 million in alleged profits earned not by him, but by the “downstream” tippees who traded.)  And as to the calculation of “ill-gotten gains,” let’s just say that the only principle the SEC accepts in doing such calculations is that “more is better.”

Unfortunately, courts have been much too willing to accept aggressive SEC theories of “disgorgement,” which naturally has led to increasingly more outrageous SEC disgorgement calculations on the “more is always better” theory of law enforcement public policy.  The law in this area is now so prolix it is impossible to follow.  Somehow, we have reached the stage where, contrary to every sense of fairness and due process, a defendant is required by some courts to bear the burden of proving that a proposed SEC disgorgement calculation is incorrect, as long as the SEC proposal is deemed by the court to be plausible.  This judicial recognition of the concept “close enough for government work” as the rule of law in an enforcement proceeding is a mockery of due process, especially when what is at issue often may be amounts of supposed “disgorgement” that make the defendant bankrupt or destitute.  And, in a bizarre rejection of jurisprudence on the issue of causation, although the courts agree that for disgorgement not to be a form of punishment, it must be “causally connected” to the wrongdoing, some courts now accept that the proceeds of misconduct can be determined by mere “but for” causation, notwithstanding what may be, at best, strained proximity between the wrongdoing and the ultimate proceeds.  These are not just district court decisions, but influential appellate decisions in the Second and Third Circuits as well.  See SEC v. Contorinis, 743 F.3d 296 (2d Cir. 2014); SEC v. Teo, 746 F.3d 90 (3d Cir. 2014).  The SEC often takes the position that a company employee who commits or assists in a violation should “disgorge” all or portions of his or her salary, apparently on the bizarre (and, of course, unproven) theory that they were paid for the violations and not to perform actual duties as employees.  Some courts actually accept this nonsense.

In short, a combination of SEC over-exuberance, to be kind, and judicial acceptance, has resulted in bringing the securities “disgorgement” remedy far from its origins as a means of divesting a wrongdoer of his or her ill-gotten gains.  This departure raises serious questions about whether what is now labeled a “disgorgement” remedy is, in fact, a traditional form of equitable relief.  See The Equity Façade of SEC Disgorgement, and Thinking about SEC Disgorgement.  There is no doubt that Supreme Court consideration will ultimately be required.

The issue of disgorgement relief is so significant and complex, it is impossible to address in a single blog post.  On several previous occasions, we have discussed the issue in specific enforcement contexts.  The SEC v. Wyly enforcement action provided several opportunities to examine the issue.  In that case, Judge Scheindlin issued one decision describing the current state of the law of disgorgement in the Second Circuit, and then refusing to follow it because the result was so plainly inequitable.  See SEC v. Wyly: New Scheindlin Disgorgement Opinion Shows How SEC Remedy Has Gone Awry.  Judge Scheindlin also rejected some of the SEC’s more far-fetched theories of unlawful proceeds — including the notion that all of the increased value of stock the Wylys over a 13-year period should be disgorged when the only violation found was that they failed to disclose those holdings in section 13(d) disclosure filings, which certainly did not drive the increasing value of the stock.  See SEC v. Wyly III: SEC’s Overreach on Disgorgement Remedy Shot Down.  On the other hand, Judge Scheindlin ultimately awarded as a “disgorgement” for securities law violations a supposed unlawful tax avoidance that, if it truly was an unlawful tax avoidance, could be recovered by the IRS — and was actively being investigated by the IRS.  As a result, the defendants will be required to “disgorge” as supposed tax benefits either amounts the IRS do not allow them to retain (meaning there are no real “ill-gotten gains” to disgorge), or amounts the tax authorities determine were not, in fact and law, unlawful tax avoidances, in which case there also is no ill-gotten gain.  (Judge Scheindlin’s disgorgement order tried to address this issue by allowing disgorged amounts to be “credited towards any subsequent tax liability determined in an IRS civil proceeding as a matter of equity,” but the effect of that determination is far from clear, since the IRS is not a party to the SEC case.  She also tried to account for the possibility that tax was not really avoided by allowing a motion to vacate the judgment if another court rules that no taxes were owed — but not if the IRS itself determines not to assert any unlawful tax avoidance — which on its face is a half-baked approach to the issue, since much tax policy is determined without a court determination.)  This is “Alice in Wonderland” jurisprudence.  See Wyly Brothers Hit with More than $300 Million Securities Law Disgorgement Order for Unpaid Taxes.  As a result of the huge “disgorgement” imposed by Judge Scheindlin, Sam Wyly, once one of the wealthiest men in America as a result of growing a huge retail and securities empire with his now-deceased brother, is in bankruptcy.

Another example of disgorgement without bounds discussed in earlier posts is the SEC’s outrageous calculation of a $2 billion disgorgement in SEC v. Life Partners Holdings, Inc., which we discussed here: SEC Again Runs Amok, Seeking $2 Billion in Texas Case.  Fortunately, the district court rejected this absurd contention: see SEC Gets Reasonable Relief in Life Partners Case — but only 2.5% of $2 Billion Request.  The combined penalties and disgorgement issued in that case still forced the company into bankruptcy.  One wonders how “equitable” that felt to the company’s shareholders, whom the SEC presumably was trying to protect.

Which brings us to the disgorgement dispute du jour: whether the SEC’s effort to obtain “disgorgement” in SEC v. Graham should be permitted because, unlike the civil remedies found time-barred in that case, the five year statutory statute of limitations under 28 U.S.C. § 2462 does not apply to the portion of an enforcement action seeking disgorgement.  Section 2462 bars government civil claims for fines, penalties, or forfeitures, “pecuniary or otherwise” if they are not commenced “within five years from the date when the claim first accrued.”  For years, the SEC argued for a restrictive reading of section 2462 which would allow it to pursue claims for five years after they were “discovered,” rather than five years from when they accrued.  That position was finally put to rest by the Supreme Court in Gabelli v. SEC, 133 S. Ct. 1216 (2013).  Since then, the SEC has been searching for other ways to pursue enforcement actions after the five-year period expires.

In Graham, the SEC alleged a classic Ponzi scheme, in which the alleged perpetrators promised wealth-creating returns to purchasers of condominium units that were to be renovated and rolled into a large, nationwide resort.  As alleged, the returns paid to investors were funded by later purchases of new investors.  Because the last condominium sale occurred in 2007, however, and the SEC didn’t commence any action until 2013, the district court held that section 2462’s five-year statute of limitations barred all of the SEC’s claims.  District Judge King rejected the SEC’s argument that its claims should continue for the requested relief of disgorgement and an injunction because those were equitable claims and therefore not subject to any statute of limitations.  On the issue of disgorgement, Judge King wrote: the “disgorgement of ill-gotten gains . . . can truly be regarded as nothing other than a forfeiture (both pecuniary and otherwise),” which is expressly covered by section 2462.  “To hold otherwise would be to open the door to Government plaintiffs’ ingenuity in creating new terms for the precise forms of relief expressly covered by the statute in order to avoid its application.”  See his opinion here: SEC v. Graham.

In our discussion of this case at the time (see SEC v. Graham: SEC’s Delay in Filing Causes Ponzi Scheme Claims To Be Dismissed) we said: “This last ruling is dagger for the SEC.  Its litigation position is always that the non-penalty relief involves equities, not penalties, which relieves the SEC of unpleasant litigation burdens (including taking those issues away from a jury).  To be fair, most courts have historically agreed with that view, although the analysis is typically thin.  But in recent years the courts have tended to take a much more critical view of the relief the SEC always seeks because it often is highly punitive, even though the SEC portrays it as otherwise.  But that is an issue for another day.”  That other day has now arrived.  The SEC’s appeal is now before the Court of Appeals for the Eleventh Circuit in SEC v. Graham, No. 14-13562-E.

Will the Eleventh Circuit look past SEC’s label of “disgorgement” and recognize that so-called “disgorgement” relief has, in reality, become a harsher form of penalty than the civil “penalties” the SEC is permitted to obtain by statute?  Will the court accept the SEC argument that the “disgorgement” remedy is no more than long-standing ancillary equitable relief forcing divestiture of ill-gotten gains, and therefore not a penalty or forfeiture and not covered by section 2462?  Or will the court take note of the myriad ways that the SEC has caused the disgorgement concept to mutate in one the most severe forms of punishment in its arsenal of punitive weapons?

The Securities Industry and Financial Markets Association (SIFMA) is hoping it can convince the Eleventh Circuit court to see things as they are, not as they are labeled.  It filed an amicus brief in support of affirming the decision below, which seeks to explain why the SEC’s actions for these so-called “equitable” remedies are government enforcement actions that are, and should be, within section 2462’s actions for “civil fine, penalty, or forfeiture, pecuniary or otherwise.”  SIFMA’s brief is available here: SIFMA Amicus Brief in SEC v. Graham.

Whichever way the Eleventh Circuit goes on this, the many disgorgement issues mentioned above will remain, and will have to be resolved over time.  Let’s hope the courts will more consistently look at “disgorgement” on a case-by-case basis, and treat it in all respects for what it really is in each case, rather than allowing the SEC to label punishment as “disgorgement,” like a wolf in sheep’s clothing.

Straight Arrow

March 3, 2015

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An Open Memo to SEC Commissioner Aguilar on the Use of Officer and Director Bars

Memo for SEC Commissioner Luis Aguilar:

Dear Commission Aguilar,

In your speech at the SEC Speaks 2015 PLI Conference (if you’ve forgotten what you said, it’s here), you advocated for increased imposition of officer and director bars against SEC enforcement targets.  It was a brief discussion in a speech covering several topics, but it reflects a shameful insensitivity to the power and impact of imposing the SEC’s “nuclear” remedy to ruin people’s lives.  I very much doubt you believe in the use of lengthy harsh prison sentences or lifetime deprivations of rights more generally in our law enforcement process.  In fact, there is a growing bipartisan recognition among our politicians that ever heavier and lengthier penalties is one of the blights of our criminal system.  Yet, when it comes to our securities laws, you seem to crave being a “hanging judge.”

As a reminder, here is what you said on the subject (footnotes omitted):

The Commission has a number of tools available when it finds that fraudulent misconduct has occurred – it can seek to enjoin such activity, disgorge ill-gotten gains, and impose civil penalties against the wrongdoers.  In addition, the Enforcement Division can use trading suspensions and asset freezes to achieve immediate impact and halt ongoing fraudulent activities.  These are all important remedies.

In my view, however, one of the most potent remedies is for the Commission to prevent wrongdoers from being allowed to remain in a role that permits them to continue to hurt investors.  To that end, the Commission needs to be more aggressive in seeking permanent industry bars and officer and director bars.  These bars, not only serve to punish the wrongdoer, but also protect investors from future misconduct by such person. These bars send a clear message to the next potential fraudster.

An SEC enforcement action should not be viewed merely as a cost of doing business; rather, it should cause individuals and companies—whether or not they are part of the Commission’s specific action—to seriously reflect on their own conduct.  This is particularly true in the case of recidivist violators.  If our remedial sanctions were ineffective in reforming a fraudster, then we must seriously consider removing them from the industry—permanently.  The SEC must do this to protect American investors.

During my time as a Commissioner, I have witnessed defendants fight charging decisions on all fronts, including fighting tooth-and-nail to avoid being prevented from serving as officers or directors of public companies or from being suspended from appearing or practicing before the Commission pursuant to Rule 102(e).  They much rather have their company pay a sizable penalty to continue to do what they do, unaffected and undeterred.  Recently, this was demonstrated in the Gupta matter, where a director convicted of insider trading and given a lifetime officer and director bar, tried to appeal that bar to the U.S. Supreme Court.  As you may know, the Court rejected that appeal by denying cert.  It is interesting to note that the $13.9 million civil fine imposed against Gupta was not appealed to the Supreme Court.

Defendants’ vigor to avoid being barred is to be expected, as those bars and suspensions take fraudsters out of the industry, and often have a far more lasting impact than the imposition of a monetary fine.  Their fight is the best indicator that the Commission’s ability to bar wrongdoers is an effective tool that should be used whenever appropriate.

The importance of a strong and robust Enforcement program is vital to an effective capital market on which investors can rely.  The Commission has to use all of the tools at its disposal, including imposing permanent industry bars and officer and director bars.

Boy, do you have it wrong.  Although I think you  are likely to be considerably too willing to impose the “permanent industry bars” you favor — by which I assume you mean bars from industries regulated by the SEC — that at least falls within the overall regulatory framework of the SEC’s governance over the securities industry.  But your advocacy for penalties that prevent people from pursuing their livelihoods in non-regulated businesses is a shameful example of self-righteous hubris that unfortunately infects not only you, but many SEC employees.

To begin, it is at least refreshing that you recognize that officer and director bars are, in fact, a form of punishment (“These bars … serve to punish the wrongdoer”).  The SEC’s enforcement staff would prefer if you had left that admission out of your speech.  You see, the problem is that you’re not supposed to admit that the SEC is really punishing people.  We all know it’s true, but your enforcement staff does not accept that this “relief” is a form of punishment, and they argue the opposite in the courts all the time because the equitable remedies available to the SEC are, under the law, available only for remedial purposes, not punishment.  So, thank you for at least recognizing in this one respect that the Emperior has no clothes.

Your argument that permanent officer and director bars are needed to prevent “recidivist fraudsters” from plying their fraudulent trade is, with respect, a laugher.  I don’t want to question how you do your job, but do you actually look at the settlements and judgments that you approve that include officer and director bars?  It is rare that an officer/director bar is aimed at a recidivist violator.  In fact, it is effectively SEC enforcement policy to demand officer/director bars in every case involving alleged violations of section 10(b).  That’s like sending a first-time drug offender to jail for 30 years.  Do you think that’s the right thing to do?

More importantly, I’m disappointed that you show no cognition of what is really going on in many of the cases you are responsible for overseeing.  You mention with apparent pride that “defendants fight charging decisions on all fronts, including fighting tooth-and-nail to avoid being prevented from serving as officers or directors of public companies.”  I bet you would do the same if you were faced with being barred permanently from public employment for an alleged defalcation you contested.  Perhaps you don’t realize that the SEC uses the unlimited resources of the Government constantly to bludgeon individuals who can’t afford to defend themselves into accepting a penalty that destroys their future and the future of their families.  It is only the lucky ones that have the resources to fight the SEC’s demand for such “relief.”

And, no, Mr. Aguilar, these are not all “fraudsters” just getting what they deserve.  Even you, I expect, have some understanding of the value of due process in determining whether someone is a “fraudster.”  And the SEC staff’s distorted way of looking at fraud, in which unfortunate mistakes or oversights are regularly argued to be “reckless disregard of the law,” leaves a lot more than “fraudsters” as victims of the SEC’s love affair with the “nuclear” officer/director bar “remedy.”

Mr. Aguilar, I’d ask that you consider the possibility that depriving a person of a large portion of her savings, and leaving her branded as a securities law violator is not just “a cost of doing business,” and may actually be enough “punishment” without seeking to deprive her permanently of future employment in a (privately-owned and managed) public company.  I daresay that if you faced accusations of stepping over the line, you would appreciate it if your accusers understood that they too have human foibles, and that “the quality of mercy is not strain’d”:

That in the course of justice none of us
Should see salvation: we do pray for mercy;
And that same prayer doth teach us all to render
The deeds of mercy.

Best Regards,

Straight Arrow

February 23, 2015

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U.S. v. Georgiou: 3rd Circuit Panel Decision Makes a “Mockery” of Brady Disclosures and Jencks Act Compliance

We previously discussed the Third Circuit’s flawed analysis in United States v. Georgiou of the extraterritorial application of the federal securities laws to trading activity centered abroad, based solely on the fact that some trades entered into abroad were executed with the involvement of market makers in the United States.  See Third Circuit Adopts “Craven Watchdog” Standard for Extraterriorial Reach of Securities Laws in U.S. v. Georgiou.  We now turn to a different respect in which that panel decision disappoints.  The defendant in Georgiou recently filed a petition for rehearing en banc on different grounds, focusing on the panel’s use of invalid standards in applying Brady v. Maryland, 373 U.S. 83 (1963).  The issues raised in the brief are significant.  A copy of the motion for rehearing is available here: Georgiou Petition for Rehearing En Banc.

Brady is the landmark Supreme Court decision that ended the ability of the Government to hide from defendants exculpatory evidence in its possession.  Mr. Georgiou raises serious concerns that the panel improperly limited the Brady rule, in a manner inconsistent with previous Third Circuit (and other appellate court) holdings, by allowing the Government to avoid the consequences of failing to make required Brady disclosures based on whether the defendant acted diligently to try to obtain those materials himself.  By using this standard, the panel allowed the prosecutors to get away with withholding evidence that could have strongly undercut the credibility of the Government’s key witness.  The withheld information was revealed only in sentencing proceedings for that witness after the Georgiou trial was over.

As the brief in support of the Georgiou petition describes, the approach adopted by the Third Circuit panel allowed a blatant evasion of the obligations imposed on the Government to disclose exculpatory evidence in its possession.  The degree of diligence used by the defense to obtain that same information simply should not be relevant.  To be blunt, it is not too great a burden to demand that Government lawyers satisfy their duties to make required disclosures without permitting them to insulate their failures from consequences by making an issue of defense diligence.  Whether defense counsel is diligent or not, Government lawyers need to recognize their duties and perform them, period.  Anything less undermines the criminal justice process.

Unfortunately, there is a near-constant need to have the courts assure that prosecutors meet their obligations.  Prosecutors seem addicted to trying to win cases through sharp practices rather than a thorough presentation of the facts to the judge or jury.  It never ceases to amaze me that prosecutors consistently try to minimize the effect of Brady by avoiding the disclosure of potential exculpatory material in their possession.  An attempt to deprive the defendant of information that might be useful at trial reflects a prosecutor’s willful effort to prevent a fair and just trial.  It should not be tolerated by the senior lawyers that manage prosecution teams, and it should not be tolerated by the courts.  Indeed, a knowing avoidance of Brady obligations should expose prosecutors to court and bar sanctions, and in some instances be prosecuted as an obstruction of justice.  Prosecutors routinely take the narrowest view possible of Brady obligations, but why they do so is a mystery to me.  What do they think they are achieving by depriving the defendant of potentially relevant evidence?  Do they really think that their views that a defendant is guilty as charged are so reliable that the jury should not be permitted to consider all of the evidence?  The job of a prosecutor is not to engineer a conviction, but to try to assure that a fair adjudication occurs.  Instead of allowing prosecutors to play games to avoid Brady obligations, U.S. Attorneys should demand that their assistants err on the side of producing potentially exculpatory evidence.

Since that did not occur here, it was up to the courts to elevate justice above the prosecutors’ hubris, or their single-minded desire for a notch in the belt.  Alas, that did not occur.  Instead of casting a jaundiced eye on the prosecution’s questionable disclosure decisions, the Third Circuit panel bent over backwards to justify or exonerate those decisions.  It should have held the prosecutors’ feet to the fire, because adhering to principles that foster a fair and just adjudication is far, far more important than the result in a particular case.  The Third Circuit panel abdicated its role to hold overly-zealous prosecutors in check.

The petition points out another serious error by the Third Circuit panel.  The Government never produced to the defense notes of witness interviews by Government officials of the prosecution’s key witness.  Any such materials known to the prosecutors should have been produced under Brady if aspects of the interviews were exculpatory, and under the Jencks Act because they reflect previous statements of one of the Government’s witnesses.  The panel ruled that even though the SEC was in possession of notes of these interviews, they were not required to be produced by DOJ prosecutors because they were in the possession of the SEC, not the DOJ.  As a result, in the court’s view, these materials “were not within the possession of the prosecutorial arm of the government” and therefore prosecutors were absolved of the duty to produce them, even if they knew they existed and could easily have obtained them.  That is a truly absurd position which has been soundly repudiated by other courts.  Those courts rightfully recognize that accepting this fiction would make a “mockery” of the Brady and Jencks Act disclosure requirements. See, e.g., United States v. Gupta, 848 F. Supp. 2d 491, 493-95 (S.D.N.Y. 2012).

In this case, as in most criminal cases involving allegations of key securities violations, the DOJ worked hand-in-hand with the SEC, often jointly participating in interviews.  To permit avoidance of disclosures by the DOJ based on which government employee took or retained those notes — whether they were SEC officials, FBI agents, U.S. mail inspectors, or some other agency employee — is a gross elevation of form over substance.  All of the law enforcement agencies in these cases cooperate and work together, and all of them should be required to treat these notes as jointly-held materials.  To rule otherwise does, indeed, make a mockery of justice.

Mr. Georgiou faces an uphill battle in his effort to win reconsideration of the decision or en banc review, or, failing so, in getting a grant of certiorari from the Supreme Court.  But if the panel decision stands as written, it represents an embarrassment to criminal justice, regardless of whether Mr. Georgiou is guilty of the crimes charged.

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February 11, 2015

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SEC ALJ Cameron Elliot Shows Why In re Bebo Should Be in Federal Court

The administrative enforcement action brought by the SEC against Laurie Bebo, the former CEO of Assisted Living Concepts, Inc. (“ALC”) is serving as a case study showing why it is highly improper to use the administrative forum to prosecute serious fraud claims against individuals or entities not subject to SEC regulatory authority.  We previously discussed elements of unfairness in this proceeding in our post In re Bebo Shows Why SEC Administrative Proceedings Have Fairness Issues.  A new ruling by the administrative law judge in that case shows once again how the administrative forum tilts the field significantly (and unfairly) in favor of the SEC in comparison to federal courts, to the point that due process of law is threatened.

The SEC filed a motion in limine to allow it to introduce a broad range of hearsay evidence: 16 sworn declarations and three deposition transcripts.  By all appearances, none of these documents would be admissible as evidence in federal court because there is no apparent exception to the hearsay rule that would allow the SEC to avoid live testimony, subject to live cross-examination.  Ms. Bebo opposed the motion.  Administrative Law Judge Cameron Elliot ruled that the evidence would be admitted under a provision of the SEC Rules of Practice allowing an ALJ to admit into evidence the prior sworn statement of a witness, other than a party, if “it would be desirable, in the interests of justice, to allow the prior sworn statement to be used.” SEC Rule 235(a)(5), 17 C.F.R. § 201.235(a).  This notwithstanding the fact that the Rules of Practice state: a “presumption that witnesses will testify orally in an open hearing.”  ALJ Elliot’s order can be read here: In re Bebo Ruling on Introduction of Hearsay Evidence.

ALJ Elliot apparently thought it was important that Ms. Bebo did not “dispute the truth of the Declarants’ statements or of the Deponents’ testimony.”  Yet, he accepted that counsel for Ms. Bebo “did not participate in any interviews of the Declarants, and so far has been able to speak to only one Declarant.”  In other words, in the ALJ’s view, Ms. Bebo was saddled with the extreme burden of disputing the truth of statements without ever having access to the declarants, which seems bizarre.  Since the “truth” of statements is heavily dependent on context and possible equivocation, it is a near-impossible burden to challenge “truth” without access to context.

Keep in mind that this is not just a private party drafting an affidavit and asking another person to sign.  It is the Government telling people who may have law enforcement exposure themselves that it would like them to sign a document, and perhaps making statements or representations about the case to encourage them to do so.  Most folks will do what they can to keep the Government off their backs.

The end result is that statements of many witnesses are now coming into evidence even though the respondent has had no opportunity to develop an understanding of what those witnesses said, and may say, outside of the four corners of declarations carefully drafted by SEC lawyers.  Moreover, because deposition discovery is not generally available in these administrative proceedings, Ms. Bebo’s counsel is placed in the impossible situation of deciding whether to call these witnesses into court to examine them without having any understanding of what they may say, or of ways in which the SEC-drafted declarations could be misleading or deceptive because of important omissions.

This could never happen in federal court. The SEC would have to identify these people as potential witnesses and they could be noticed for depositions.  Those depositions might show that what the witnesses have to say is not as clear-cut as the SEC contends – or may even vary significantly from what the SEC says.  In all likelihood, the SEC would have to decide whether to bring these witnesses into court to testify, and to take the risk that their proffered witnesses would provide unhelpful testimony in response to non-leading questions and the right of cross-examination.  Even if the SEC were permitted to introduce such declarations into evidence – which is highly unlikely – the defense would be in a position, based on pretrial discovery, to decide which should be brought in as live witnesses. In short, the advantage to the SEC created by ALJ Elliot’s ruling allowing SEC-drafted declarations as evidence in this case is palpable.

ALJ Elliot blithely ignores these issues, notwithstanding that even under SEC Rules of Practice that are less demanding than the Federal Rules of Evidence, he is obligated to allow this to occur only if “it would be desirable, in the interests of justice.”  There is precious little discussion in his opinion of how justice is served by putting the respondent behind the 8-ball with respect to 16 witnesses by allowing into evidence hand-crafted statements by SEC lawyers signed by people who need never appear in court.  (Is the ALJ truly ignorant of how these declarations are typically crafted to leave out things that may be helpful to the opposition?)  ALJ Elliot simply takes no cognizance of the burden this imposes on the defense, and the near-impossibility of overcoming that burden without full, fair, and open discovery in advance of trial.  He merely says that “it will not be unreasonable or unduly burdensome to place on Bebo the burden of calling the Deponents as witnesses,” and it is not “a violation of due process to admit undisputed hearsay.”  But why does it serve the interests of justice to impose this burden and to admit this evidence? It is the SEC’s burden to show this, and the ALJ’s duty to make appropriate findings in support of his order, but, incredibly, the ALJ appears to proceed based on the presumption that easing the burden on the SEC at the expense of the respondent is what justice is about.

SEC administrative law judges are used to a regime in which they let the SEC enforcement lawyers cut procedural and evidentiary corners in administrative actions involving respondents associated with SEC-regulated entities.  But after the new expansion of ALJ jurisdiction under Dodd-Frank, they are hearing prosecutions of non-regulated persons that often will involve “nuclear” punishments, like lifetime bars from ever serving as an officer or director of any public company.  In such cases, they have to learn that justice requires a less “loosey-goosey” approach to adjudicating the claims before them.  When a person’s future ability to earn a living and support his or her family is at stake, that person is entitled to considerations of “the interests of justice” that take account of the stakes in the case.  ALJ Elliot doesn’t seem to get that; he’s acting as if he’s hearing just another charge against a delinquent broker.  The common practice of giving the SEC lawyers the home-court advantage in cases against regulated persons is wrong, and should be stopped.  But using those flawed standards in the new higher-profile cases the ALJ’s are now hearing amplifies the problem to the point that due process is threatened.

If ALJ Elliot were focused on fairness and justice, which seems not to be the case, he would have told the SEC: if a witness’s evidence is important to your case but you want to avoid in-court testimony, you should take a deposition that allows full cross-examination by the opponent, and then make your motion to allow portions of the out-of-court deposition into evidence, to which the opponent could respond with fair knowledge about what the witness has to say on the issue.  By shifting the burden to Ms. Bebo of showing injustice from the admission of SEC-drafted declarations, ALJ Elliot tilted the playing field against Ms. Bebo, violated the SEC Rules of Practice, and, in my view, violated due process of law.  None of this, of course, could happen if the SEC brought its case in federal court, where it should be.

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February 9, 2015

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In re Bebo Shows Why SEC Administrative Proceedings Have Fairness Issues

We previously discussed the challenge brought by Laurie Bebo, the former CEO of Assisted Living Concepts, Inc. (“ALC”), against an SEC administrative enforcement action brought against her: New Challenge to the Constitutionality of an SEC Administrative Proceeding Filed in Bebo v. SEC.  We now provide an example of why SEC procedures create at least the appearance of bias, and likely more than that, in these proceedings.

You see, the SEC Commissioners have already entered into a settlement with Bebo’s co-respondent, John Buono, who was the CFO of ALC who reported to Ms. Bebo.  As is typical in these administrative cases, the settlement agreement results in a filing in which the SEC literally makes “findings” consented to by the settling respondent, laying out what supposedly happened and why it was unlawful.  Indeed, the document issued by the SEC is an “Order Making Findings and Imposing Remedial Sanctions.”  See the Order just issued in the case captioned In the Matter of Laurie Bebo and John Buono, CPA here: In re Bebo and Buono Administrative Findings.  The Order says that it is “not binding on any other person or entity in this or any other proceeding,” but it also plainly is, and is intended to be, “findings” of the Commission justifying the “remedies” — actually penalties — it imposes.

Laurie Bebo

Laurie Bebo

John Buono

John Buono

Here, the Order presents 54 paragraphs of detailed factual “findings” and another six paragraphs laying out multiple violations of law “found” by the Commission against Mr. Buono.  The Order says that the Commission has already “found” that Mr. Buono “willfully violated” section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”) and Rule 10b-5 thereunder, “willfully aided and abetted and caused” violations by ALC of section 13(a) of the 1934 Act and rules thereunder, “willfully violated” SEC Rule 13a-14, “willfully violated” section 13(b)(5) of the 1934 Act, “willfully violated” SEC Rules 13b2-1 and 13b2-2,  and “willfully aided and abetted and caused” ALC’s violations of sections 13(b)(2)(A) and 13(b)(2)(B) of the 1934 Act.

The fact that these are “findings,” and not “allegations,” which is what the SEC files in federal court cases, is no mere accident.  It is a long-standing practice for administrative settlements.  The difference is meaningful in some areas.  For example, the existence of “findings” of violations by the SEC creates potential insurance coverage or licensing issues that “allegations” do not.  As a result, in some cases settling parties would prefer to settle a case based on allegations in federal court than accept an administrative settlement based on SEC “findings.”

The Commission also imposed severe penalties on Mr. Buono, including permanent bars against him ever serving as an officer or director of a public company, or ever practicing accounting before the Commission (i.e., taking an accounting job with any public company), plus a $100,000 penalty.  It thus has already concluded that its “findings” warrant those draconian penalties.  (For a 51-year-old professional, likely supporting a family, who has just been effectively barred from the employment for which he is most suited, there is no doubt these are severe penalties.)

Now, Ms. Bebo is being forced to appear at trial before an administrative law judge who reports to the Commission that made these “findings.”  And once that administrative judge issues a ruling, Ms. Bebo’s only path of appeal goes through the very same Commission that made “findings” of illegality by her colleague and imposed severe penalties on that basis.  (Only after the SEC adjudicates a challenge to the ALJ decision is there an appeal to a federal appellate court, and that appeal requires that court to treat SEC findings with deference.)  The Buono findings are not “binding” on Ms. Bebo or the Commission in  her case, but the notion that the same people who decided the case against Mr. Buono as they did will ultimately hear the case being litigated by Ms. Bebo strikes at the heart of fundamental concepts of fairness.  Does anyone want to take odds that the SEC will not take contrary positions in Ms. Bebo’s case to the ones they already approved in Mr. Buono’s case?  Contact me and we’ll work out a bet.

The potential bias arising out of the adjudicators’ “findings” against co-respondents is just one of numerous fairness issues raised by SEC administrative proceedings that may impose severe penalties against persons unregulated by the SEC.  Some others were discussed in our previous posts: Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions, and Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions.

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January 30, 2015

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Third Circuit Adopts “Craven Watchdog” Standard for Extraterriorial Reach of Securities Laws in U.S. v. Georgiou

In United States v. Georgiou, No. 10-4774 (Jan. 20, 2015), the Third Circuit recently applied the Supreme Court’s extraterritoriality ruling in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), to a criminal securities fraud conviction.  Georgiou was convicted of securities fraud, wire fraud, and conspiracy for a stock manipulation scheme orchestrated outside of the United States. The court affirmed the conviction, finding that even though the securities trading did not occur on a U.S. securities exchange, it was actionable under the U.S. securities laws because an aspect of the securities transactions was completed within the United States.  A copy of the opinion can be found here: US v Georgiou.

The case involved an alleged classic manipulative scheme to buy thinly-traded stocks, inflate their prices with matched trades, wash sales, and the like, and dump the stocks at the artificially high prices.  Georgiou used brokerage accounts in Canada, the Bahamas, and Turks and Caicos for the manipulative trading.  The stocks were traded over-the-counter on the OTC Bulletin Board (“OTCBB”) or the Pink OTC Markets (“Pink Sheets”).

In Morrison, the Supreme Court limited the application of section 10(b) to the use of “manipulative or deceptive device[s]” in securities transactions involving either (i) “the purchase or sale of a security listed on an American stock exchange,” or (ii) “the purchase or sale of any other security in the United States.”  Morrison , 561 U.S. at 273.  The Third Circuit sought to apply that standard to the Georgiou trades.

The court first considered whether securities listed on the OTCBB and the Pink Sheets are “listed on an American stock exchange.”  It noted that the SEC identifies 18 nationally registered securities exchanges, but does not include the OTCBB and the Pink Sheets.  It also noted that both the OTCBB and the Pink Sheets are self-described as trading mechanisms for securities not listed on any exchange.  Finally, it noted that the securities statutes themselves distinguish between “securities exchanges” and “over-the-counter markets.”  For those reasons, it found the transactions here were not the purchase or sale of a security on “an American stock exchange,” and therefore were not subject to U.S. securities laws on that basis. See slip op. at 13-15.

The analysis then moved to the second Morrison prong: whether these transactions were the purchase or sale of securities “in the United States.”  The court took note of the fact that Morrision involved a so-called “foreign-cubed” transaction – foreign plaintiffs suing a foreign issuer based on securities transactions in foreign countries.  In contrast, the securities in the Georgiou case were those of U.S. issuers, and the transactions involved the participation of “market makers” operating in the United States.

Morrison instructed that transactions are “domestic transactions” based not on “the place where the deception originated,” but the place where the purchases and sales occurred.  Morrison, 561 U.S. at 266-67.  It is the “location of the transaction” that determines the applicability of the U.S. securities laws.  See id. at 268.  The Georgiou court noted that the 2d, 9th, and 11th Circuits had previously found that a “domestic transaction” was one (i) where the parties became obligated to proceed in the U.S., or (ii) where the actual transfer of title occurred in the U.S.  Georgiou, slip op. at 16-17 (referring to Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 69 (2d Cir. 2012); Quail Cruise Ship Mgmt Ltd. v. Agencia de Viagens, 645 F.3d 1307, 1310-11(11th Cir. 2011); SEC v. Levine, 462 Fed. App’x717, 719 (9th Cir. 2011)).  The court then “agreed” that “commitment” is “a simple and direct way of designating the point at which . . . the parties obligated themselves to perform . . . even if the formal performance of their agreement is to be after a lapse of time.”  Slip op. at 17 (quoting Absolute Activist, 677 F.3d at 68).  Accordingly, “the point of irrevocable liability” can be used to determine where a securities purchase or sale occurred; “territoriality under Morrison turns on ‘where, physically, the purchaser or seller committed him or herself’ to pay for or deliver a security.”  Slip op. at 17 (citations omitted).

This is all largely consistent with previous decisions.  But here the Third Circuit took a detour. The court found the involvement of U.S.-based market makers in “facilitating” at least some of the otherwise foreign transactions made them “domestic transactions” under Morrison: “Here, at least one of the fraudulent transactions in each of the Target Stocks was bought and sold through U.S.-based market makers. . . .    [A]ll of the manipulative trades were ‘facilitate[d]’ by U.S.-based market makers, i.e., an American market maker bought the stock from the seller and sold it to the buyer. . . .  Therefore, some of the relevant transactions required the involvement of a purchaser or seller working with a market maker and committing to a transaction in the United States, incurring irrevocable liability in the United States, or passing title in the United States.”  Id. at 18.  The court concluded: “We now hold that irrevocable liability establishes the location of a securities transaction. Here, the evidence is sufficient to demonstrate that Georgiou engaged in ‘domestic transactions’ under the second prong of Morrison, i.e., transactions involving ‘the purchase or sale of any [] security in the United States.’  See Morrison, 561 U.S. at 273.  Thus, the District Court’s application of Section 10(b) to Georgiou’s transactions was proper.” Slip op. at 19.

The rationale adopted by the court is, at best, designed to satisfy Morrison’s letter rather than its spirit.  Although the opinion is somewhat opaque, it seems apparent that the court concluded that the mere involvement of a U.S. person as a market intermediary in a transaction that in all other respects was between foreign persons is sufficient to make the transaction one properly governed by the U.S. securities laws.  But to allow the apparently unknown involvement of U.S. market makers “as intermediaries for foreign entities” to serve as the basis for subjecting a transaction to U.S. law seems to violate both the language and spirit of the Morrison opinion.  It totally ignores the point made by the Morrison Court that the standard for applicability of U.S. law to a transaction could not be whether some aspect of the transaction touched upon the United States: “For it is a rare case of prohibited extraterritorial application that lacks all contact with the territory of the United States. But the presumption against extraterritorial application would be a craven watchdog indeed if it retreated to its kennel whenever some domestic activity is involved in the case.”  Morrison, 561 U.S. at 266.

The Morrison Court noted that the subject “purchase-and-sale transactions are the objects of the statute’s solicitude.” Id. at 267.  It did not look to see if the interstices of those transactions involved some other agreement (i.e., between the seller’s foreign broker and a U.S. market maker) that occurred in the United States, because any such “facilitating” transaction was not “the object of the statute’s solicitude.”  Instead, “it is parties or prospective parties” to the purported unlawful transaction that “the statute seeks to ‘protec [t].’”  Id.  In the Georgiou case, the U.S. market maker is not one of those parties.

If the acknowledged test for the locus of a transaction is, as the Third Circuit says, where the parties “irrevocably” “obligated” themselves to the transaction, then, by all appearances, in this case that was outside of the United States, where the buyer and seller made their purchase and sale commitments.  It is not faithful to Morrison to rule that because the market mechanism by which those commitments were implemented included a transaction by other unaffiliated persons within the U.S., the transaction at issue morphed into a “domestic transaction.”  In a globalized electronic marketplace, almost any securities transaction that parties commit to on foreign soil can involve an “intermediary” in the United States that “facilitates” its completion.  To allow that to trigger the extraterritorial reach of the U.S. securities lawyers would, in fact, make “the presumption against extraterritorial application . . . a craven watchdog . . . retreated to its kennel.” Morrison, 561 U.S. at 266.

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January 23, 2015

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Stratte-McClure: 2d Circuit Creates Circuit Split on 10(b) Actions Founded on Alleged Item 303 Violations

The Second Circuit’s recent decision in Stratte-McClure v. Morgan Stanley, No. 13-0627-cv (Jan. 12, 2015) (2015 WL 13631) (slip opinion available hereStratte-McClure v. Morgan Stanley) (also referred to as Fjarde AP‐Fonden v. Morgan Stanley), stirs the pot on the important issue of private section 10(b) claims based on alleged violations of Item 303 of SEC Regulation S-K, 17 CFR § 229.303.  Claims founded on a purported failure to comply with Item 303 are problematic because Item 303 is the SEC’s effort to enhance disclosures of “soft information,” not historical facts, about a public company.  It requires that a company evaluate and discuss the future prospect that some developments or uncertainties could be important in future company performance.  Because such decisions (i) inevitably involve the exercise of management judgment the need for disclosure, and the nature and scope any such discussion, and (ii) are almost always subject to second-guessing in retrospect, when the future is revealed and the uncertainties become less uncertain, they present serious risks of converting private section 10(b) claims into a form of hindsight insurance against stock price declines.

The SEC at one time excluded forward-looking information from SEC filings, but about 40 years ago started to encourage companies to provide forward-looking information in SEC filings.  This eventually led to the development of mandatory disclosure requirements of “MD&A,” the short term for the Management Discussion and Analysis of Financial Condition and Results of Operations required by Item 303.

 Item 303 arose out of SEC concerns that investors were missing out on key elements of company information if they obtained only purely historical information.  Informed investment decision-making could be greatly improved if investors were able to get management insights into areas of company risk and uncertainty that had not yet been realized.  This type of non-historical, future-looking evaluation is often referred to as “soft information.”  The area of soft information disclosure is problematic because the SEC wants to encourage management to share such evaluative analysis, but to do so in a way that does not expand company and management exposure for not reading the future correctly.  Accordingly, along with developing rules encouraging such disclosure, the SEC, Congress, and the courts have taken steps to limit private securities claims based solely on allegedly inadequate forward-looking disclosures.

The SEC adopted so-called “safe harbor” rules (Rule 175 under the Securities Act of 1933 and Rule 3b-6 under the Securities Exchange Act of 1934), under which a forward-looking statement in a company’s MD&A disclosures could not be found fraudulent absent proof that it “was made or reaffirmed without a reasonable basis or was disclosed other than in good faith.”  In the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress enacted a more general safe harbor precluding liability in private actions for a forward-looking statement if: (i) it is identified as such and accompanied by “meaningful cautionary statements identifying important factors that could cause actual results to differ materially,” or (ii) immaterial, or (iii) the plaintiff fails to prove that the forward-looking statement was made “with actual knowledge . . . that the statement was false or misleading.”  15 U.S.C. § 78u-5(c). The first portion of this statutory safe harbor was effectively a legislative adoption of the judicially-created “bespeaks caution” doctrine under which a forward-looking statement accompanied by meaningful cautionary language was deemed immaterial as a matter of law.

Nevertheless, forward-looking statements that turn out to be inaccurate, or the failure to provide advance warning of a likely future impact of a current problem, has been a theory underlying private securities actions for decades.  Because this allows a backward-looking theory of fraud to be pursued after events occurring after the alleged misleading statements or omissions are accompanied by significant stock price impact, it is a powerful lure for the plaintiffs’ class action bar.

This theory can be especially powerful in the context of so-called “material omissions.”  In those cases, the plaintiff can seek damages supposedly arising out of a company’s failure to provide a prediction about the future – the failure to disclose the potential impact of facts or circumstances that later turn out to harm the company.  The most difficult hurdle in these cases is finding a “duty to disclose.”  The securities laws do not require the disclosure of all company information to investors, nor even all material company information.  Instead, public companies are required to disclose only the specified information mandated in SEC regulations, and to ensure that when they do disclose information, they do not at the same time withhold information without which the disclosed information becomes misleading.  In general, companies have no obligation to provide evaluations or predictions about possible future developments, so this “duty to disclose” requirement can be a major obstacle to a private securities action based on a failure to do so.

It is in this context that recent cases have considered the impact on private securities actions of Item 303 of Regulation S-K.  Two recent appellate cases adopt very different approaches to this issue: the Second Circuit’s decision in Stratte-McClure and the Ninth Circuit’s decision in In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014).  It is no exaggeration to say that billions of dollars of future litigation costs and liabilities may turn on which of these approaches ultimately prevails.

Item 303(a)(3)(ii) requires that as part of its annual (Form 10-K) and quarterly (Form 10-Q) MD&A disclosures, a company must:

Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

The SEC discussed this requirement further in an interpretive release:

Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:

(1) Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.

(2) If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.

Exchange Act Release No. 34–26831 (May 24, 1989).

NVIDIA and Stratte-McClure examine whether the failure to comply with this SEC disclosure requirement can form the basis for a private securities fraud action under section 10(b) and Rule 10b-5.  NVIDIA says “no”; Stratte-McClure says “yes.”

NVIDIA involved the company’s alleged failure to include in its Item 303 MD&A disclosures the potential financial impact of a defect in a chip incorporated into various manufacturers’ computers and other devices.  Although the existence of the defect was disclosed, the amounts to be paid under warranty obligations were allegedly known uncertainties, and the MD&A allegedly failed to include a required discussion of that prospect.  Stratte-McClure involved the alleged failure by Morgan Stanley to include in its MD&A a discussion of the potential future financial impact of long positions it held on collateralized debt obligations or credit default swaps at the time of the housing mortgage meltdown.

Let’s start with a key point on which both courts agree.  They both emphasize that information required to be disclosed under Item 303 may not satisfy one of the key elements of a section 10(b) claim: materiality.  That is because the SEC instructions make it clear that disclosures may be required “unless management determines that a material effect . . . is not reasonably likely to occur” (emphasis added).  As a result, disclosures of immaterial information are required if management cannot “determine” they are unlikely to have a future material impact.  Accordingly, plaintiffs will still have the burden of pleading facts showing a required disclosure was, in fact, material. See NVIDIA, 768 F.3d at 1055; Stratte-McClure, slip op. at 18-19.

Add to this another point of agreement: a section 10(b) claim requires proof that the defendants acted with scienter, which means that a claim can proceed only if the plaintiff pleads particular facts – under the PSLRA pleading standard, as further interpreted in Tellabs Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322-23 (2007) – plausibly supporting that the defendants’ omission was intended to defraud shareholders.  That could be even more difficult than normal for these cases to the extent the safe harbor provisions mentioned above may apply.  Both NVIDIA and Stratte-McClure found the allegations of scienter in failing to make required Item 303 disclosures were deficient and supported dismissal of the claims.  See NVIDIA, 768 F.3d at 1056-65; Stratte-McClure, slip op. at 26-29.  In Stratte-McClure, the Second Circuit found the failure to plead scienter adequately was grounds to affirm the district court’s dismissal of claims, even while reversing the lower court’s ruling that Item 303 did not create a disclosure duty.  (Technically, that makes the panel decision on the “duty to disclose” issue dicta, which theoretically has diminished precedential value, but don’t count on it.)

The difference between the courts – a critical one – is that the NVIDIA court concluded that Item 303’s requirement that certain immaterial information must be disclosed prevents it from creating the “duty to disclose” necessary to support a fraud claim under section 10(b), while the Stratte-McClure court concluded that the “duty to disclose” and materiality elements should be disaggregated for this purpose.

The NVIDIA court relied heavily on reasoning in the Third Circuit decision Oran v. Stafford, 226 F.3d 275, 287–88 (3d Cir. 2000) (Alito, J.), which in turn relied heavily on the discussion of section 10(b) elements in the Supreme Court’s opinion in Basic, Inc. v. Levinson, 485 U.S. 224, 238 (1988).  The NVIDIA wrote as follows:

[I]n Basic, the Supreme Court stated that materiality of forward-looking information depends “upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” . . . As the court in Oran also determined, these two standards differ considerably.  226 F.3d at 288.  Management’s duty to disclose under Item 303 is much broader than what is required under the standard pronounced in Basic.  The SEC intimated this point as well: “[Item 303] mandates disclosure of specified forward-looking information, and specifies its own standard for disclosure—i.e., reasonably likely to have a material effect….  The probability/magnitude test for materiality approved by the Supreme Court in [Basic] is inapposite to Item 303 disclosure.”  Exchange Act Release No. 34-26831, 54 Fed. Reg. at 22430 n. 27.  The SEC’s effort to distinguish Basic’s materiality test from Item 303’s disclosure requirement provides further support for the position that Item 303 requires more than Basic—what must be disclosed under Item 303 is not necessarily required under the standard in Basic. Therefore, “[b]ecause the materiality standards for Rule 10b5 and [Item 303] differ significantly, the ‘demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b–5. Such a duty to disclose must be separately shown.’”  Oran, 226 F.3d at 288.

The Stratte-McClure court, on the other hand, saw no reason why a “duty to disclose” sufficient to make an omission potentially actionable must satisfy the Basic materiality requirement. Instead, it concluded the materiality standard should be applied separately, only after the determination whether there was a duty to disclose the omitted information.  Immaterial information could still satisfy the “duty to disclose” requirement, even if a plaintiff could not show it was material:

The Supreme Court has instructed that “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b–5.”  Basic, 485 U.S. at 239 n. 17….  Such a duty may arise when there is “a corporate insider trad[ing] on confidential information,” a “statute or regulation requiring disclosure,” or a corporate statement that would otherwise be “inaccurate, incomplete, or misleading.”…

As Plaintiffs correctly argue, Item 303 of Regulation S–K imposes disclosure requirements on companies filing SEC-mandated reports, including quarterly Form 10–Q reports…. Those requirements include the obligation to “[d]escribe any known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.” …  The SEC has provided guidance on Item 303, clarifying that disclosure is necessary “where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.” …

Item 303’s affirmative duty to disclose in Form 10–Qs can serve as the basis for a securities fraud claim under Section 10(b).  Rule 10b–5 requires disclosure of “material fact[s] necessary in order to make … statements made … not misleading.”  This Court and our sister circuits have long recognized that a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak….  And this conclusion stands to reason—for omitting an item required to be disclosed on a 10–Q can render that financial statement misleading….  Due to the obligatory nature of these regulations, a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of “known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on ․ revenues or income from continuing operations.”…  It follows that Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).

The failure to make a required disclosure under Item 303, however, is not by itself sufficient to state a claim for securities fraud under Section 10(b)….  Since the Supreme Court’s interpretation of “material” in Rule 10b–5 dictates whether a private plaintiff has properly stated a claim, we conclude that a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b–5 if the allegedly omitted information satisfies Basics test for materiality.  That is, a plaintiff must first allege that the defendant failed to comply with Item 303 in a 10–Q or other filing. Such a showing establishes that the defendant had a duty to disclose.  A plaintiff must then allege that the omitted information was material under Basic‘s probability/magnitude test….

Stratte-McClure, slip op. at 14-20 (citations and footnotes omitted).

The Stratte-McClure court noted the NVIDIA court’s disagreement, arguing that the NIVIDIA court conflated the “duty to disclose” and materiality requirements, and misapplied then-Judge (now Justice) Alito’s reasoning in Oran:

We note that our conclusion is at odds with the Ninth Circuit’s recent opinion in In re NVIDIA Corp. Securities Litigation….  That case held that Item 303’s disclosure duty is not actionable under Section 10(b) and Rule 10b–5, relying on a Third Circuit opinion by then-Judge Alito, Oran v. Stafford….  But Oran simply determined that, “[b]ecause the materiality standards for Rule 10b–5 and [Item 303] differ significantly,” a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b–5” (emphasis added).…  Having already decided that the omissions in that case were not material under Basic, the Third Circuit concluded that Item 303 could not “provide a basis for liability.”… Contrary to the Ninth Circuit’s implication that Oran compels a conclusion that Item 303 violations are never actionable under 10b–5, Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material 10b–5 omission. At a minimum, Oran is consistent with our decision that failure to comply with Item 303 in a Form 10–Q can give rise to liability under Rule 10b–5 so long as the omission is material under Basic, and the other elements of Rule 10b–5 have been established.

It is possible that the differences between these decisions reflect the proverbial “distinction without a difference.”  After all, the Stratte-McClure court requires that materiality be pleaded and proved in addition to a disclosure duty, which eventually may lead to the same result.  But “eventually” can be a big word.  The name of the game is these cases is surviving dismissal and getting into discovery.  Materiality is a notably hard element on which to get a claim dismissed.  Even scienter-based dismissals tend to be arduous litigated results with multiple amended complaints, and plaintiff’s counsel often manage to survive dismissal by presenting often dubious “confidential witness” allegations that prevent dismissal, even if they don’t stand up in discovery.  Dismissing these cases will be much easier if the “duty to disclose” is understood to mean “duty to disclose material information,” as the NVIDIA (and arguably Oran) court ruled.  That would require a disclosure duty in an omissions case to be founded in the substance of omitted material, and not just on a disclosure duty not founded in the importance to investors of the omitted information.  The practical effect of the two different rules could be enormous, since the issue is not which side will win at trial, or even summary judgment, but will the case survive to the point that a hefty settlement may be the preferred result for both sides.

It is important to remember, as the Supreme Court has done in past private actions under section 10(b), that the section 10(b) private right of action was judicially created, and for that reason is more amenable to judicial interpretation and refinement than statutory causes of action.  The Supreme Court has in the past, and likely will in the future, taken into account the policy implications of endorsing one approach or another in determining the precise parameters of the elements of private section 10(b) claims.  In doing this, the Court may also place some weight on obvious efforts by the SEC and Congress to limit exposure to private actions from the forward-looking disclosure requirements.  As a result, even if the Second Circuit’s disaggregation approach is arguably more sound from the standpoint of pure logic, the practical appeal of interpreting “duty to disclose” to include, at least implicitly, a materiality aspect could ultimately prevail.

Straight Arrow

January 19, 2015

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SEC v. Wyly: New Scheindlin Disgorgement Opinion Shows How SEC Remedy Has Gone Awry

On December 19, 2014, Judge Shira Scheindlin issued yet another opinion in SEC v. Wyly, addressing yet another SEC theory of disgorgement against the Wyly brothers.  The opinion is available here: SEC v Wyly Opinion on New SEC Disgorgement Theory.  It is unusual because it covers many pages ruling that a new disgorgement calculation proposed by the SEC is, for the most part, consistent with Second Circuit law, but then decides to disregard that approach because she believes her previous disgorgement calculation is more appropriate. The earlier disgorgement opinion can be seen here: SEC v Wyly September 25 Disgorgement Order.

The previous disgorgement analysis led to an order that the Wylys pay just short of $200 million plus prejudgment interest for the securities law violations found by the jury.  It was based on benefits directly flowing from the Wylys’ use of offshore trusts for their trading in securities of companies they controlled, those benefits being the avoidance of taxes they should have paid (according to the court) if they Wylys owned up to the fact that they controlled those offshore trusts for taxation purposes.  In an earlier post, I questioned the propriety of using a securities disgorgement award to cause the payment of taxes, especially when there is ongoing IRS consideration of that very same issue.  See here: Wyly Brothers Hit with More than $300 Million Securities Law Disgorgement Order for Unpaid Taxes.  The SEC’s new disgorgement theory called for an additional disgorgement (beyond the taxes avoided) of about $200 million plus prejudgment interest.

The newest opinion lays out an extensive review of the status of the law of the so-called disgorgement remedy.  The effective end point of this review is that courts have great discretion to decide what amounts to “disgorgement of ill gotten gains,” largely unencumbered by traditional considerations of causation.  Once Judge Scheindlin establishes that the only standard guiding this process is that there must be a “reasonable” basis to find “but for” causation of a benefit, the sky is essentially the limit.

Based on this standard, the judge examines a new disgorgement calculation proposed by an SEC expert.  She conducted an extended hearing on this proposal, including testimony from the SEC expert and a defense expert.  In essence, the new approach put forward by the SEC was to calculate purported profits the Wyly brothers obtained from undisclosed stock trading activity greater than the profits that would have been realized by a hypothetical uninformed “buy and hold” investor.  The Wylys’ trading was never found to be unlawful, however. The violation of law that occurred was the failure to comply with disclosure requirements under SEC Rule 13D by not filing Schedules 13D for securities held by offshore trusts that the jury found they controlled.  The SEC’s theory was that the 13D violations enabled the Wylys to do their trades secretly, which allowed them to garner more profits than the hypothetical “buy and hold” investor.  This, the SEC argued, was sufficient to satisfy the meager “but for” causation requirement render the gains “ill gotten,” and justify a disgorgement of those profits, which would not have been obtained “but for” the 13D violations.

You can read the opinion to see how Judge Scheindlin handles this novel theory.  It was novel both as a disgorgement theory and as a matter of expert testimony – it was acknowledged by the SEC’s expert that her calculation had never been accepted in the field of economics or econometrics.  It was unsupported by any generally-accepted form of economic or statistical analysis for determining excess stock profits. The judge nevertheless found that what the expert did was “reasonable” and, therefore, under Second Circuit law, agreed it could form the basis for a disgorgement calculation under a “but for” causation theory.  She rejected a portion of the analysis, but otherwise accepted the approach as a valid disgorgement calculation under Second Circuit law.

Judge Scheindlin then took an unusual step: she decided not to issue an order following that approach, saying she was “confident that the remedy already imposed” in her earlier September 25, 2014 disgorgement order (see here) was “the best measure of the Wylys’ ill-gotten gains.”  Slip op. at 56.  She accepted the alternative calculation “only in the event that a higher court disagrees with the measure of disgorgement calculated in the September 25 Order.”  Id.  In other words, she appears to be saying to the Second Circuit: “accept this if you want to under the law you have laid out in other cases, but I don’t think it really think it is a just and fair result as an order of disgorgement in this case.”

Judge Scheindlin was right to reject the proposal as an inappropriate “disgorgement” of ill-gotten gains by the Wylys.  Without saying so, she seems to have — properly in my view – balked at the application of the “but for” concept to deprive a violator of profits with only an attenuated relationship to the violations of law found by the jury.

“But for” causation is essentially a meaningless concept in the context of awarding a remedy because it is almost infinitely flexible, making it a standardless standard.  One need not have attended law school and studied the concept of proximate causation to understand that “but for” arguments can launch absurd chains of causation that are purposeless other than for metaphysical ruminations.  Without some directness requirement, one can spin a “reasonable” theory of “but for” causation that borders on the absurd.  If someone intentionally breaks the speed limit to get to a Seven-Eleven before the deadline for buying a lottery ticket, and buys a ticket that wins a $500 million prize, is the $500 million an “ill-gotten gain,” making disgorgement of the $500 million for speeding an appropriate remedy?  Of course not (even if the violator intentionally violated the speed limit with this purpose in mind).  There is no real nexus between winning the lottery — a random event — and the speeding violation, even though there plainly is “but for” causation.

For disgorgement to serve as a reasonable form of “remedial” relief in law enforcement actions, there must be a limiting theory on the concept of “ill gotten gain” beyond the non-standard of “but for” causation.  Without some form of directness analysis – some way of tying the profits obtained to the substance of the violation found – the disgorgement remedy is so amorphous that it will, in many cases, swamp the formal remedies prescribed for these violations (i.e., schedules of penalties adopted by Congress), yielding equitable relief that truly shocks the conscience, as I believe it did for Judge Scheindlin.

Straight Arrow

December 25, 2014

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SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5

On December 15, 2014, in a far-reaching opinion arguably extending well beyond what was required to decide the case, three of the five Commissioners of the SEC adopted extensive arguments for a broad reading of Rule 10b-5 and section 17(a) in the enforcement proceeding In re Flannery and Hopkins, File No. 3-14081.  A copy of the majority opinion can be read here: In re Flannery Majority Opinion.  Two Commissioners dissented, but no dissenting opinion was published as of December 18.

This is an extraordinary document.  It attempts to preempt judicial development of the scope of several aspects of the securities laws by interceding and applying “agency expertise” to interpret those laws and regulations extremely broadly.  On multiple occasions, these commissioners invoke the purported policy need to maintain as broad and malleable set of governing laws as possible to allow the Commission to address fraudulent conduct in whatever form it may appear.  The policy need to provide certainty to people about what their legal exposures are is not mentioned.

The opinion ranges far and wide in discussing the scope of SEC Rule 10b-5 and section 17(a).  It is difficult to summarize.  But essentially, these commissioners rule that Rule 10b-5(a) prohibits almost any form of participation in deceptive conduct relating to securities as long as a person participates in some form of deceptive act.  Although it does not say so outright, it represents an unveiled attempt to negate the Supreme Court decision in Janus Capital Group v. First Derivative Traders, 131 S. Ct. 2296 (2011).

There is much too much here to cover in a single blog piece.  The opinion will require multiple reads to understand the many ways in which the three commissioners use this relatively minor case to try to revise the law, essentially by fiat.  Some would say that taking such substantial steps to revise and expand the scope of a key regulation, and to interpret a key statutory provision, should occur only after a robust notice and comment process.  Instead, what we have is a questionable act of policy-making by a divided Commission with no public input.

The case had been tried to an administrative law judge, who ruled in the initial decision that Flannery and Hopkins did not violate section 17(a) of the Securities Act of 1933, section 10(b) of the Securities Exchange Act of 1934, or SEC Rule 10b-5.  The Commission majority ruled otherwise, finding both Flannery and Hopkins liable for violations of some provisions, but also rejecting the Division of Enforcement’s appeal in other respects.

The case involved communications by Flannery and Hopkins with investors about the Limited Duration Bond Fund of State Street Bank and Trust Co. (“LDBF”).  LDBF was heavily invested in asset-backed securities, including residential mortgage-backed securities (“RMBS”), and by 2006-2007, its holdings became increasingly concentrated in subprime RMBS.  The claim asserted that in various communications with investors, the respondents provided misleading information about the extent of subprime RMBS holdings and the risk profile of the fund.

The Commission majority used this case as a vehicle to present its position on the proper scope of liability under Rule 10b-5 and section 17(a) following the Supreme Court’s decision in Janus.  In that case, the Court held that SEC Rule 10b-5(b)’s prohibition against “mak[ing] any untrue statement of a material fact” created liability only for persons with “ultimate authority” over the alleged false statement.  People who assist in the preparation of such statements do not “make” them, and therefore are not liable under that language of the Rule.

Since Janus, the courts have hotly debated the scope of liability under other provisions of Rule 10b-5 that do not prohibit only “making” a misrepresentation.  Rule 10b-5(a) prohibits the use  of a “device, scheme, or artifice to defraud,” and Rule 10b-5(c) prohibits an “act, practice, or course of business which operates or would operate as a fraud or deceit,” each in connection with a purchase or sale of securities.  Following Janus, SEC enforcement lawyers often took the position that people not liable under Rule 10b-5(b) under the Janus ruling nevertheless had so-called “scheme liability” under subparts (a) and (c) of Rule 10b-5 because they either used a “device” or “scheme” to pursue a fraud, or used acts that “operated” as a fraud, even if they did not make misrepresentations.  These arguments often were resisted because they tended to “prove too much” by creating “primary” liability under Rule 10b-5 for people who did no more than “assist” fraudulent conduct by others.  That distinction is important because part of the rationale of the Janus Court was that the broad application of Rule 10b-5 to create primary liability for people who were essentially aiders and abettors conflicted with the Supreme Court’s decision in Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164 (1994), which held that Rule 10b–5’s private right of action did not include suits against aiders and abettors.  That case ruled that actions “against entities that contribute ‘substantial assistance’ to the making of a statement but do not actually make it” may be brought by the SEC, but not by private parties.  The Janus opinion noted:If persons or entities without control over the content of a statement could be considered primary violators who ‘made’ the statement, then aiders and abettors would be almost nonexistent.”  The Janus decision was plainly motivated in part by the importance of retaining a distinction between primary and secondary violators because the first are subject to private 10b-5 actions and the second are not under Central Bank.  This is reflected in the following passage in footnote 6: “[F]or Central Bank to have any meaning, there must be some distinction between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits).  We draw a clean line between the two—the maker is the person or entity with ultimate authority over a statement and others are not.”

The Commission majority in Flannery emasculates Janus with the simple view that the Janus Court was expressly addressing only Rule 10b-5(b), which includes the “making” language, but made no determinations about Rule 10b-5(a) or (c), which does not have the same language.  In an extraordinary act of administrative legerdemain, the three commissioners negate Janus by ruling first, that its analysis does not apply outside of Ryle 10b-5(b), and second, that Rule 10b5(a) is so broad that it covers everything covered in Rule 10b5(b) plus other forms of deceptive conduct in connection with the purchase or sale of securities that are excluded from Rule 10b-5(b).  With apologies for the length of the quoted material, here is some of what the three commissioners say about Rule 10b-5:

The Supreme Court’s recent decision in Janus Capital Group v. First Derivative Traders resolved some of the differences among the lower courts, as it clarified—and limited—the scope of liability under Rule 10b-5(b).  The decision was silent, however, as to Rule 10b-5(a) and (c) and Section 17(a), creating confusion in the lower courts as to whether its limitations apply to those provisions, as well.  Moreover, Janus’s narrowing of liability under Rule 10b-5(b) has shifted attention to Rule 10b-5(a) and (c), as well as Section 17(a), making the lower courts’ divergence of views on the scope of those provisions especially evident.  We appreciate the challenges lower courts have faced, and we recognize the ambiguity in Section 10(b), Rule 10b-5, and Section 17(a).  Further, we note that, to date, Commission opinions have provided relatively little interpretive guidance regarding the meaning and interrelationship of these provisions.  By setting out our interpretation of these provisions—which is informed by our experience and expertise in administering the securities laws—we intend to resolve the ambiguities in the meaning of Rule 10b-5 and Section 17(a) that have produced confusion in the courts and inconsistencies across jurisdictions. . . .

In Janus, the Supreme Court interpreted Rule 10b-5(b)’s prohibition against “mak[ing] any untrue statement of a material fact.”  After concluding that liability could extend only to those with “ultimate authority” over an alleged false statement, the Court held that an investment adviser who drafted misstatements that were later included in a separate mutual fund’s prospectus could not be held liable under Rule 10b-5(b).  The adviser could not be said to have “made” the misstatements, the Court reasoned. . . .

Unlike Rule 10b-5(b), Rule 10b-5(a) and (c) do not address only fraudulent misstatements.  Rule 10b-5(a) prohibits the use of “any device, scheme, or artifice to defraud,” while Rule 10b-5(c) prohibits “engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit.”  The very terms of the provisions “provide a broad linguistic frame within which a large number of practices may fit.”  We have explained that Rule 10b-5 is “designed to encompass the infinite variety of devices that are alien to the climate of fair dealing . . . that Congress sought to create and maintain.” . . .

 [W]e conclude that primary liability under Rule 10b-5(a) and (c) extends to one who (with scienter, and in connection with the purchase or sale of securities) employs any manipulative or deceptive device or engages in any manipulative or deceptive act. . . .   In particular, we conclude that primary liability under Rule 10b-5(a) and (c) also encompasses the “making” of a fraudulent misstatement to investors, as well as the drafting or devising of such a misstatement.  Such conduct, in our view, plainly constitutes employment of a deceptive “device” or “act.” . . .  We note that, contrary to what some district courts have suggested, Janus does not require a different result. In Janus, the Court construed only the term “make” in Rule 10b-5(b), which does not appear in subsections (a) and (c); the decision did not even mention, let alone construe, the broader text of those provisions. And the Court never suggested that because the “maker” of a false statement is primarily liable under subsection (b), he cannot also be liable under  subsections (a) and (c).  Nor did the Court indicate that a defendant’s failure to “make” a misstatement for purposes of subsection (b) precludes primary liability under the other provisions. . . .

The [Janus] Court began its analysis with a textual basis for its holding, concluding that one who merely “prepares” a statement necessarily is not its “maker,” just as a mere speechwriter lacks “ultimate authority” over the contents of a speech.  Our approach does not conflict with that logic: Accepting that a drafter is not primarily liable for “making” a misstatement under Rule 10b-5(b), our position is that the drafter would be primarily liable under subsections (a) and (c) for employing a deceptive “device” and engaging in a deceptive “act.”

 Our approach is also consistent with the Court’s second justification for its holding—that a drafter’s conduct is too remote to satisfy the element of reliance in private actions arising under Rule 10b-5.  Investors, the Court explained, cannot be said to have relied on “undisclosed act[s],” such as merely drafting a misstatement, that “preced[e] the decision of an independent entity to make a public statement.”  Again, our analysis fully comports with that logic.  Indeed, we do not suggest that the outcome in Janus itself might have been different if only the plaintiffs’ claims had arisen under Rule 10b-5(a) or (c).  As Janus recognizes, those plaintiffs may not have been able to show reliance on the drafters’ conduct, regardless of the subsection of Rule 10b-5 alleged to have been violated.  Thus, our interpretation would not expand the “narrow scope” the Supreme Court “give[s to] the implied private right of action.”  But to say that a claim will not succeed in every case is not to say that there is no claim at all.  In contrast to private parties, the Commission need not show reliance as an element of its claims.  Thus, even if Janus precludes private actions against those who commit “undisclosed” deceptive acts, it does not preclude Commission enforcement actions under Rule 10b-5(a) and (c) against those same individuals. . . .

Several courts have adopted [an] approach . . . effectively holding that any misstatement-related conduct is exclusively the province of subsection (b).  For multiple reasons, we disagree with those decisions. . . .  [W]e understand their approach to have arisen from a misunderstanding of the Supreme Court’s decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver.  In Central Bank, the Court explained that only defendants who themselves employ a manipulative or deceptive device or make a material misstatement may be primarily liable under Rule 10b-5; others are, at most, secondarily liable as aiders and abettors.  Lower courts appropriately read Central Bank to require that, in cases involving fraudulent misstatements, defendants could not be primarily liable under Rule 10b-5(a) or (c) merely for having “assisted” an alleged scheme to make a fraudulent misstatement.  But they then began to articulate this “more-than-mere-assistance” standard imprecisely, stating that primary liability under Rule 10b-5(a) and (c) must require proof of particular deceptive conduct “beyond” the alleged misstatements.  We cannot agree with this construction of our rule, particularly given how far removed it is from its origins in Central Bank.  And Central Bank itself certainly does not hold that primary liability under Rule 10b-5(a) and (c) turns on whether a defendant’s conduct is “beyond” a misstatement.  Moreover, we note that Janus also does not independently justify such a test.   As discussed, Janus does not address Rule 10b-5(a) or (c), let alone suggest that primary liability under those provisions is limited to deceptive acts “beyond” misstatements.  Indeed, reading Janus to require such an approach would be inconsistent with the decision’s own emphasis on adhering to the text of the rule.

Slip op. at 14-21.

No doubt about it, this is a slap in the face of the Supreme Court — an assertion that the Supreme Court should get its hands off of SEC regulatory matters and let the SEC decide what is and is not unlawful under the securities laws.  To be sure, Rule 10b-5 is an agency rule, not a statute, and the SEC should be able to interpret and apply its rules.  But Rule 10b-5 was adopted by the SEC in 1942 without anything approaching the consideration and parsing done by the three commissioners in Flannery.  It was originally approved without debate or comment, and it is reported that the full extent of consideration was Commissioner Sumner Pike’s comment: “Well, we are against fraud aren’t we?”  The creation of new agency positions on the meaning and scope of this rule without any rulemaking or public comment process, with the specific design to trump the Supreme Court, is risky business indeed.

The regulatory reason for biting off this issue remains less than clear.  Very little about what was said actually alters what the SEC can do in the way of enforcement actions.  That is because, as noted in the Central Bank decision, the SEC already has acknowledged enforcement authority to bring actions for secondary liability against aiders and abettors.  It doesn’t matter whether someone is sued by the SEC as an aider and abettor of a primary violation of Rule 10b-5(b) or a primary violator of Rule 10b5(a) (as the commissioners now hold can be done in many cases).  Either way, the SEC can pursue its enforcement goals.  The only material difference that would be caused by this new view of the scope of Rule 10b-5(a) and (c) is that it creates a new group of persons with primary liability who can be subjected to private securities actions.  Private securities plaintiffs have no cause of action against aiders and abettors, but they can sue primary violators using the implied section 10(b) private cause of action.  That difference was a significant aspect of the Central Bank decision, and was noted in the Janus decision as well.  Why are the SEC commissioners so keen on expanding the scope of liability in private actions?  We don’t know because that consideration wasn’t even mentioned in Flannery.

Much will be written about Flannery.  It certainly will go up on appeal, and if it stands there is a more than fair chance that the Supreme Court will consider it.  A majority of three commissioners is committed to providing the Commission and the Division of Enforcement maximum flexibility in attacking any conduct they choose to categorize as deceptive or fraudulent.  They believe the Nation should put its trust in the ability of SEC commissioners and enforcement lawyers and bureaucrats to decide what may and may not be done in the securities marketplace with as few restrictive parameters as possible.  Count me as dubious.

Straight Arrow

December 19, 2014

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US v. Newman: 2d Circuit Hands Government Stunning, Decisive, and Far-Reaching Insider Trading Defeat

Today (December 10, 2014), the Second Circuit court of appeals delivered a stunning rejection of Government insider trading theories in United States v. Newman and Chiasson, Nos. 13-1837, 13-1917 (“Newman”).  Coming from an appellate court traditionally receptive to government efforts to extend the scope of insider trading liability, this decision may have a major impact on insider trading enforcement, criminal and civil.

The court not only rejected the theory of violation reflected in government-proposed jury instructions accepted by district court judge Richard Sullivan, it took the highly unusual step of determining that no evidence could support a conviction of Newman and Chiasson, and vacated the indictment with prejudice.  In doing so, the court gave the government insider trading law enforcement entities – the Department of Justice and Securities and Exchange Commission – an impetus to reconsider their entire mindset on insider trading.  You can read a copy of the opinion here: U.S. v. Newman and Chiasson.

The case involved the use by hedge funds of analysts who are hired to scour all sources of business information to generate non-public sources of expected company performance, and feed that information to stock traders who invest in portfolios for their hedge funds.  Todd Newman was a portfolio manager for Diamondback Capital Management, and Anthony Chiasson was one for Level Global Investors.  Both funds are now defunct – they were forced to close because of the impact of the government’s insider trading investigation and charges (which now prove unfounded).

Todd Newman and Anthony Chiasson (Courtesy NY Times)

Todd Newman and Anthony Chiasson

The indictment charged that a group of these analysts from several hedge funds communicated with each other and shared tips.  Among the information they shared were earnings predictions emanating from tech companies Dell and Nvidia.  The analysts did not know what motivated the insiders at those companies to provide this information.  Neither of the insiders ultimately identified by the government as the sources of this information were prosecuted, criminally or civilly.  The government went after the analysts and gave them deals as government witnesses to assist in the prosecution of the portfolio managers to whom they passed on these tips.

The government’s prosecution was driven by the same overall theory it has pursued in many criminal and civil cases for many years – that people who trade stock in possession of material non-public information, and who have strong grounds to know they have material non-public information, commit insider trading offenses in violation of section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 issued thereunder.  The Supreme Court rejected this concept twice, in Chiarella v. United States, 445 U.S. 222 (1980), and then again in Dirks v. SEC, 463 U.S. 646 (1983).  But government lawyers persisted in the view that the rulings handed down in Chiarella and Dirks left enough leeway to allow them to stretch the scope of insider trading violations beyond the limits apparently imposed by those decisions.  See our earlier post entitled: “SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.”

In the past, the Second Circuit’s loose language in some cases suggested it was willing to accept extensions of the law beyond the strict language of Chiarella and Dirks.  But in Newman, the Second Circuit obliterates that view of their cases.  The panel provided an exceptionally clear statement of its holding and rejection of attempts to find support for the government case in earlier Second Circuit decisions.  Even more important, it explained that the government’s preferred approach – to bar trading by persons with material non-public information as part of an overall concept of parity of information for all stock traders – had been rejected by Chiarella and Dirks and was inconsistent with how the financial markets are supposed to work.

The Court’s Description of Current Law

The court briefly explained the current status of insider trading law as set forth in what are known as the “classical” and “misappropriation” theories.  “The classical theory holds that a corporate insider (such as an officer or director) violates Section 10(b) and Rule 10b‐5 by trading in the corporation’s securities on the basis of material, nonpublic information about the corporation.”  That is because “there is a special ‘relationship of trust and confidence between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position within that corporation.’”  This relationship means insiders have “‘a duty to disclose [or to abstain from trading] because of the ‘necessity of preventing a corporate insider from . . . tak[ing] unfair advantage of . . . uninformed . . . stockholders.’”  Slip op. at 9-10 (quoting Chiarella).

The court emphasized, however, that “the Supreme Court explicitly rejected the notion of ‘a general duty between all participants in market transactions to forgo actions based on material, nonpublic information,’” and instead “limited the scope of insider trading liability to situations where the insider had ‘a duty to disclose arising from a relationship of trust and confidence between parties to a transaction,’ such as that between corporate officers and shareholders.”  Id. at 10 (quoting Chiarella).

The “misappropriation theory” of insider trading liability “expands the scope of insider trading liability to certain other ‘outsiders,’ who do not have any fiduciary or other relationship to a corporation or its shareholders.  Liability may attach where an ‘outsider’ possesses material non‐public information about a corporation and another person uses that information to trade in breach of a duty owed to the owner. . . .  In other words, such conduct violates Section 10(b) because the misappropriator engages in deception by pretending ‘loyalty to the principal while secretly converting the principal’s information for personal gain.’” Id. (quoting and citing United States v. O’Hagan, 521 U.S. 642 (1997), and SEC v. Obus, 693 F.2d 276, 285-86 (2d Cir. 2012)).

Finally, the court explained that the liability of “tippees,” who obtain information from others is governed by the same elements, regardless of whether the “tipper’s” duty arises from the classical or misappropriation theory.  The key case on this is Dirks, under which, the Newman court noted: “The test for determining whether the corporate insider has breached his fiduciary duty ‘is whether the insider personally will benefit, directly or indirectly, from his disclosure.  Absent some personal gain, there has been no breach of duty. . . .” Slip op. at 11 (quoting Dirks, 463 U.S. at 662, with added emphasis).  Moreover, the Dirks Court “rejected the SEC’s theory that a recipient of confidential information (i.e. the ‘tippee’) must refrain from trading ‘whenever he receives inside information from an insider.’”  Id. (quoting Dirks, 463 U.S. at 655).  Instead, the Dirks Court held “that ‘[t]he tippee’s duty to disclose or abstain is derivative from that of the insider’s duty.’”  Id. at 11-12 (quoting Dirks, 463 U.S. at 659).  “Because the tipper’s breach of fiduciary duty requires that he ‘personally will benefit, directly or indirectly, from his disclosure,’. . . a tippee may not be held liable in the absence of such benefit.”  Id. at 12 (quoting Dirks, 463 U.S. at 662).

The Court Takes the Government To Task for Ignoring Key Language in Dirks

The Newman court then went about explaining why the government’s case against Newman and Chiasson failed to satisfy the key requirements in Dirks.  It acknowledged that the Second Circuit had been “accused of being ‘somewhat Delphic’ in our discussion of what is required to demonstrate tippee liability,” but nevertheless, “the Supreme Court was quite clear in Dirks.”  Slip op. at 13.  In particular, tippee liability “derives only from the tipper’s breach of a fiduciary duty, not from trading on material, non-public information”  Id.  (This is critical, because the government’s refusal to accept this aspect of Chiarella and Dirks underlies many of the improper extensions of insider trading liability the DOJ and SEC pursue.)  And there is no insider breach of fiduciary duty “unless he receives a personal benefit in exchange for the disclosure.”  Id. at 13-14.  Finally, “even in the presence of a tipper’s breach, a tippee is liable only if he knows or should have known of the breach.”  Id.

The court then pounded this point again: “Dirks counsels us that the exchange of confidential information for personal benefit is not separate from an insider’s fiduciary breach; it is the fiduciary breach that triggers liability for securities fraud under Rule 10b‐5.  For purposes of insider trading liability, the insider’s disclosure of confidential information, standing alone, is not a breach.  Thus, without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.”  Id.  Then, in an unusual aside, the court noted that the government’s failure to accept this led to excessively “novel” insider trading prosecutions: “The Government’s overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.”  Id.

Perhaps the most telling portion of the opinion is the court’s explanation that the government’s “novel” insider trading prosecutions not only ignore Dirks, but they ignore the very foundation of financial markets.  Because this is where the court puts the barrel of the bat on the ball, we quote the entire paragraph here:

In light of Dirks, we find no support for the Government’s contention that knowledge of a breach of the duty of confidentiality without knowledge of the personal benefit is sufficient to impose criminal liability.  Although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.  The Supreme Court explicitly repudiated this premise not only in Dirks, but in a predecessor case, Chiarella v. United States.    In Chiarella, the Supreme Court rejected this Circuit’s conclusion that “the federal securities laws have created a system providing equal access to information necessary for reasoned and intelligent investment decisions . . . . because [material non‐public] information gives certain buyers or sellers an unfair advantage over less informed buyers and sellers.”  445 U.S. at 232.  The Supreme Court emphasized that “[t]his reasoning suffers from [a] defect. . . . [because] not every instance of financial unfairness constitutes fraudulent activity under § 10(b).”  IdSee also United States v. Chestman, 947 F.2d 551, 578 (2d Cir. 1991) (Winter, J., concurring) (“[The policy rationale [for prohibiting insider trading] stops well short of prohibiting all trading on material nonpublic information.  Efficient capital markets depend on the protection of property rights in information.  However, they also require that persons who acquire and act on information about companies be able to profit from the information they generate . . . .”).  Thus, in both Chiarella and Dirks, the Supreme Court affirmatively established that insider trading liability is based on breaches of fiduciary duty, not on informational asymmetries  This is a critical limitation on insider trading liability that protects a corporation’s interests in confidentiality while promoting efficiency in the nation’s securities markets.

Slip op. at 15-16 (emphasis added).

The court did not go on to explain why the Supreme Court made a breach of fiduciary duty the basis for insider trading liability, but that is apparent in the Chiarella and Dirks opinions.  Insider trading is a violation of federal law only to the extent it is prohibited by section 10(b) of the 1934 Act.  Because section 10(b) only prohibits fraudulent conduct, the mere trading with asymmetric information is not a violation because the trade is based on neither a misrepresentation to the counter-party, or an omission to disclose required information to the counter-party.  Only the existence and breach of a fiduciary duty between parties in connection with that trade establishes a fraud.  The fiduciary duty creates a duty of disclosure to the fiduciary that does not otherwise exist, and the breach of that duty constitutes fraud.  Justice White’s pithy comment way back in the Chiarella opinion applies no less now than it did then: “Section l0(b) is aptly described as a catch all provision, but what it catches must be fraud.  When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak. We hold that a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.”  Chiarella, 445 U.S. at 235 (emphasis added).  In short, the government (DOJ and SEC) has been fighting that admonition since 1980.  It is time to accept it and apply the law as decided by the Supreme Court.  (For more on these underlying insider trading issues, see our post: The Myth of Insider Trading Enforcement (Part I).)

The Coup de Gras: The Newman Court Rules There Is Insufficient Evidence To Convict

Appellate courts rarely decide on the appeal of a criminal conviction that a jury could not convict the defendant on the basis of the evidence presented.  As the Newman court acknowledged: “As a general matter, a defendant challenging the sufficiency of the evidence bears a heavy burden, as the standard of review is exceedingly deferential.”  Slip op. at 20.  But the evidence presented by the government that either the insiders leaking corporate information breached a fiduciary duty, or that the defendants knew that such a breach of duty occurred, was so meager that the court dismissed the entire case on the merits.  This is a huge and stunning blow, because it not only says the government got the law wrong, but that its entire view of what satisfies the required element of a “benefit” to the tipper in return for the tip is unacceptably distorted.

The government will argue almost anything satisfies the “benefit” requirement.  Nowadays, the government argues that almost any form of positive interaction between the tipper and the tippee satisfies the benefit requirement.  The Newman court rejects that view handily.  It notes that the government has taken permissive language finding a benefit may be more than just a pecuniary gain to an absurd logical conclusion: “This standard, although permissive, does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature.  If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity. To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades ‘resemble trading by the insider himself followed by a gift of the profits to the recipient,’ see 643 U.S. at 664, we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. . . .  While our case law at times emphasizes language from Dirks indicating that the tipper’s gain need not be immediately pecuniary, it does not erode the fundamental insight that, in order to form the basis for a fraudulent breach, the personal benefit received in exchange for confidential information must be of some consequence. ”  Slip op. at 21-22.

In one instance, the government contended that by receiving career advice from the tippee, the tipper satisfied the benefit requirement.  In the other, the government argued that the required benefit was shown because the tipper and tippee were “family friends” that met through church and socialized occasionally.  The court concluded with some apparent irony: “The Government argues that these facts were sufficient to prove that the tippers derived some benefit from the tip.  We disagree.  If this was a ‘benefit,’ practically anything would qualify.”  Slip op. at 21.

The court later reiterated: “The Government now invites us to conclude that the jury could have found that the appellants knew the insiders disclosed the information “for some personal reason rather than for no reason at all.”  Gov’t Br. 65.  But the Supreme Court affirmatively rejected the premise that a tipper who discloses confidential information necessarily does so to receive a personal benefit.”  Slip op. at 25.

This is a potentially far-reaching development.  The government, and in particular the SEC, commonly treats the “benefit” requirement as de minimis in tippee cases.  For example, in the recently filed case SEC v. Peixoto, in which the respondent Peixoto is alleged to be a second-level tippee (having allegedly obtained information from a tippee who was the roommate of a hedge fund analyst who had mentioned some non-public hedge fund activities), the only allegation bearing on “benefit” to the alleged tipper was that he and the tippee “were very close friends who had grown up together in Poland.  From 2008 to April 2013, they shared an apartment as roommates in New York, New York.”  The supposed benefit flowing to the roommate from Peixoto was that he “received a personal benefit by gifting confidential information to his friend, Peixoto.”  That is precisely the sort of “benefit” rejected as insufficient in Newman.

                                                           *                      *                      *

In short, the Newman decision strikes a major blow against government attempts to pursue attenuated insider trading theories.  Insider trading must involve fraud in the traditional, common law sense.  Coming from the influential Second Circuit, the impact of this decision could be huge.  Unfortunately, it comes too late to save the Diamondback and Level Global hedge funds, who were effectively put out of business for doing nothing wrong, or their hundreds of employees.

Straight Arrow

December 10, 2014

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Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit

It’s not often that securities litigators get to breathe the rarefied air of constitutional law, but there are some challenging constitutional issues now being raised in opposition to the SEC’s use of administrative proceedings for its civil enforcement proceedings.

A range of such issues could be raised, some of them not limited to the administrative proceedings themselves.  They derive from the SEC’s peculiar (at least constitutionally) combination of authorities, powers, and responsibilities under the statutory framework created in the Securities Exchange Act of 1934.

In particular, the constitutionality of the administrative proceedings presided over by SEC administrative law judges has been challenged in two recent district court filings in Peixoto v. SEC and Stilwell v. SEC.  Those cases argue the administrative law judges cannot properly preside over such proceedings because they are officers of the United States who are not subject to removal at will by either the President or an appointee of the President, in violation of Article II of the Constitution.  Se our earlier discussion of these allegations here.  The complaints filed in those cases can be found here (Peixoto v SEC) and here (Stilwell v SEC).  Issues of due process were raised in Wing  Wing Chau v. SEC).  And there remains a distant cloud over much of the prosecutorial power of the SEC itself because its commissioners do not answer to the President when they exercise such powers.

A Little History Will Get Us Started

Although the first so-called independent agency was created before the turn of the 20th century when the Interstate Commerce Commission was established, the enormous growth of the so-called “Fourth Branch” came in the 1930s, when the Roosevelt Administration undertook a fundamental restructuring of the national government, based on a growing legal movement arguing that government affairs had grown too complex and specialized to be run by the purely political executive branch.  Complex commercial and financial activities, it was said, require the oversight of specialists in the field, who can apply expertise that normal executive department appointees, who come and go, cannot develop.  Brilliant legal minds like Felix Frankfurter developed jurisprudential theories justifying the need for, and propriety of, these administrative entities under our legal traditions.  Generations of lawyers have since been trained to accept this model as an enlightened approach to governance of the complex industrial state.

Frankfurter was a progenitor of the administrative state.  He was certain that the only viable means of governing a complex modern industrial state was to create government bureaus composed of experts who could apply neutral, scientific principles to guide commerce in the right direction.  He wrote in 1932:

Governmental regulation of banking, insurance, public utilities, industry, finance, immigration, the professions, health and morals, in short, the inevitable response of government to the needs of modern society, is building up a body of enactments not written by legislatures and of adjudications not made by courts, and only to a limited degree subject to their revisions.  These powers are lodged in vast congeries of agencies.  We are in the midst of a process, still largely unconscious and unscientific, of adjusting the play of these powers to the traditional system of Anglo-American law and courts.

Frankfurter and Davison, Cases and Other Materials on Administrative Law (1932), at vii.

So began the modern administrative state.  Multiple administrative agencies were created to develop rules governing commercial and financial activities, and to oversee compliance with those rules.  The FTC was created in 1914 to promote competition amidst great concern about trusts and monopolies, but it also was involved in efforts to try to deal with sharp practices in the sale of securities.  A focus on securities practices during the 1932 campaign led to the early proposal of a securities act, which became the Securities Act of 1933.  For a year, it was the FTC that had responsibility for overseeing that statute.  In 1934, the SEC was created in the Securities Exchange Act of 1934.  (Interestingly, some questioned the constitutionality of giving an independent agency the powers granted to the SEC, suggesting instead in earlier legislative proposals that they be given to the U.S. Post Office, based on the notion that the use of the postal service was key to securities transactions.)  Felix Frankfurter, who was thought by Roosevelt to be perhaps the greatest legal mind of his time, was a key architect of that statute.

Frankfurter brought with him some key protégés, not the least of which was James Landis, who eventually served on the FTC and as Chairman of the SEC from 1935 to 1937.  Landis is most renowned for his encomium to administrative agencies in the book The Administrative Process (1938).  In that book, Landis argued that the Nation desperately needed a “Fourth Branch” because of “the inadequacy of a simple tripartite form of government to deal with modern problems.”  Like Frankfurter, he believed that because complexities of modern commerce, “the need for expertness became dominant.”  In his view, legislation should only identify the scope of subject matter for an agency and the issues it should address, and then stand aside and allow administrative experts to apply broad discretion to those matters.  Landis and another Frankfurter acolyte, Benjamin Cohen, created the first draft of the Securities Act of 1933.

Felix Frankfurter

Frankfurter signature

James Landis 1936Benjamin V. Cohen

                James Landis                                                                                Benjamin Cohen

Even as the governmental alphabet soup burgeoned with the establishment of the SEC, FCC and other agencies, it was apparent that the precise constitutional nature of these entities was not clear.  They were touted as the best means of regulating business activity because they were supposedly “non-political,” applying expertise to set an enlightened path to guide and develop commerce.  To promote that theoretical aim, and because they were to set rules for and govern vast portions of United States commerce, these agencies were designed not to be a captive of, or to answer to, the “political” branches – the President and the Congress.

The SEC itself was created in the Securities Exchange Act of 1934.  There was a legislative battle over whether the securities regulator would be the FTC or a new commission created specifically to oversee the securities exchanges.  Roosevelt preferred FTC oversight, but a separate SEC won the day largely because of fear that the FTC would overregulate the securities industry.  Like the FTC, the SEC was conceived as an “independent agency,” with five commissioners that were Presidential appointees subject to Senate approval.  A maximum of three commissioners could be members of the same party.  It was intended by its creators to populate the growing “Fourth Branch.”

Like the FTC, and unlike an executive department, the President was not given the power to remove a commissioner.  In fact, although the Federal Trade Commission Act gave the President power to remove FTC commissioners for “inefficiency, neglect of duty, or malfeasance in office” (i.e., not “at will”), the Securities Exchange Act had no provision addressing removal of commissioners.  It has since remained unclear what power the President may have to remove SEC commissioners, although it is usually assumed that he may do so only “for cause,” i.e., like the FTC, for “inefficiency, neglect of duty, or malfeasance in office.”  The only time the Supreme Court addressed that issue, it accepted a stipulation by the parties that SEC commissioners “cannot themselves be removed by the President except [for] “inefficiency, neglect of duty, or malfeasance in office,” and “decide[d] the case with that understanding.”  Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477, 487 (2010) (“Free Enterprise Fund”).

The Problem

The constitutional problems created by some powers and authorities exercised by the SEC arise out of the Commission’s intended independence of the Executive Branch.  As discussed above, there is no doubt that independence was intended.  The ability to act independently of both the Executive and Legislative Branches was the sine qua non of Frankfurter and his disciples because that was the only way to create the hypothesized “experts” that would provide reasoned, non-political, direction to the Nation’s complex financial and commercial activity.  James Landis’s The Administrative Process left no doubt that the intention of the creators of “independent agencies” was indeed to make them independent of the branches of government designated in the Constitution.  Here are his words:

The reasons for favoring [the independent, regulatory administrative agency] seem simple enough – a desire to have the fashioning of industrial policy removed to a degree from political influence.  At the same time, there seems to have been a hope that the independent agency would make for more professionalism than that which characterized the normal executive department.  Policies would thus be more permanent and could be fashioned with greater foresight than might attend their shaping under conditions where the dominance of executive power was pronounced.  Again, the idea of the independent Commission seems naturally to have evolved from the very concept of administrative power.  That power embraces functions exercisable by all three branches of government.  To have taken these functions and to have placed them in the hands of any one of the three branches of government would have seemed incongruous.  The natural solution was to place them beyond the immediate control of any one of the three branches, yet subject to checks by each of them.

Landis, The Administrative Process (1966 ed.), at 111.  Landis goes on to note that independence allowed agencies “to have achieved a degree of permanence and consistency that they might not have possessed had their formulation been too closely identified with the varying tempers of changing administrations,” and “professionalism in the nonindependent agencies has suffered on occasion at the hands of political superiors.”  Id. at 113-14.

But the traditional “separation of powers” among the three branches of government recognized in Articles I-III of the Constitution – Legislative, Executive, and Judicial – could not easily accommodate this new conception; recall that Landis argued the administrative agencies were needed to cure “the inadequacy of a simple tripartite form of government to deal with modern problems.”  Id. at 1.  Ever since 1935, the Supreme Court has had great difficulty articulating how to accommodate the Constitution’s framework with various forms of creative governing mechanisms that fall outside of Articles I, II or III.

In a nutshell, the SEC’s constitutional challenges are: (1) to remain consistent with Article II’s statement of Executive powers and responsibilities while pursuing law enforcement activities that by all appearances are Executive functions, i.e., “executing” those laws placed by Congress within its (and not the Executive’s) jurisdiction; and (2) to adjudicate law enforcement proceedings internally while still complying with judicial concepts of due process and fundamental fairness.

The constitutional quagmires that the SEC’s “Fourth Branch” status raise can come in multiple forms.  They range from the question of how the insulation of SEC Commissioners from Presidential control (because they are not removable “at will”) may affect the SEC’s ability to appoint some officials who operate under its aegis, or to function as a powerful vehicle for enforcing a wide range of laws of the United States, to the question of how the SEC can function simultaneously as the enforcer of those laws and the adjudicator of the enforcement actions it decides to bring while still affording due process to those it prosecutes.

The issue currently at the top of the heap is how the SEC’s establishment as an independent agency impacts its ability to operate administrative courts with judges not subject to the control of the President, and we turn to that now.

The Constitutional Issue Raised About the SEC’s Administrative Law Courts

The current constitutional challenges to SEC proceedings flow from the SEC’s increased use of its administrative law courts to hear major law enforcement proceedings.  Although the constitutional issues discussed below might also apply to SEC administrative proceedings of a more traditional type (involving alleged violations of law by SEC-regulated entities), the intrusion on purely executive functions seems most clear when the “executive” action occurring is a prosecution for violation of the law by persons not otherwise subject to SEC regulation.

Stilwell v. SEC and Peixoto v. SEC involve challenges to the constitutionality of threatened and filed proceedings in the SEC’s administrative law court.  In these cases, the plaintiffs seek declaratory relief that their administrative proceedings would violate Article II of the Constitution because the officials administering those proceedings – SEC administrative law judges – are “officers” of the United States and therefore must be reasonably subject to Executive control under Article II.  Plaintiffs argue (i) the SEC ALJs are “officers” of the United States in the constitutional sense; (ii) the ALJs may be removed from their jobs only “for cause” by the SEC; and (iii) the SEC commissioners can be removed by the President only “for cause.”  This arrangement, it is alleged, so diminishes the President’s ability to control the conduct of executive officers that it violates Article II.

The Constitution

Particularly relevant to this issue are the following provisions of the Constitution:

Article  II, Section 1 vests “The executive Power” “in a President of the United States of America.”

Article II, Section 2, in delineating aspects of the “executive Power,” states that the President “shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Court of Law, or in the Heads of Departments.”

Article II, Section 3 states that the Presidentshall take Care that the Laws be faithfully executed, and shall Commission all the Officers of the United States.”

The Defense Argument

The validity of the defense argument turns on whether the SEC ALJs are “Officers” or “inferior Officers” of the United States, and, if so, whether the President’s inability to remove them “at will,” or reasonably cause someone else to remove them “at will,” impedes his ability to “take Care that the Laws be faithfully executed.”

Free Enterprise Fund  is the Supreme Court precedent most central to this argument.  In that case, the Court considered a constitutionality challenge to the law enforcement powers of the Public Company Accounting Oversight Board (“PCAOB”).  The PCAOB was created in the Sarbanes Oxley Act of 2002 as a government organization with powers to adopt and enforce rules governing the public accounting profession, under the oversight of the SEC.  Its five Board Members are appointed by the SEC.  They are not government employees for statutory purposes, but they were acknowledged by all parties to be “Officers of the United States” who exercised “significant authority pursuant to the laws of the United States.”  561 U.S. at 485-86.  They are removable by a formal order of the SEC only “for good cause shown,” subject to judicial review.  Id. at 486.  As noted above, the parties in the case also stipulated that the SEC Commissioners were removable by the President only for “inefficiency, neglect of duty, or malfeasance in office.”  Id.  at 487.  The case presented the question whether the layering of “for cause” removal restrictions – limiting the President as to “a principal officer” (the SEC Commissioners) “who is in turn restricted in his ability to remove an inferior officer (the PCAOB Members) – is permissible “even though that inferior officer determines the policy and enforces the laws of the United States.”  Id. at 483-84.

The Court found that the appointments of the PCAOB Members did not violate the Appointments Clause because the SEC is a “Department” within the meaning of that clause, noting that “the common, near-contemporary definition of a ‘department’ as a ‘separate allotment or part of business; a distinct province, in which a class of duties are allotted to a particular person’ is consistent with that result even thought the SEC was created as an independent agency.  Id. at 511.  As a result: “Because the Commission is a freestanding component of the Executive Branch, not subordinate to or contained within any other such component, it constitutes a “Departmen[t]” for the purposes of the Appointments Clause.”

But the Court nevertheless concluded that the PCAOB violated Article II because its members were too insulated from presidential control to allow the President to perform his required executive functions: “We hold that such multilevel protection from removal is contrary to Article II’s vesting of the executive power in the President.  The President cannot “take Care that the Laws be faithfully executed” if he cannot oversee the faithfulness of the officers who execute them.  Here, the President cannot remove an officer who enjoys more than one level of good-cause protection, even if the President determines that the officer is neglecting his duties or discharging them improperly.”  Id. at 484.

That raises questions about the SEC’s ALJs.  Under the Administrative Procedure Act, the SEC is responsible for the appointment of the ALJs that preside over its administrative courts.  The SEC is also responsible for their removal.  But it can’t do so “at will.”  5 U.S.C. § 7521 states: “An agency may remove, suspend, reduce in level, reduce in pay, or furlough for 30 days or less an administrative law judge only for good cause established and determined by the [Merit Systems Protection Board] on the record and after opportunity for a hearing before the Board.”  In other words, the SEC’s ALJs are removable by the SEC only after proof of good cause as found by the Merit Systems Protection Board.  In that respect, it appears to be somewhat more difficult for the SEC to remove an ALJ than it is to remove a Member of the PCAOB.

Since no one has yet disputed that SEC Commissioners are removable only for cause, that appears to resolve the issue of whether an ALJ “enjoys more than one level of good-cause protection.”  That would make the dispositive issue whether an SEC ALJ is an “Officer” or an “inferior Officer” of the United States performing executive functions that should be subject to presidential influence.  If he/she is, then by all appearances his/her protection from removal by the President would be “contrary to Article II’s vesting of the executive power in the President” because “[t]he President cannot “take Care that the Laws be faithfully executed.”

Is an Administrative Law Judge an Officer or Inferior Officer of the United States?

Treatment of ALJs in the Free Enterprise Fund decisions.  So is an ALJ an Officer or inferior Officer of the United States?  The Court in Free Enterprise Fund addressed, but did not decide this issue.  Stating that nothing in its opinion “should be read to cast doubt on the use of what is colloquially known as the civil service system within independent agencies,” Justice Roberts devoted a footnote to the impact of the opinion on administrative law judges:

For similar reasons, our holding does not address that subset of independent agency employees who serve as administrative law judges. . . .  Whether administrative law judges are necessarily “Officers of the United States” is disputed.  [See Landry v. FDIC, 204 F.3d 1125 (D.C. Cir. 2000).]  And unlike members of the Board, many administrative law judges of course perform adjudicative rather than enforcement or policymaking functions. . ., or possess purely recommendatory powers.  The Government below refused to identify either “civil service tenure-protected employees in independent agencies” or administrative law judges as “precedent for the PCAOB….”

Free Enterprise Fund, 561 U.S. at 507 n.10.  The Court did “not address” the issue, but it certainly raised a significant obstacle, seemingly suggesting that if ALJs “perform adjudicative rather than enforcement or policymaking functions” they may be constitutionally okay.

The difficulty of getting ALJs included as “officers” is also reflected in Judge Kavanagh’s dissenting opinion in the D.C. Circuit ruling in which the majority rejected the constitutional challenge to the PCAOB.  See Free Enterprise Fund v. PCAOB, 537 F.3d 667 (D.C. Cir. 2008).  Justice Roberts liberally referred to and incorporated arguments from Judge Kavanagh’s dissent as part of his majority Supreme Court opinion, so Judge Kavanagh’s thoughts could be influential.  Here is what he said on the ALJ question (much of which was tracked by Justice Roberts in his footnote):

[A]dministrative law judges in the independent agencies are removable only for cause at the initiation of the agency that employs them and with approval of the Merit Systems Protection Board, . . . whose members in turn are removable only for cause by the President. . . .  [T]here are good reasons the Board and the United States did not cite ALJs as a precedent.  First, an agency has the choice whether to use ALJs for hearings . . . Congress has not imposed ALJs on the Executive Branch.  Second, many ALJs are employees, not officers.  [See Landry v. FDIC, 204 F.3d 1125, 1132-34 (D.C. Cir. 2000)] (ALJs in FDIC are employees because they possess only recommendatory powers that are subject to de novo review by agency).  Third, ALJs perform only adjudicatory functions that are subject to review by agency officials . . . and that arguably would not be considered “central to the functioning of the Executive Branch” for purposes of the Article II removal precedents. . . .  Nothing in this dissenting opinion is intended to or would affect the status of employees in independent agencies who have congressionally mandated civil service tenure protection or the status of administrative law judges.

537 F.3d 667 at 699 n.8 (dissenting opinion).

The opinion in Landry v. FDIC.  Both Justice Roberts’s Supreme Court opinion and Judge Kavanagh’s D.C. Circuit dissent cite only one case in relation to the ALJ issue: Landry v. FDIC, 204 F.3d 1125 (D.C. Cir. 2000).  Kavanagh cites Landry to support the statement that “many ALJs are employees, not officers” and Roberts cites it for the point that “Whether administrative law judges are necessarily ‘Officers of the United States’ is disputed.” Neither judge is suggesting that the holding in Landry decides the issue completely, but it would be important for someone asserting the SEC ALJs are “officers” to be able to explain why the rationale underlying Landry is not especially helpful in evaluating the status of the SEC ALJs.

Landry involved a challenge to sanctions imposed by the FDIC after it reviewed the decision of an FDIC administrative law judge recommending findings and sanctions under the operative FDIC statute.  Among the grounds for appeal to the D.C. Circuit was the contention that the appointment of the FDIC’s ALJ violated the Appointments Clause of the Constitution, Article II, Section 2, Clause 2: “[The President] … shall appoint … Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.”  Landry contended that an FDIC ALJ was an “inferior Officer” who could be appointed only by the President, the Courts, or a Head of Department, but had been appointed by a federal banking agency, which was not a “Department” in the constitutional sense.

 A majority of the D.C. Circuit panel ruled that the FDIC ALJ was not an inferior officer, but was instead a mere “employee.”  The court noted that “[t]he line between ‘mere’ employees and inferior officers is anything but bright. . . .  In fact, the earliest Appointments Clause cases often employed circular logic, granting officer status to an official based in part upon his appointment by the head of a department.”  Landry, 204. F.3d at 1132 (citations omitted).  The Supreme Court’s statement in Buckley v. Valeo, 424 U.S. 1, 126 n.162 (1976), that “any appointee exercising significant authority pursuant to the laws of the United States is an ‘Officer of the United States,’” was treated as not especially helpful.  Instead, “ascertaining the test’s real meaning requires a look at the roles of the employees whose status was at issue in other cases.”  Landry, 204 F.3d at 1133.

 The one case deemed “most analogous” was Freytag v. Commissioner, 501 U.S. 868 (1991), in which the Court found that special trial judges (“STJ”) for the Tax Court were indeed “inferior Officers.”  The Landry majority distinguished Freytag, however, because the Freytag Court relied in part on powers of the STJ not matched by the FDIC ALJs: “the authority to render the final decision of the Tax Court in declaratory judgment proceedings and in certain small-amount tax cases.”  Landry, 204 F.3d at 1133.  Because the FDIC ALJ could only render a recommended decision, findings of fact, and conclusions of law, with final decisions reserved to the FDIC, and because the Supreme Court in Freytag “laid exceptional stress on the STJs’ final decisionmaking power” (id. at 1134), the majority found the ALJ was not an “officer” of the United States.

 Judge Randolph concurred in the result based on no prejudice suffered by the appellant, but strongly disagreed on the determination that the ALJ was not an officer of the United States.  He found the FDIC ALJ indistinguishable in material respects from the Tax Court STJ under the reasoning of the Supreme Court in Freytag.  Quoting the Freytag opinion extensively, he argued that the Supreme Court placed no great importance on the limited respects in which the STJs had final authority.  In particular, the mere fact “that an ALJ cannot render a final decision and is subject to the ultimate supervision of the FDIC shows only that the ALJ shares the common characteristic of the ‘inferior Officer,’” that is that “‘inferior’ officers are officers whose work is directed and supervised at some level by others who were appointed by Presidential nomination….”  Landry, 204 F.3d at 1142 (quoting Edmond v. United States, 520 U.S. 651, 663 (1997).

 In the end, the divided opinion in Landry v. FDIC lends some, but limited, support to the notion that an ALJ whose authority is exclusively limited to recommending determinations to be made finally by others may be an “employee” and not an “inferior Officer.”  But the division in the court makes this far from clear.

 The decision in Freytag v. Commissioner.  Since the Landry decision turns on how the disagreeing judges read the Supreme Court decision in Freytag, we should at least understand what the Freytag court decided.

 As noted above, the Freytag case involved the status of special trial judges (formerly known as “commissioners”) appointed by the Tax Court.  The Tax Court is an Article I court created by Congress with judges appointed for limited terms.  Congress authorized the Chief Judge of the Tax Court to appoint STJs to hear specific types of tax cases, some of which could be decided by the STJ but others of which require a recommended decision by the STJ and final determination by a regular judge of the Tax Court.  Freytag’s case was one of those that required review and adoption by a regular judge, and that is what occurred.

 Freytag challenged the validity of the judgment against him in part because the appointment of STJs by the Chief Judge of the Tax Court violated the Appointments Clause.  The Court unanimously rejected this contention, although it was sharply divided on the reasoning.  A majority of five justices reasoned that the STJ was an “inferior Officer” whose appointment was proper because the Tax Court could properly appoint an inferior officer as one of “the Courts of Law” under Article II, Section 2, Clause 2.  The remaining four justices reasoned that the STJ was an “inferior Officer,” but that the Tax Court’s power to make such appoints derived from the fact that it was a Department within the meaning of Article II, Section 2, Clause 2.  All nine justices, therefore, agreed that the STJs were “inferior Officers.”

The reasoning behind that was laid out in the majority opinion.  That opinion rejected the contention set forth by the Commissioner of the IRS that the STJs were “employees” who did no more than assist the regular Tax Court judges in taking evidence and preparing proposed findings and an opinion.  The Court started with the statement in Buckley v. Valeo, 424 U.S. 1, 126 (1976), that” “Any appointee exercising significant authority pursuant to the laws of the United States is an ‘Officer of the United States,’ and must, therefore, be appointed in the manner prescribed by § 2, cl. 2, of [Article II].”  It went on to reject the argument that STJs are only employees “because they lack authority to enter into a final decision” because that argument “ignores the significance of the duties and discretion that special trial judges possess.”  Freytag, 501 U.S. at 881.  The Court focused on the facts that “the office of special trial judge is ‘established by Law’” and the statute lays out their “duties, salary, and means of appointment for that office” (id.); they “perform more than ministerial tasks” including “tak[ing] testimony, conduct[ing] trials, rul[ing] on the admissibility of evidence, and hav[ing] the power to enforce compliance with discovery orders.”  Id. at 881-82.  And in the course of doing so, they “exercise significant discretion.”  Id. at 882.  These factors were bolstered by others, because “[e]ven if the duties of [STJs] were not as significant as . . . we have found them to be,” there are circumstances where “they exercise independent authority,” and they cannot be “inferior Officers” for some purposes and not others.  See id.

 So, Freytag rejects the argument that officials who “lack authority to enter into a final decision” must be employees and not inferior officers, places great weight on whether a person’s job was created and delineated by statute and involves the exercise of significant discretion, and notes that if this is accompanied by the exercise of “independent authority,” there is no doubt that the official is an inferior officer.

Supreme Court decisions in the military judge cases.  The Supreme Court issued a triumvirate of opinions of relatively recent vintage in cases applying the Appointments Clause to judges presiding over military courts.  See Weiss v. United States, 510 U.S. 163 (1994); Ryder v. United States, 515 U.S. 177 (1995); Edmond v. United States, 520 U.S. 651 (1997).  These cases could be viewed as providing strong support for the view that government officials other than Article III judges who preside over government legal proceedings are to be considered “inferior Officers” of the United States.  (Article III judges almost certainly would be viewed as principal officers.)

Weiss challenged military trial judges who were appointed by the President as officers of the military but never appointed to be judges.  The case proceeded on the “common ground” of the parties, with apparent acquiescence by the Court, that “military judges, because of the authority and responsibilities they possess, act as ‘Officers’ of the United States.”  Weiss, 510 U.S. at 169; see id. at 173 (Buckley, Freytag, and Morrison v. Olson “undoubtedly establish the analytical framework upon which to base the conclusion that a military judge is an ‘officer of the United States’ – a proposition to which both parties agree”).  The Court held that because the appointment as military officers of those serving as judges was consistent with the Appointments Clause, no “reappointment” was required.  The only issue disputed by the justices was how to decide whether the military judges were “inferior Officers” or “principal officers.”  See id. at 182-94 (Souter, J., concurring).

Ryder involved a challenged conviction where the intermediate appellate court, the Coast Guard Court of Military Review, included two civilian judges whose appointments did not comply with the Appointments Clause, and, because they were not military officers, were never appointed to a military office by means consistent with the Appointments clause.  The Court unanimously reversed the decision of the United States Court of Military Appeals (the highest military appellate court) that there were ground to ignore this flaw, and overturned the conviction.  In doing so, the Court agreed that judges serving on the Coast Guard Court of Military Review were officers required to be appointed in accordance with the Appointments Clause.  Significantly, the Court reached this result despite the fact that the intermediate appellate judges in question were subject to review by the higher appellate court, noting that the lower and higher courts applied different standards of review.  Ryder, 515 U.S. at 187-88.

Edmond also involved a challenge to a conviction where the intermediate appellate court (now renamed the Coast Guard Court of Criminal Appeals) included two civilian judges who were assigned to the intermediate court by the Judge Advocate General of the Coast Guard (who also was General Counsel of the Department of Transportation).  After Weiss was decided, the Secretary of Transportation “adopted” the assignments as his own “judicial appointments.”  The Court found no violation of the Appointments Clause because the judges were officers of the Department of Transportation and the power to appoint all such officers was given by statute to the Secretary of Transportation, consistent with the Appointments Clause.  One of petitioner’s challenges was that these judges were “principal officers,” not “inferior officers.”  The Court noted that its “cases have not set forth an exclusive criterion for distinguishing between principal and inferior officers,” and discussed several cases finding other officials to be inferior officers.  Edmond, 520 U.S. at 661.  In response to the argument that these judges exercised “significant authority” on behalf of the United States, the Court that this does not make them principal officers, but draws “the line between officer and non-officer.”  Id. at 662.  The Court concluded they would be “inferior officers” because “[g]enerally speaking, the term ‘inferior officer’ connotes a relationship with some higher ranking officer or officers below the President: whether one is an ‘inferior’ officer depends on whether he has a superior.”  The fact that these judges were subject to administrative oversight by the Judge Advocate General, and could be removed by the Judge Advocate General “without cause,” were strong grounds to show they were subordinates.  Id. at 664.  And the fact that the decisions of the intermediate court were subject to reversal on further appeal, also showed that these judges “have no power to render a final decision on behalf of the United States unless permitted to do so by other executive officers” and are therefore inferior officers.  Id. at 665.  Justice Souter’s concurrence argued that more factors should be considered in determining whether these judges were principal or inferior officers, but in the end agreed “that the judges . . . are inferior officers within the meaning of the Appointments Clause.”  Id. at666-70 (Souter, J., concurring).

The SEC’s ALJs exercise powers of the government and have significant discretion in adjudicating enforcement proceedings involving major sanctions.  Although they are subject to review by the SEC, the cases seem to make it crystal clear that merely being subject to reversal does not render an inferior officer a non-officer.  That their decisions can be reversed is a sign that they are not “principal officers,” but has little bearing on whether they are inferior ones.  To the contrary, in the words of Justice Scalia in Edmond, “we think it evident that ‘inferior officers’ are officers whose work is directed and supervised at some level by others who were appointed by presidential nomination with the advice and consent of the Senate.”  Edmond, 520 U.S. at 663.

 Beyond the case law.  This certainly has not been an exhaustive review of all cases discussing the scope of “inferior Officers.”  But it seems sufficient to conclude that the characterization of the SEC ALJs as inferior officers, on the one hand, or employees, on the other, is not easily made based solely on the cases.  One question to ask is whether there are other authorities addressing the issue that might be helpful.  It turns out that the Office of Legal Counsel of the Department of Justice (OLC) has on several occasions considered how to determine whether certain officials are officers of the United States.  Might these analyses be useful?

 In April 2007, the OLC produced its most recent analysis, a Memorandum Opinion for the General Counsels of the Executive Branch entitled Officers of the United States Within the Meaning of the Appointments Clause (Apr. 16, 2007) (“OLC April 2007 Opinion”).  A copy of that document can be found here: Officers of the United States Within the Meaning of the Appointments Clause – OLC Opinion.  With extensive analysis, the OLC concluded:

 We conclude that any position having the two essential characteristics of a federal “office” is subject to the Appointments Clause.  That is, a position, however labeled, is in fact a federal office if (1) it is invested by legal authority with a portion of the sovereign powers of the federal Government, and (2) it is “continuing.”  A person who would hold such a position must be properly made an “Officer[ ] of the United States” by being appointed pursuant to the procedures specified in the Appointments Clause.

 OLC April 2007 Opinion at 1.

The crux of the OLC analysis is that a person is a federal officer if he or she has a continuing position established by law that involves the application of the sovereign powers of the federal government.  That would be in contrast to a person whose position is “purely advisory” or who “provides goods and services.”  Id.  at 4.  If their official positions involve “the wielding of delegated sovereign authority,” they hold an office, and are officers.  Id. at 7.  Citing historic authorities, the OLC says: “Officers, thus, were persons holding sovereign authority delegated from the King that enabled them in conducting the affairs of government to affect the people “against [their] will, and without [their] leave.”  Id.  at 8.  An influential 19th century treatise cited by the OLC summarized a public office as follows:  “A public office is the right, authority and duty, created and conferred by law, by which for a given period, either fixed by law or enduring at the pleasure of the creating power, an individual is invested with some portion of the sovereign functions of government, to be exercised by him for the benefit of the public. The individual so invested is a public officer.”  Id. at 10 (citing F. Mechem, A Treatise on the Law of Public Offices and Officers § 1, at 1-2 (1890)).

Critically, the OLC emphasizes that “‘independent discretion’ is not a necessary attribute of delegated sovereign authority.”  Id. at 17.  “[T]reating discretion as necessary for the existence of an office conflicts with the original understanding of ‘office,’ early practice, and early precedents.”  Id. at 18.  Nor is the exercise of “independent” authority needed:  “If it is not necessary to the existence of delegated sovereign authority (and thus to the existence of an office) that a position include the exercise of discretion, all the more is it not necessary that a position include some sort of ‘independent’ discretion in carrying out sovereign functions.  The question for purposes of this first element is simply whether a position possesses delegated sovereign authority to act in the first instance, whether or not that act may be subject to direction or review by superior officers.”  Id.

 This OLC opinion, coupled with the Supreme Court decisions in Freytag and Edmond, provides heavy artillery in support of the argument that the SEC ALJs are “inferior Officers” under the Appointments Clause.  They surely are “invested by legal authority with a portion of the sovereign powers of the federal Government.”  They wield governmental power to issue subpoenas and compel testimony.  They determine what evidence should be included in the record, and decide whether portions of the case should proceed to trial or not.  They can sanction lawyers.  In short, they have all the powers of a judge in their courtrooms, and those powers are derived from the sovereign.  They hold “continuing” positions and can only be removed for cause.  They do not appear distinguishable from military judges, and are barely distinguishable from Tax Court special trial judges, or for that matter, from U.S. magistrates.

Do the SEC’s Administrative Law Judges Perform Executive Functions?

Since  the constitutionality issue in Free Enterprise Fund turned on the inability of the President to exercise sufficient influence over the PCAOB’s executive functions, could the SEC’s ALJs be approved on the theory that they do not perform executive functions?  After all, they are serving in a traditional adjudicative capacity, and Justice Roberts did note in his footnote that “unlike members of the Board, many administrative law judges of course perform adjudicative rather than enforcement or policymaking functions. . ..”  Free Enterprise Fund, 561 U.S. at 507 n.10.

Surely that comment provides the opening for an argument, but it is difficult to conceive of the Court concluding that the SEC’s ALJs are not functioning as Executive officers even though they perform key functions in what the Court concluded was an Executive Department.  When the Court decided the Freytag case, it left open whether a “principal agenc[y], such as . . . the Securities and Exchange Commission” is a “Department” under the Appointments Clause.  Freytag, 501 U.S. at 887 n.4.  But with that issue now resolved with the ruling that it is such a Department, it is difficult to create an argument that statutory judges performing adjudicative functions within that Department, just as the special trial judges functioned within the Treasury Department, should be treated as outside of the Executive power.  Likewise, the military court triumvirate of cases all involved officers performing adjudicative functions as part of an arm of the Executive, and it was never suggested that this impacted the importance of their Executive roles.

Because the SEC’s ALJs perform their adjudicative functions as a critical part of executing the SEC’s overall law enforcement authority, which plainly must be considered an executive function, it seems unlikely that the Supreme Court will decide that the adjudicative nature of their functions alone places them outside of the Article II mandate that it is the President who must “take Care that the Laws be faithfully executed.”

Conclusion

 The constitutional challenges raised in the Stilwell and Peixoto cases are far from makeweight.  The Supreme Court decision in Free Enterprise Fund coupled with the SEC’s status as an “independent agency” with Commissioners not subject to removal by the President other than “for cause” seem to make these cases come down to a single issue: are the SEC’s administrative law judges “officers” of the United States performing Executive functions.  A significant line of Supreme Court cases provides apparent support for finding these officials to be “inferior Officers” within the meaning of that clause.  There is also apparent support for this contention from the Department of Justice Office of Legal Counsel opinion addressing the issue of how to decide when a person is an “inferior Officer.”  And the determination that the SEC is to be treated as “a freestanding component of the Executive Branch” leaves little room to conclude that ALJs working for the SEC are not performing Executive functions.

 To be sure, the majority opinion of the D.C. Circuit in Landry, and the footnotes of Justice Roberts and Judge Kavanagh in the Free Enterprise Fund cases noting this to be an open issue, make it clear this is not a slam dunk.  But there can be no doubt that the constitutional issues raised are real and serious, and it seems likely that the Supreme Court will be deciding them relatively soon.

                                                         *                    *                    *

When we next delve into SEC constitutional issues, which may take awhile, we will address why it is that an “independent agency” can exercise enormous power in executing the law through enforcement proceedings even though Article II of the Constitution places the power to “take Care that the Laws be faithfully executed” solely in the hands of a unitary Executive.

 Straight Arrow

 December 2, 2014

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Michael Lewis Saved from Paying the Piper for False Portrayal in “The Big Short”

By virtue of a poorly reasoned opinion from Second Circuit Judge Richard Wesley, author Michael Lewis narrowly escaped answering to a jury for blatantly inaccurate and unfair descriptions of CDO manager Wing Chau in Lewis’s apocryphal book, The Big Short.  On November 14, 2014, a majority of the three-judge panel in Chau v. Lewis, No. 13-1217, affirmed a district court grant of summary judgment to Lewis on Chau’s claims that descriptions of him in The Big Short were libelous.  Although the majority’s ruling for Lewis was hardly a vindication – it acknowledged the falsity of Lewis’s statements but merely inoculated them against liability in a libel action – it also reflected a myopic elevation of legal nicety over the real world.  A copy of the majority opinion can be found here: Chau v. Lewis 2d Circuit Opinion (Opinion”) .

Courtesy Lucas Jackson/Reuters

Michael Lewis (Courtesy Lucas Jackson/Reuters)

Senior Judge Ralph Winter, a dean of the 2d Circuit bench and author of many securities law opinions over the years, tried to restrain himself, but could not avoid a satiric tinge in a dissenting opinion lambasting the majority for using trees to obscure the forest, even while claiming they were deciding the case based on “the context of the publication as a whole, not just the paragraph or chapter containing them.” Opinion, slip op. at 14.  A copy of Judge Winter’s dissent can be found here: Chau v. Lewis 2d Circuit Dissent (“Dissent”).  Perhaps the great disappointment was that Senior Judge Amalya Kearse, who is highly respected, joined in Judge Wesley’s weak effort.

For those who may be interested in looking at what the lawyers of Chau and Lewis had to say on appeal, copies of their briefs filed in redacted form (to omit the most juicy stuff) can be found here (Appellant Brief in Chau v Lewis) and here (Appellee Brief in Chau v Lewis).

The case originated in Lewis’s blockbuster work of purported non-fiction about the underpinnings of the 2007-2008 financial crisis in the massive market of mortgage-backed securities offerings, and in particular collateralized debt obligations built on subprime mortgages.  Lewis’s book was on the New York Times bestseller list for 28 weeks, but over time has been shown to be far from accurate in key respects.  Nevertheless, as is the way of the world nowadays, the book created impressions that last and are taken as fact, regardless of its degree of accuracy or inaccuracy.  The district court record in Chau v. Lewis includes an expert report from a Northwestern University Medill School of Journalism professor stating: ““Lewis’ methodology in researching, drafting, and fact-checking The Big Short fell far below the standard required by this profession.”  Lewis chose not to have an expert defend his work.  Revelations about Lewis’s factual sloppiness (to be kind) in The Big Short do not bode well for verity-checks of Lewis’s new tabloid-like charges in Flash Boys that the stock market is “rigged” for the benefit of high frequency traders. 

Wing Chau’s company Harding Advisory LLC served as collateral manager for many CDO offerings.  Lewis dwelled in particular on an attack on Wing Chau in Chapter 6 of the book, entitled Spider-Man at the Venetian.  Relying on a report from co-defendant Steven Eisman of a supposed conversation between Chau and Eisman at a dinner in Las Vegas, Lewis presented a no-holds-barred indictment of CDO managers in general, and Wing Chau in particular, for having fostered the origination of worthless mortgage loans which were packaged to create also-worthless CDOs, all to satisfy the wealth and greed of Wall Street, CDO managers, and Wing Chau himself.

Any person who read Chapter 6 came away from the book believing Wing Chau was an idiot, moron, fool, greedy bloodsucker, and fraudster.  That was Lewis’s plain intent and the obvious import of what he wrote.  It ruined Chau’s career, and is a picture he will never live down.  The problem is, Lewis based it on hyperbole, insidious mockery, Eisman’s questionable portrayals, and plainly false statements.  Presumably he relied on Eisman and did little in the way of independent analysis.  I don’t know what steps he took before deciding to commit Chau to a public pillory, but one thing we do know, at least if Judge Winter is reliable, is that Lewis “admits that he does not use a fact checker.”  Dissent, slip op. at 5.  No surprise there.

Judge Wesley decided that just because Lewis ridiculed and demeaned Chau professionally and personally with false statements is not an adequate reason to force him to explain to a jury why he did what he did.  Instead, Wesley wrote down the 26 nasty, snarky, and sometimes false things Lewis said (or Lewis said that Eisman said) and, one by one, explained why each one, standing alone, was not a valid basis for a libel claim.  His opinion is the definition of myopia.  It is as far as you can get from what Wesley portrayed as the correct approach, which requires examining “the context of the publication as a whole, not just the paragraph or chapter containing them.”  Opinion, slip op. at 14.  Somehow he decides that pages and pages of statements that disparaged Chau, portrayed him as a greedy profiteer who made tens of millions of dollars for doing nothing, and accused him of being a fraudster, was not libelous because each statement taken alone was either “opinion” or not sufficiently harmful to qualify as being defamatory.  How frightening that an appellate judge tucked away in his robes and life-tenured position could be so clueless.  By deciding in his view what “an average reader” would and would not view to be defamatory – a plain invasion of the province of the jury – Judge Wesley deprived Chau of his only chance to regain dignity and a future: a decision from a jury of his peers.

As Judge Winter pointed out in dissent, the opinion is just plain wrong.  Lewis used statements that were admittedly false, or in some instances could be proved to be false, to portray Chau as lawless, stupid, greedy, unethical, and immoral.  For example:

  • He wrote that Chau “spent most of his career working sleepy jobs at sleepy life insurance companies” before turning to CDO investing, to make the point that Chau lacked the skills to work as a CDO Manager.  This is now admitted to be false.
  • He said Chau invested in only “dog shit” subprime CDOs when in fact 40 percent of his CDOs were not in that category.  Faced with this, Judge Wesley lamely opined: that this was a “fine and shaded distinction[]” that would not matter to a reader.  Opinion, slip op. at 24.  That’s what juries are supposed to decide.
  • He said Chau “made it possible for tens of thousands of actual human beings to be handed money they could never afford to repay.”  There’s so much wrong with that statement it’s hard to know where to start.  Suffice it to say that there is an ample likelihood that it would be proved false at trial.
  • He said Chau “didn’t do much of anything” as a CDO manager, which almost certainly is inaccurate.
  • He said Chau was a “double agent” who “represented the interests of Wall Street bond trading desks” and not that of investors.  He surely had no facts to support that beyond Eisman’s meanderings, but its truth or falsity is certainly a jury issue.  Judge Wesley exonerates Lewis for this and some other statements because he cloaked them by referring to “CDO Managers” generally, but not Chau in particular.  Opinion, slip op. at 21.  But that is laughable, since the whole chapter is about Chau as a CDO Manager and Eisman’s purported discussion with Chau, as Judge Winter points out (Dissent, slip op. at 3).
  • He said Chau didn’t care about what his CDOs invested in because he “simply passed all the risk that the underlying home loans would default on to the big investors.”  The point is that he allegedly failed in his duties to investors because he passed on risk to others.  Another clear jury issue.
  • He said Chau served “as a new kind of front man for the Wall Street firms,” i.e., that Chau allegedly committed fraud on investors by favoring the Wall Street firms.  That could be true or false, but is again a jury issue.  Judge Wesley gave Lewis a pass on this because he viewed calling someone a “front man” for others is a matter of “opinion.”  Opinion, slip op. at 20.  Far from it.  It is an accusation that someone falsely portrayed himself as protecting investor interests when he was not doing so, in other words, that he committed mail, wire, and securities fraud.  Accusing someone of criminal conduct is not “opinion,” as Judge Winter recognized.  See Dissent, slip op. at 10 (“This description could easily serve as the opening statement in a civil or criminal fraud trial.”).
  • He said Chau took home $26 million in a single year for doing all this but “didn’t spend a lot of time worrying about what was in CDOs.”  That is patently false as to what he earned (by a factor of ten), and likely is false as to the rest.  It suggests, falsely, that Chau earned $26 million in return for betraying his duties to investors.

How an appellate judge could declare that pages of such statements were not actionable “because an ordinary person would not take the statement (albeit incorrect) in context to be sufficiently derogatory to make an actionable claim for defamation” is totally beyond comprehension.  Judge Wesley said that a statement is defamatory if it exposes an individual to, among, other things, “shame, obloquy, contumely, odium, contempt, ridicule, aversion, ostracism, degradation or disgrace.”  Opinion, slip. op. at 15 (emphasis added).  Let’s see.  Obloquy is “the condition of someone who lost the respect of other people.”  That seems pretty clear here.  Shame means “dishonor or disgrace.”  Ditto.  Ostracism — “exclusion by general consent from common privileges or social acceptance” — was actually reflected in evidence in the district court record.  Ridicule is patently apparent on the face of the publication.  Judge Wesley either didn’t read what he wrote or didn’t bother to take it seriously.  His only role was to decide whether a reasonable jury (not him) could look at the evidence and find any of those impacts on Chau, and it really seems beyond debate that the evidence would permit that.  

Judge Winter certainly thought so.  He wrote:

Michael Lewis’s book describes appellant as admitting to acts that a jury could easily find to have breached his obligations to investors in the fund that employed him and to have constituted civil or criminal fraud. . . .  [T]heir conclusion that certain statements are not defamatory is reached only by evaluating those statements in hermetic isolation from the context in which they were made.  They conclude that certain statements can have only a single and non-defamatory meaning even where the book clearly conveyed a different and defamatory meaning that was adopted by the book’s readership. . . .

*          *          *

 A trier of fact could easily find the following.

. . .  Appellant is portrayed as lining his own pockets and foisting doomed-to-fail portfolios upon investors.  Although he was paid to monitor the amount of risk in the fund’s portfolio, he worried only about volume because he was paid by volume.  And, knowing that the default rate of residential mortgages was sufficient to wipe out the fund’s holdings, appellant sold all his interests in the fund, passing all the risk to the fund’s investors, who believed he was monitoring that risk. The portrayal of the appellant is particularly graphic because it purports to show his state of mind and his actions out of his own mouth. . . .

 The book’s author admits that he does not use a fact checker, and much of what the book says about the appellant is known even now (before a trial) as false. . . .  These falsehoods provide the scenic background for the portrayal of the appellant as engaging in conduct that a trier of fact could find amounted to fraud in order to line appellant’s own pockets.  This portrayal can be described as non-defamatory only by declining to view it as a whole; by taking some of the statements and quotations entirely out of the context in which they were made; by finding that some statements have only a single and non-defamatory meaning when the book clearly intended a different and defamatory meaning, one adopted by readers, or so a trier could find; a