Tag Archives: Chau v. SEC

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 Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case

On May 27, 2015, the SEC agreed to expand its own consideration of constitutionality challenges to its administrative law adjudicative process.  It issued an order asking for further briefing on whether the appointment of its administrative law judges conforms to the Constitution’s Appointments Clause.  The order, which was issued in the administrative proceeding In the Matter of Timbervest LLC et al., File No. 3-15519, is laid out below.  We previously discussed the briefing of constitutional issues before the SEC in the Timbervest case here: Briefing of ALJ Constitutionality Before SEC Leaves Resolution in Doubt.

This new development was set in motion by the May 7, 2015 Wall Street Journal article by Jean Eaglesham reporting on questions being raised about the fairness and constitutionality of the SEC’s use of its own administrative courts to prosecute securities enforcement actions for severe penalties, especially against people who were not otherwise subject to SEC regulatory oversight.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.  Among other things, that article quoted a former SEC administrative law judge about pressure that had been placed on her to favor the SEC in her rulings.  That revelation spurred respondents in SEC actions to seek further information from the SEC about possible bias or other taints to the SEC’s administrative law proceedings.  In the proceeding In the Matter of Charles L. Hill, Jr., administrative law judge James Grimes approved a subpoena to the SEC staff for the production of documents relating to the matters discussed in the Wall Street Journal article.  See SEC ALJ James Grimes Issues Important Discovery Order Against SEC.  The respondents in the Timbervest proceeding, which is now under review by the Commission itself after an Initial Decision against the respondents by ALJ Cameron Elliot, also asked for discovery into the matters raised in the WSJ article in a filing that can be read here: Respondents’ Motion To Allow Submission of Additional Evidence and Motion for Leave To Adduce Additional Evidence.  That led to the May 27 SEC order:

On May 20, 2015, Respondents filed a Motion to Allow Submission of Additional Evidence and for Leave to Adduce Additional Evidence.  Based on that motion, the Respondents now appear to be asserting that the manner of appointment of the administrative law judges who presided over this matter violates the Appointments Clause of the Constitution.

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.

Accordingly, it is ORDERED that the Division of Enforcement shall by June 4, 2015 file and serve on the parties 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.

It is further ORDERED that the parties shall file simultaneous supplemental briefs . . . limited to the following two issues: (1) whether, assuming solely for the sake of argument that the Commission’s ALJs are “inferior officers” within the meaning of Article II, Section 2, Clause 2 of the Constitution, their manner of appointment violates the Appointments Clause; and (2) the appropriate remedy if such a violation is found.

In a footnote, the Commission said it was not yet deciding the Timbervest motion, including “the materiality of the discovery sought.”  The order in its entirety can be found here: Order Requesting Additional Submissions and Additional Briefing.

The SEC is treading carefully here.  We know, of course, that there is no chance the Commission will rule that its own administrative proceedings are unconstitutional in any respect, but Mary Jo White is a good enough lawyer to know she has to make a record that will not undercut the appearance of fairness in this entire process, or suggest any SEC bias in its own favor.  Just saying that shows how absurd the process is: the SEC is obviously conflicted in considering whether the prosecutions it sent to its administrative judges are unconstitutional.  That, among other reasons, is why this issue needs to be thrashed out fully before actual Article III judges in Article III courts.  Nevertheless, federal district court judges, with one exception, have ruled they lack the jurisdiction to consider the issue.  See Court Dismisses “Compelling and Meritorious” Bebo Constitutional Claims Solely on Jurisdictional Grounds; SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding.  The one exception led to a decision in the SEC’s favor that lacked the substance to serve as a compelling precedent: see In Duka v. SEC, SDNY Judge Berman Finds SEC Administrative Law Enforcement Proceedings Constitutional in a Less than Compelling Opinion.

The revelation of possible pressure on SEC ALJs to favor the SEC would be a game-changer if it is substantiated.  That introduces new elements of due process and fundamental fairness concerns beyond the separation of powers and appointments clause issues that have been the focus of most of the challenges to date.  How the Commission could question the “materiality” of that information is hard to fathom.  As we previously wrote, the only appropriate response to such a “red flag” is to commence a fully independent review of issue.  That is, of course, what the SEC would demand if a similar event were to occur in a public company, in order to avoid a later charge by the SEC and its staff of “reckless disregard” of “red flags.”  But apparently different rules govern the Commission, which seems to be placing itself above the law.

Straight Arrow

May 28, 2015

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In Duka v. SEC, SDNY Judge Berman Finds SEC Administrative Law Enforcement Proceedings Constitutional in a Less than Compelling Opinion

Southern District of New York federal Judge Richard Berman yesterday decided that Barbara Duka, a former Standard & Poor’s employee charged with securities law violations by the SEC, cannot enjoin the SEC administrative enforcement action brought against her.  In doing so, Judge Berman rejected the argument that he lacked jurisdiction over the case, unlike two previous federal court judges.  See SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding, and Court Dismisses “Compelling and Meritorious” Bebo Constitutional Claims Solely on Jurisdictional Grounds.  As a result, he addressed the merits of Ms. Duka’s constitutional argument, finding the she was “unlikely to succeed on the merits” of that claim. Likely success on the merits of the claim is a requirement for granting the preliminary injunctive relief sought by Ms. Duka.  The opinion is available here: Order Denying Relief in Duka v. SEC.

Jurisdiction

Judge Berman rejected the jurisdictional argument accepted by two prior judges because, unlike them, he concluded that the relief sought by Ms. Duka could not be satisfied within the administrative adjudication process, the challenge made addressed not the substance of the claims against her but the very suitability of the forum to adjudicate those claims, and the constitutional issue fell outside of the SEC’s area of expertise.

On the availability of a remedy, here is what the court said:

The Court concludes that the absence of subject matter jurisdiction “could foreclose all meaningful judicial review” of Plaintiff’s claim. . . .  The Court of Appeals obviously would not be able, upon appellate review of any final SEC order, to enjoin the SEC from conducting the Administrative Proceeding, as Duka asks this Court to do.  And, while the Court of Appeals could, presumably, vacate an adverse decision (order) by the SEC on constitutional grounds, it would be unable to remedy the harm alleged by Plaintiff in this Court, i.e., the “substantial litigation and resource burdens incurred during [the] administrative proceeding,” and the “reputational harm” associated with her defending the Administrative Proceeding. . . .

Plaintiff is not here challenging the outcome of her Administrative Proceeding or any order(s) issued by the SEC.  Rather, Plaintiff seeks to enjoin the proceeding itself, and the (injunctive and declaratory) relief she seeks is to prevent the Administrative Proceeding from occurring in the first place. . . .  If Plaintiff were required, as the Government urges, to await the completion of the Administrative Proceeding to seek (any) judicial intervention, important remedies could be foreclosed.  That is, her claim for injunctive and declaratory relief would likely be moot at that stage because the allegedly unconstitutional Administrative Proceeding would have already taken place. Simply put, there would be no proceeding to enjoin. . . .

Slip op. at 10-12 (cites and footnotes omitted).

And this on whether the relief sought was collateral to the substance of the underlying proceeding, or an appropriate part of that proceeding:

The Court concludes that Plaintiff’s claim for injunctive and declaratory relief is “wholly collateral” to “any Commission orders or rules from which review might be sought” in the Court of Appeals. . . .  In Free Enterprise, the Supreme Court found that the petitioners’ Article II claim was collateral because “petitioners object[ed] to the Board’s existence, not to any of its auditing standards.”. . .  Similarly, Duka contends that her Administrative Proceeding may not constitutionally take place, and she does not attack any order that may be issued in her Administrative Proceeding relating to “the outcome of the SEC action.”  Chau [v. SEC], 2014 WL 6984236, at *13; see Gupta [v. SEC], 796 F. Supp. 2d at 513 (where plaintiff “would state a claim even if [he] were entirely guilty of the charges made against him . . . .”).

Unlike the plaintiffs in Chau, Duka does not assert an “as-applied” challenge to agency action “in light of the facts of a specific case.”  Chau, 2014 WL 6984236, at *6.  Rather, she contends that Administrative Proceedings are “unconstitutional in all instances—a facial challenge.”  Id.  As Judge Kaplan noted in Chau, “courts are more likely to sustain preenforcement jurisdiction over broad facial and systematic challenges.” Id. (internal quotation marks omitted).

Slip op. at 12-13.

On the issue of the SEC’s expertise to decide the constitutional issue, Judge Berman wrote:

Without in any way diminishing ALJ Elliot’s exceptional legal background, the Court concludes that the constitutional claim posed in this injunctive/declaratory judgment case is outside the SEC’s expertise.  This aspect of executive agency practice is governed by clear Supreme Court precedent.  See Thunder Basin [Coal Co. v. Reich], 510 U.S. at 215 (“[A]djudication of the constitutionality of congressional enactments has generally been thought beyond the jurisdiction of administrative agencies.”); see also Free Enterprise [Fund v. Pub. Co. Accounting Oversight Bd.], 561 U.S. at 491 (“Petitioners’ constitutional claims are also outside the Commission’s competence and expertise . . . .  [T]he statutory questions involved do not require ‘technical considerations of [agency] policy’. . . .  They are instead standard questions of administrative law, which the courts are at no disadvantage in answering.”).

Slip op. at 14.

Likelihood of Success on the Merits

When he turned to the merits of the constitutional issue, Judge Berman was unwilling to apply the Supreme Court’s Free Enterprise Fund decision to the SEC’s administrative law judges. Not, however, because he doubted that SEC ALJ’s are “inferior officers” of the Executive Branch in constitutional terms.  He did not decide that issue, because he said it was unnecessary, but plainly viewed prior Supreme Court precedent regarding Tax Court special trial judges in Freytag v. Commissioner likely to be determinative: “The 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. See Freytag, 501 U.S. at 881–82 (“[S]pecial trial judges perform more than ministerial tasks. They take testimony, conduct trials, rule on the admissibility of evidence, and have the power to enforce compliance with discovery orders. In the course of carrying out these important functions, the special trial judges exercise significant discretion.”).  Slip op. at 16.  As noted, however, Judge Berman decided he “need not resolve that issue.”  Id.

That is because he reasoned that even if the SEC’s ALJ’s are inferior officers, the double-layer of removal protection they are accorded by statute does not undermine the President’s Executive power.  He noted that the Free Enterprise Fund Court “specifically excluded ALJs from the reach of its holding,” and rejected Ms. Duka’s argument that Free Enterprise Fund established a “categorical rule” forbidding two levels of “good cause” tenure protection.  Slip op. at 17.

Instead, Judge Berman created “a functional test to determine whether and when statutory limitations on the President’s power to remove executive officers violate Article II” based on other Supreme Court precedent.  He relied on the Supreme Court’s special prosecutor case, Morrison v. Olson, 487 U.S. 654 (1988), to argue for a test focused on whether Congress “interfere[d] with the President’s exercise of the ‘executive power’ under Article II” (quoting Morrison, 487 U.S. at 689-90). Although Free Enterprise Fund had no similar language regarding the double-layer of removal protection, Judge Berman argued that the Free Enterprise Fund decision “likewise focused upon whether the statutory restrictions on removal of PCAOB members were so structured as to infringe the President’s constitutional authority by ‘depriv[ing] the President of adequate control over the Board.’ Free Enterprise, 561 U.S. at 508.”  Slip op. at 17-18.

Judge Berman went on to reason “that congressional restrictions upon the President’s ability to remove ‘quasi judicial’ agency adjudicators are unlikely to interfere with the President’s ability to perform his executive duties.”  He argued that SEC ALJs exercise adjudicative power rather than executive power, and therefore the limits on removal of ALJs do not interfere with the President’s exercise of executive power.  He contrasted the Free Enterprise Fund case, which involved a subordinate entity of the SEC that “determines the policy and enforces the laws of the United States.”  Slip op. at 19-20.  In contrast, he said: “SEC ALJs perform solely adjudicatory functions, and are not engaged in policymaking or enforcement.”  Id. at 20.  As a result, “[t]he challenged (good cause) limitations upon the removal of an SEC ALJ will in no way ‘impede the President’s ability to perform his constitutional duty.’  Morrison, 487 U.S. at 691.”

Indeed, he argues that if the President could dismiss ALJ’s without cause, that would “undermine” the agency adjudication process, citing an article by Elena Kagan, written before she became a Supreme Court justice. Slip op. at 21.

How Good Is the Opinion, and How Influential Might It Be

Having elided the issue of whether the SEC ALJs are “inferior officers,” the opinion strikes me as somewhat superficial and relatively weak effort at resolving the constitutional issues that arise if they are, indeed, officers in the Executive Branch.  Judge Berman dispenses with this issue in a mere 4-1/2 double-spaced pages. His treatments of the Supreme Court decisions in Morrison v. Olson, Wiener v. United States, and the grandfather of them all, Humphrey’s Executor v. United States, are largely superficial.  In Judge Berman’s view, the fact that ALJ’s perform their executive duties as part of an adjudicative process insulates them from the need for control or influence by the Chief Executive.  He makes no real effort to examine the constitutional consequences of exempting large numbers of Executive Department officers from the need for Presidential control, and fails even to address the conundrum of treating an Executive Department officer within a law enforcement agency as if he or she were just another judge.  The nuances of how to accord administrative judges the freedom to act as an independent judicial branch within a powerful law enforcement department of the Executive Branch are basically ignored.  In sum, the effort lacks the depth and studiousness of an opinion likely to persuade appellate courts, and possibly other district courts as well.  It may well be that a proper, complete, and thorough argument along these lines can be made, but it is not reflected in this opinion.

Judge Berman effectively creates an adjudicative exception to the need for Presidential control over “inferior officers” involved in an adjudicative process within the Executive Branch. That is, essentially, formed out of whole cloth.  His core argument — “that congressional restrictions upon the President’s ability to remove ‘quasi judicial’ agency adjudicators are unlikely to interfere with the President’s ability to perform his executive duties” — is pure ipse dixit.  Short references to Humphrey’s Executor, Wiener, and Morrison, none of which involved facts and circumstances even vaguely like this case, hardly suffice to justify such a broad-reaching conclusion.  Many of the Supreme Court decisions addressing the role of the Executive in non-Article III courts are not examined, or even mentioned. Included among these is the separation of powers discussion in Freytag v. Commissioner, which Judge Berman acknowledged in the first part of his opinion and ignored thereafter (Freytag has an extensive discussion of the separation of powers implications of performing adjudicative functions outside in non-Article III courts).  Since Free Enterprise Fund plainly treats the SEC as an Executive Department, and there is abundant case law addressing the constitutional treatment of non-Article III courts, an in-depth analysis of those cases would seem necessary before reaching Judge Berman’s conclusions. I haven’t delved into those cases any more than he does (which is to say, not at all), but I’m certain that a reasoned resolution of the issue requires a lot more spade work than I see reflected in Judge Berman’s four pages on the issue.

Judge Berman’s decision also proceeds on the assumption that it is not important – and, indeed, could be harmful – for the President to be able to exercise authority over officials within the Executive Branch who perform adjudicative-like functions. That fails totally to consider the context in which the SEC ALJs function.  Judge Berman seems to think all ALJs perform the same kind of function, and none of them do things the Chief Executive cares much about.  But some ALJs, like those in the SEC, are critical cogs in a law enforcement process addressing large portions of the Nation’s economic and financial infrastructure.  They play a critical role in an Executive process to enforce the law, and exercise considerable discretion in doing so, without any direct supervisors.  The SEC’s enforcement actions already proceed with, at best, limited input from, or control by, the President. To the contrary, the SEC touts itself as being “independent” of the President.  If the SEC’s ALJs are, indeed, executive officers playing key roles in implementing a quintessentially executive function – the enforcement of the laws – why does the fact that ALJs follow an adjudicative-like process as part of that function mean they should be doubly insulated from Presidential influence? Judge Berman effectively postulates this as a necessary aspect of having an agency-based adjudicatory function, but the stated support for that – even if it is a law review article by Elena Kagan — is slim indeed, putting aside whether the very concept of an independent judiciary, functioning within an independent law enforcement agency, has any place in Articles I, II, or III of the Constitution.

There also is no mention or apparent consideration of potential Appointments Clause issues in this context. That may well be because Ms. Duka’s counsel never pressed those issues.  But if the SEC’s ALJs are officers of the Executive Branch, the Appointments Clause applies, and it is not at all clear whether the appointment process for SEC ALJs complies with that process.

Conclusion

To be sure, this decision represents a victory for the SEC in another battle in this campaign.  The loss on the jurisdiction issue is more than outweighed by the favorable ruling on the merits issue.  (Although it may encourage the DC Circuit to reach the merits of the constitutional issue in the recently-argued appeal in Jarkesy v. SEC).  The approach taken by the court does suggest that the SEC may not fare well in its arguments that its administrative law judges are not “inferior officers,” but the overall rejection of the Free Enterprise Fund double-insulation theory provides the groundwork for future SEC arguments on the merits in other courts.  One of those courts may take the time and make the effort to provide a more thorough consideration of the merits issue, but for now, count this as a significant, if not definitive, victory for the Commission.

Straight Arrow

April 16, 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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New Challenge to the Constitutionality of an SEC Administrative Proceeding Filed in Bebo v. SEC

On January 2, 2015, Laurie Bebo, the former CEO of Assisted Living Concepts, Inc., filed an action against the SEC in the Eastern District of Wisconsin for injunctive and declaratory relief to halt an administrative enforcement proceeding against Ms. Bebo in the SEC’s administrative courts. The complaint alleges that the administrative enforcement process under which Ms. Bebo would be prosecuted is unconstitutional for three reasons: (1) the SEC’s administrative law court violates Article II because an SEC administrative law judge is an executive branch officer who is not under the control or influence of the President; (2) the provision of the Dodd-Frank Act granting the SEC the same powers to impose penalties through the administrative court process as may be imposed by a federal district court is unconstitutional because it negates a respondent’s Seventh Amendment rights to a jury trial in a civil action by giving the SEC the sole power to determine whether a jury trial will occur; and (3) the SEC’s administrative actions proceed under rules and procedures that violate Ms. Bebo’s rights of procedural due process because they do not permit the development and presentation of a fair defense and are inj other respects fundamentally unfair.  A copy of the complaint can be found here: Bebo v. SEC Complaint.

Laurie Bebo

Laurie Bebo

The first several paragraphs of the complaint summarize these arguments, as follows:

1.  For over two years, the Division of Enforcement of the SEC has been investigating whether there had been any violations of the federal securities laws in relation to certain periodic financial reports file d with the Commission by Assisted Living Concepts, Inc. (“ALC”). The SEC issued 43 subpoenas for testimony or documents, collected millions of pages of documents (approximately 270 gigabytes of data), and took a cumulative total of 55 days of on -the-record testimony.

2.  Those financial reports, filed on Forms 10-K (annual reports) and 10-Q (quarterly reports) consist of thousands of pages of information about ALC.

3.  The net result of this investment of extensive investigation is the allegation that a single statement – asserting compliance with a lease agreement – out of those thousands of pages of financial statements an d disclosure documents was false or misleading because it failed to provide additional information about how the Company was meeting the lease covenants. The SEC alleges, in turn, that Ms. Bebo, who was the Chief Executive Officer of ALC during the time period in which the challenged periodic reports were filed with the Commission (approximate ly 2009 to 2012), should be found guilty of committing securities fraud; should be subject to civil monetary penalties of hundreds of thousands, or even millions, of dollars ; and should be subject to a permanent ban on serving as an officer or director of a publicly-traded company.

4.  Prior to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (hereafter “Dodd-Frank”), which became effective July 21, 2010, the SEC would have been required by law to bring charges seeking the remedies set forth in the immediately preceding paragraph in the federal district court.

5.  Bebo would have had a Seventh Amendment right to a trial by a jury of her peers. Any trial in the action would have been subject to the Federal Rules of Evidence, which preclude the use of unreliable evidence such as hearsay.

6.  Bebo would have been protected by the numerous substantive and procedural mechanisms of the Federal Rules of Civil Procedure, including depositions and other discovery. And Ms. Bebo would have had a reasonable amount of time to review the 1.5 million pages of documents that the SEC has collected over the course of its two-year investigation.

7.  However, pursuant to Section 929P(a) of Dodd-Frank, the SEC may now obtain the same remedies in administrative proceedings overseen by the Commission Providing an agency with the ability to obtain the same remedy in federal court or in an administrative proceeding is a unique (and unconstitutional) enforcement regime previously unheard of in the large and ever-growing administrative state.

8.  That is, the SEC has been given unlimited discretionn to bring enforcement actions against unregulated persons either in federal district court or in internal administrative proceedings. There are no statutes or regulations to guide these decisions.

9.  On December 3, 2014 the SEC exercised its newly-granted discretion and, instead of filing an action in federal district court, the Commission issued an Order Instituting Public Administrative and Cease-and-Desist Proceedings (“OIP”), initiating administrative proceedings against Ms. Bebo.

10.  The SEC’s rules of practice set a presumptive hearing date (trial) within four months (i.e. April 2015), which will preclude Ms. Bebo from adequately defending against the charges against her given the massive investigative file amassed during the two-year investigation. The SEC’s Rules of Practice also preclude most pre-hearing discovery, such as depositions, and the final hearing will not be governed by the Rules of Evidence.

11.  Most disturbingly, as set forth in more detail below, by proceeding administratively the Commission has stripped her entirely of the ability to secure the testimony at the hearing, much less at a deposition, of key witnesses in the case, including the ALC’s chairman and vice chairman of the board, the chair of ALC’s audit committee, and two other members of the audit committee.

12.  In sum, the SEC has chosen a forum that allows it to investigate, prosecute, adjudicate, and if successful in supporting the charges before an administrative law judge, provide appellate review of a case for which the very same Commissioners approved the filing of charges in the first place.

13.  These administrative proceedings violate the U.S. Constitution, and the SEC’s unlimited ability to choose that forum deprives Ms. Bebo of her constitutional rights to due process and equal protection under the law.

14.  SEC administrative proceedings—governed by an administrative law judge protected by at least two layers of tenure—violate Article II of the U.S. Constitution, which mandates that the “executive Power shall be vested in a President of the United States of America.”

15.  And because the remedies are the same in either forum, in bringing these charges administratively, the SEC concluded that the government would have been disadvantaged by Ms. Bebo’s anticipated assertion of her Seventh Amendment right to a jury trial in district court. Under established Supreme Court precedent, this statutory regime, which penalizes the exercise or anticipated exercise of a fundamental constitutional right, is a violation of the Ms. Bebo’s right to due process under the Fifth Amendment of the U.S. Constitution.

16.  Section 929P(a) of the Dodd-Frank Act, which grants the SEC authority to choose, arbitrarily and without any legitimate reason, to pursue civil remedies against unregulated citizens in either federal district court (where the defendant is entitled to a jury) or SEC administrative proceedings (where she is not), violates the U.S. Constitution’s Fifth Amendment guarantee of equal protection of law.

 As discussed in an earlier Securities Diary post, the contentions laid out here with regard to compliance with Article II may have merit based on recent Supreme Court precedent.  The procedural due process arguments are also substantial.  They were recently rejected by District Judge Kaplan in the Southern District of New York case of Chau v. SEC (see here), although that decision did not occur until after the administrative trial was concluded.  There is no doubt that from a practical litigation standpoint, the administrative proceeding strips a respondent of valuable resources to prepare and present a defense, and allows consideration of “evidence” that would not be permitted in a federal court (see our discussion of that here).  But whether this rises to the level of a due process violation has not yet been addressed by a court in any definitive or authoritative opinion.  The notion that the availability of ultimate review by a court of appeals is sufficient to protect those rights (using a deferential appellate standard) is certainly arguable.  Most trial lawyers would raise grave concerns on that issue.

To our knowledge, there are now two federal cases pending that challenge the constitutionality of the SEC’s use of its administrative courts to prosecute law enforcement actions against non-regulated persons – this case and Stilwell v. SEC, pending in the Southern District of New York (see here). A third case making such a challenge, Peixoto v. SEC, was mooted by the SEC’s decision to drop its administrative action against Mr. Peixoto (see here).

The future of these challenges remains in doubt. But whichever way the courts eventually go on this, the filing of these actions reflects a genuine concern that the SEC has gone too far in its zeal to win enforcement actions at the expense of allowing a just and fair process for targeted individuals to defense themselves.  On that issue, it may be worth reading our very first post on why the SEC doesn’t seem very interested in justice and fairness in its enforcement process, which can be found here.

Straight Arrow

January 7, 2005

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SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding

On December 11, 2014, Judge Lewis Kaplan ruled that his court lacked jurisdiction to consider Wing Chau’s injunctive action to prevent an SEC administrative prosecution against him on due process and equal protection grounds.  Although the ruling was narrowly confined to the jurisdiction issue, it nevertheless was a significant victory for the Commission.

In October 2013, the SEC commenced an administrative proceeding against Chau and his firm, Harding Advisory, alleging misrepresentations in connection with the sale of collateralized debt obligations (“CDOs”) that imploded during the housing/mortgage crisis.  The allegations essentially charged that Chau and Harding misrepresented the nature of the process for selecting assets that went into the CDOs.  After seeking to work within the administrative process to get the kinds of discovery and preparation time that typically would be available if the action were brought in federal court, Chau and Harding commenced a federal action in the Southern District of New York to stop the administrative proceeding.  They asserted in their complaint (which can be reviewed here: Wing Chau v. SEC), that the SEC administrative action violated due process because it did not allow a fair defense to be developed, and denied equal protection of the law because they were singled out for administrative prosecution when similar actions against other persons were brought in federal court (and two of three were lost by the SEC).

The court had previously denied a temporary restraining order and the administrative trial went forward and was concluded.  The parties are awaiting an ALJ determination.

The threshold issue was whether such an action was permissible — whether the district court had jurisdiction to hear a claim to preempt the administrative action.  Applying the standards set forth in Thunder Basin Coal Co. v. Reich, 510 U.S. 200 (1994), Judge Kaplan ruled there was no jurisdiction because (1) the plaintiffs could get meaningful judicial review in an appeal of the administrative action, (2) the claimed constitutional violations were not wholly collateral to the issues to be decided in the administrative action, and (3) the consideration of due process and equal protection claims were not outside of the SEC’s “expertise.”  A copy of the opinion can be found here: Chau v SEC Opinion.

The court found it significant that the due process claim “has been that the SEC’s procedural rules . . . are unfair in light of ‘facts and circumstances of [their] case'” and not that “the SEC’s rules are unconstitutional in every instance.”  Slip op. at 18-19.  The numerous grounds asserted to show that the respondents had been prevented from presenting a fair defense did not provide jurisdiction because they “all . . . are inextricably intertwined with [the] ongoing administrative proceeding and can be reviewed by a court of appeals.”  Id. at 20.  And because the challenges involve the day-to-day conduct of the proceeding, the due process arguments are not “wholly collateral” to the proceeding under Thunder Basin.  Id.  Finally, “plaintiffs fail to articulate any convincing reason why the SEC lacks the competence to consider the fairness of proceedings before its ALJs.”  Id. at 22.  The issue is the fairness of a particular hearing, not a determination that one of the SEC’s “constituent parts is unconstitutional,” and the “SEC is well equipped to evaluate claims of unfairness in proceedings before its ALJs — and if it fails to do so, the courts of appeals stand ready to correct the error.”  Id. at 22-23.

The equal protection claim yielded the same result.  Although a sister court found jurisdiction for such a claim in Gupta v. SEC, 796 F. Supp.2d 503 (S.D.N.Y. 2011), Judge Kaplan was not convinced to follow that decision.  He found the Gupta allegations of discriminatory conduct stronger, but also did “not find Gupta‘s application fo the Thunder Basin factors persuasive in these circumstances.”  Slip op. at 25.  In essence, he disagrees with the reasoning in Gupta and relied on modestly different facts to rule the other way.  He again also found no basis to conclude that the equal protection claim is outside of the SEC’s “expertise.”  But he did so with a circular argument.  He acknowledged that adjudicating such claims “is ‘not peculiarly within the SEC’s competence,'” but without addressing why equal protection analysis was within the SEC’s competence, stated that the SEC’s attempt to address the equal protection issues in an attempted interlocutory appeal from an ALJ decision “indicate that the SEC is competent to consider plaintiff’s constitutional claims.”  Id. at 31-32. 

At the end of the opinion, the judge noted that plaintiffs’ challenge “[t]aken to its logical conclusion . . . would upend all manner of administrative enforcement schemes.”  Id. at 32. He concluded that because “the normal channels of statutory review are adequate” his court lacked subject matter jurisdiction.

In an epilogue, Judge Kaplan took note that “the growth of administrative adjudication, especially in preference to adjudication by Article III courts and perhaps particularly in the field of securities regulation, troubles some.”  Id. at 34.  He singled out concerns that this approach could “increase the role of the Commission in interpreting the securities laws to the detriment or exclusion of the long standing interpretive role of the courts.”  This is a concern that has been raised by federal district judge Jed Rakoff (see here).  He also mentions concern that such SEC determinations might be accorded “broad Chevron deference to SEC interpretations of the securities laws in the determination of administrative proceedings.”  Id. at 34-35.  Concern about the proper scope of Chevron deference to SEC statutory interpretations was noted recently by Justice Scalia (see here).

Judge Kaplan said “[t]hese concerns are legitimate, whether born of self-interest or of a personal assessment of whether the public interest would be served best by preserving the important interpretative role of Article III courts in construing the securities laws – a role courts have performed since 1933.”  “But they do not affect the result in this case. . . .  This Court’s role is a modest one” — to determine subject matter jurisdiction.  Id. at 35.  In reaching its conclusion, the court “has not considered any views concerning the proper or wise allocation of interpretive functions between the Commission and the courts,” which “are policy matters committed to the legislative and executive branches of government.”  Id. at 35-36.

The takeaway from this decision is limited.  Although the jurisdictional issue required some consideration of the merits of the constitutional claims, the due process and equal protection concerns raised by Chau and Harding plainly were left for another forum to decide.  The very different constitutional issues raised by the plaintiffs in Stilwell v. SEC and Peixoto v. SEC (see here), were not mentioned.  As to those cases, even as to subject matter jurisdiction the analysis would have to be very different because, unlike Chau, they do involve a fundamental challenge to the structure of SEC administrative proceedings, i.e., they do require a determination whether one of the SEC’s “constituent parts is unconstitutional.”  It would be difficult to argue that the structural issues raised about SEC administrative law judges in Stilwell and Peixoto are even arguably within the competence of the SEC to decide for itself.  (For an in depth discussion of the merits of those issues, see here.)

But there remains no doubt that this is an SEC victory that, at a minimum, delays consideration of some aspects of the propriety of shifting SEC enforcement actions to its own administrative courts (see posts on this issue here and here).

Straight Arrow

December 15, 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.

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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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