Tag Archives: arbitrary and capricious

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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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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ACAP Financial v. SEC: 10th Circuit Questions SEC Enforcement Policies in Denying Appeal of Administrative Sanctions

The Tenth Circuit’s recent decision in ACAP Financial, Inc. v. SEC, No. 13-9592 (10th Cir. Apr. 3, 2015), should have been a straightforward victory for FINRA and the SEC.  Instead, the court seemed peculiarly reticent about denying the relief requested.  It emphasized the narrow grounds asserted in support of the petition for relief from the administrative sanctions, and ultimately denied the relief, in its own words, because it was “unable to discern any basis on which we might deem the agency’s decision impermissible under the standards of review that cabin our involvement in this case.”  Slip op. at 12.  The opinion is notable for its unusually provocative asides about issues not raised in the petition for review, along with comments that these would present “meaty” issues if only the petitioners had raised them.  A copy of the decision is available here: ACAP Financial, Inc. v. SEC.

The case was not an appealing one for the petitioners, a penny stock brokerage firm and its head trader and compliance manager.  They were sanctioned by FINRA for allowing sales of unregistered stock from accounts maintained at ACAP by fraudsters engaged in hyping a shell company and cashing out in a pump and dump scheme. The SEC reviewed and approved the sanctions imposed.  The petitioners did not contest the violations, but challenged the propriety of the remedies imposed — a $100,000 fine for the firm, and a $25,000 fine and six-month suspension for the individual.  They argued that FINRA guidelines supported the sanctions imposed only in “egregious” cases, and, under SEC precedent, “egregious” conduct requires intentional or knowing violation of a regulatory duty, or a breach of fiduciary duty, which they contended had not occurred.

The court found the argument failed because the premise was wrong — the petitioners could not show any such prior SEC precedent.  But in doing so, the court emphasized that because the petitioners did not raise other potentially viable issues, it could not reach them.  Among those issues were:

  • Whether the SEC applied an altered remedial policy to the case without adequate explanation, which could support a claim of “arbitrary and capricious” decision-making.  Slip op. at 4 (“It’s an argument that sounds promising on first encounter.  After all, courts routinely fault agencies for ‘arbitrary and capricious’ decisionmaking when they change an administrative policy without explanation.”).
  • Whether the SEC failed to provide sufficient content to the term “egregious,” when “close cousins in the law’s large clan of vituperative epithets (‘wanton,’ ‘wicked,’ and ‘gross’ come quickly to mind) have proven anything but self-defining.”  Id. at 6 (citing “Steamboat New World King, 57 U.S. (16 How.) 469, 474 (1853); Daniels v. Williams, 474 U.S. 327, 334 (1986); Wilson v. Brett, (1843) 152 Eng. Rep. 737 (Exch.) 739 (opinion of Rolfe, J.)”).  This could “leav[e] members of the securities industry without fair warning about when their conduct might invite the epithet’s application.”  Id.
  • Whether the SEC used this particular proceeding “to expand its definition of the term ‘egregious’ beyond intentional and knowing misconduct and breaches of fiduciary duties and then apply its newly expanded definition retroactively,” which the court termed “a species of argument with a long provenance of its own.”  Id. at 6-7 (citing “SEC v. Chenery Corp., 332 U.S. 194, 216-17 (1947) (Jackson, J., dissenting); Henry J. Friendly, The Federal Administrative Agencies: The Need for Better Definition of Standards, 75 Harv. L. Rev. 863, 867 (1962); Stewart Capital Corp. v. Andrus, 701 F.2d 846, 848 (10th Cir. 1983) (identifying circumstances in which retroactive agency adjudication can be an abuse of discretion)”).

But because the petitioners made it clear they were not pursuing any of these arguments, the court was “left with no occasion to pass on any of the meatier arguments we imagined might be before us.”  Id. at 7.  And elsewhere the court says: “[petitioners] present us only with a narrow challenge, disputing whether the SEC offered a reasoned explanation for its decision to reject their … arguments.  At least that much the agency did.”  Id. at 9.

This certainly makes it sound like this was a court that would give serious consideration to challenges of SEC sanctions on the grounds not pursued by the petitioners in this case.  Is the Tenth Circuit ready to take on excessively vague SEC sanction policies, or the SEC’s common practice of law-making by enforcement — creating legal policies in enforcement actions after the fact, rather than by means of an orderly, forward-looking regulatory process?  Only the future will tell.  But it sure does sound like some Tenth Circuit judges were frustrated that those “meaty arguments” were not presented.  Why else make a point of issues that might have been, but were not, raised?  Why else take the trouble to cite materials addressing issues not presented on appeal (including an 1843 English case!)?  And why else conclude the opinion with the statement: “No doubt the open-ended nature of the multi-factor balancing tests the SEC uses when setting sanctions could be attacked on a variety of potential grounds.  But the petitioners before us have repeatedly demurred when presented with the opportunity to challenge the propriety of the SEC’s decisionmaking processes, asking us only to decide much narrower questions — such as the consistency of the results reached here with those in earlier cases.  And when it comes to those narrower questions, we are unable to discern any basis on which we might deem the agency’s decision impermissible under the standards of review that cabin our involvement in this case.”  Slip op. at 12.

This was a pedestrian case that the court turned into a commentary on possible regulatory flaws in SEC policy-making and enforcement practices.  Although the petition for review was denied, I would not take that as a ringing endorsement that the noted SEC policies or practices are safe from challenge under an “arbitrary and capricious” standard.

Straight Arrow

April 6, 2015

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Gray Financial Group v. SEC Is SEC’s Latest Constitutional Challenge

The latest constitutional challenge to an SEC administrative enforcement proceeding was filed in the United States District Court for the Northern District of Georgia on February 19, 2015 in a case captioned Gray Financial Group, Inc. v. SEC, No. 1:15-cv-0492 (N.D. Ga.).  Gray Financial is a registered investment advisor subject to SEC regulatory oversight, and, as a result, has not been newly subjected to SEC administrative proceedings by the Dodd Frank Act’s 2010 expansion of jurisdiction of SEC administrative law judges to non-regulated persons.  As a result, the theory of the case is limited to alleged constitutional shortcomings that are unaffected by whether or not the putative respondent is an SEC-regulated entity.  In this respect, of the recent cases challenging SEC administrative enforcement actions, Gray Financial most resembles Stilwell v. SEC, previously filed the Southern District of New York.  See Stilwell v. SEC.

The complaint alleges that Gray Financial is a small investment advisory firm registered with the SEC, and in Georgia and Michigan.  It established as an investment alternative for Georgia-based pension funds, and with advice of counsel, an “alternative investment” in the form of a fund of funds.  Georgia recently adopted a new pension law permitting alternative investments by public pension funds.  The SEC commenced an investigation of whether the new fund complied with the Georgia law.  The SEC staff thereafter issued a “Wells notice” on the theory that the fund was not in compliance with the Georgia pension law.  Gray Financial contends that the Georgia law is unclear, has never been interpreted by Georgia courts, and that it acted only on the advice of experienced counsel.  Nonetheless, the SEC argued the firm intentionally violated the Georgia law and insisted on a “draconian” settlement to avoid an administrative enforcement proceeding.  A copy of the complaint is available here: Gray Financial Group v. SEC Complaint.

The complaint describes the SEC administrative proceeding process and the role of SEC ALJ’s in detail, including the insulation of the ALJ’s from removal by the SEC or the President for other than good cause.  It then lays out its constitutional argument that the SEC administrative law judges are executive officers outside of the control of the President, in violation of Article II of the Constitution:

Article II’s vesting authority requires that the principal and inferior officers of the Executive Branch be answerable to the President and not be separated from the President by attenuated chains of accountability.  Specifically, as the Supreme Court held in Free Enterprise, Article II requires that executive officers, who exercise significant executive power, not be protected from being removed by their superiors at will, when those superiors are themselves protected from being removed by the President at will.

The SEC ALJs’ removal scheme is contrary to this constitutional requirement because SEC ALJs are inferior officers for the purposes of Article II, Section 2 of the U.S. Constitution, and because:

a. SEC ALJs are protected from removal by a statutory “good cause” standard; and

b. The SEC Commissioners who are empowered to seek removal of SEC ALJs – within the constraints of the “good cause” standard – are themselves protected from removal by an “inefficiency, neglect of duty, or malfeasance in office” standard; and

c. The MSPB members who are empowered to effectuate the removal decision – again limited by a “good cause” standard – are themselves protected from removal by an “inefficiency, neglect of duty, or malfeasance in office” standard.

Under this attenuated removal scheme, “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.  That judgment is instead committed to another officer, who may or may not agree with the President’s determination, and whom the President cannot remove simply because that officer disagrees with him.  This contravenes the President’s ‘constitutional obligation to ensure the faithful execution of the laws.’”  Free Enterprise [Fund v. Pub. Co. Accounting Oversight Bd.], 130 S. Ct. at 3147 (quoting Morrison v. Olson, 487 U.S. 654, 693 (1988)).

Because the President cannot oversee SEC ALJs in accordance with Article II, SEC administrative proceedings violate the Constitution.

Complaint, ¶¶ 60-63.  The relief sought is an injunction barring an SEC administrative proceeding.

Although the complaint describes many respects in which SEC administrative proceedings are less fair to respondents than federal court actions, it does not explicitly contend that the SEC’s threatened administrative proceeding would violate due process, the equal protection clause, the Seventh Amendment right to a jury trial in civil actions, or be an arbitrary and capricious agency action under the Administrative Procedure Act.  That likely is because SEC-regulated entities like Gray Financial have long been subject to administrative enforcement actions as part of the SEC’s overall authority over regulated entities.

The merits of the Article II theory laid out in the complaint were previously discussed in the earlier post: Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit.

Straight Arrow

February 24, 2015

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SEC Commissioner Michael Piwowar Comments on Increased Use of Administrative Enforcement Actions

At the 2015 SEC Speaks PLI Conference, Commissioner Michael Piwowar devoted part of his address to the SEC’s decision to make increased use of administrative proceedings in its enforcement actions.  He advocated that “In order to ensure that the Commission does not engage in arbitrary or capricious conduct in enforcement matters, the Commission should formulate and adhere to a consistent set of guidelines when conducting our enforcement proceedings.”  Here is what he said on the subject (footnotes omitted):

Our enforcement program could also benefit from a look through the lens of fairness.  In order to ensure that the Commission does not engage in arbitrary or capricious conduct in enforcement matters, the Commission should formulate and adhere to a consistent set of guidelines when conducting our enforcement proceedings.

Commission staff has recently indicated that they will recommend instituting more enforcement matters, including insider trading cases, through administrative proceedings rather than going through the federal district courts.  Announcement of this plan to increase the use of administrative proceedings in insider trading cases followed the Commission’s loss in two insider trading cases in federal district courts.  Regardless of whether these circumstances are linked, this change has the appearance of the Commission looking to improve its chances of success by moving cases to its in-house administrative system.

Even prior to the staff announcement, more cases were being brought in administrative proceedings as a result of the enactment in 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd‑Frank Act).  Prior to the Dodd-Frank Act, the Commission only had the authority to seek monetary penalties in administrative proceedings against regulated entities and would have needed to file an action in federal court to obtain a monetary penalty against any other person.

In administrative proceedings, there is no jury and cases are presented to administrative law judges that are employees of the Commission.  In addition, discovery available to defendants is more limited.  The Commission has an extremely high success rate when litigating through administrative proceedings.  One Article III federal judge has stated that in fiscal year 2014 the SEC won 61 percent of federal court trials but was successful in 100 percent of its administrative proceedings.  To avoid the perception that the Commission is taking its tougher cases to its in-house judges, and to ensure that all are treated fairly and equally, the Commission should set out and implement guidelines for determining which cases are brought in administrative proceedings and which in federal courts.

The lack of any standards governing the SEC’s determination when to use the administrative process instead of the federal courts to pursue enforcement actions is one of the grounds used to challenge the constitutionality of those proceedings.  It is argued that according the SEC unfettered discretion over when to allow an enforcement target the right to a jury trial violates the Seventh Amendment and the equal protection clause of the Constitution, and also results in arbitrary and capricious agency decision-making.  Commissioner Piwowar’s suggestion does not vitiate the fundamental problem of denying key substantive and procedural rights to SEC enforcement targets by circumventing the federal courts, but it represents at least a small step in the direction of limiting unbridled power in the decision whether to strip an enforcement defendant of those rights.

The full speech is available here: Remarks at the “SEC Speaks” Conference 2015: A Fair, Orderly, and Efficient SEC.

Straight Arrow

February 23, 2015

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