Tag Archives: constitutionality

Bloomberg View: No Kangaroo Courts at the SEC, Please!

The editors of Bloomberg View published the following important editorial comment on the SEC’s administrative prosecution of alleged securities law violations.  A consensus seems to be growing that fairness and due process trump claimed “efficiencies” is prosecuting these cases.  Recognizing that this is a serious problem (which the SEC has not yet done) is the first step in moving toward a solution.

Here is what Bloomberg View said:

The U.S. Securities and Exchange Commission wants to show it can be trusted with a potent weapon: the ability to act as prosecutor, judge and jury in its pursuit of financial miscreants. The real question is why it should have such power in the first place.

In the U.S., the judicial branch doesn’t have a monopoly on dispensing justice. Myriad regulatory agencies, including the SEC, have their own in-house proceedings. Originally, these were designed to handle misconduct involving people who chose to enter the regulators’ remit — say, by registering as brokers or investment advisers. Punishments were mostly limited to disciplinary measures, such as revoking registrations. The idea was to handle routine business more quickly and efficiently than federal courts.

Over the past few decades, though, the SEC’s powers have expanded immensely. The Dodd-Frank Act of 2010 gave the agency’s judges authority to impose large monetary penalties on anyone who violated federal securities laws — not just on regulated people and companies. The SEC no longer had to go to federal civil court to pursue many securities-fraud and insider-trading cases. A janitor who passed on a stock tip could end up being tried and fined hundreds of thousands of dollars without ever setting foot in a real court.

That’s a problem. The SEC’s proceedings differ from federal civil trials in important ways. The agency hires, pays and shares offices with the administrative judges. The defense has no access to a jury trial, little time to prepare its case, and no power to get its own pretrial depositions from witnesses. Appeals go to the same SEC commissioners who approved the filing of charges in the first place — and then to federal courts that tend to defer to the SEC’s judgment.

Not surprisingly, an initial push by the SEC to send more cases to its administrative judges provoked a backlash. Defendants have challenged the system’s constitutionality. Legal experts are concerned that it will usurp the federal judiciary’s role of construing and elaborating the law. To its credit, the SEC has pulled back in recent months and offered some changes for public debate. Among other things, the agency proposes giving the defense more time to prepare and the ability to obtain depositions from as many as five witnesses.

That isn’t enough — but it’s hard to see what would be, without defeating the purpose. If the SEC had to give defendants most of the rights they enjoy in federal court, it would no longer be able to deal with cases quickly.

There’s another way. If the SEC’s administrative proceedings are equitable, as the agency insists they are, both sides should prefer their speed in cases that don’t require the fuller examination of a federal court. So why not let defendants — at least, those not regulated by the SEC — choose the system in which their cases will be heard? If the SEC won’t allow it, Congress can. Such an option needn’t increase miscreants’ chances of escaping justice, and it would give the SEC an added incentive to keep its process fair.

Some have likened the SEC’s quasi-judicial system to a kangaroo court. Even if it isn’t, it has the potential to become one. It should be restrained before it does too much damage.

See The SEC’s Kangaroo Courts.

Perhaps this will cause some folks at the SEC to reconsider whether the marginal (at best) proposed changes to its Rules of Practice are an appropriate response to serious due process and fairness issues at stake here.  Or if not, maybe Congress will step in to cure the problem it started in the Dodd-Frank Act by handing the SEC jurisdiction over many more cases than it should have.  We can only keep the drums beating and hope someone listens.

Straight Arrow

October 27, 2015

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SEC Proposes Amended Rules of Practice in Recognition of Unfair Procedures

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

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

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

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

Straight Arrow

September 24, 2015

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

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

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

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

Judge Richard Berman - NYLJ/Rick Kopstein 100614

Judge Richard Berman – NYLJ/Rick Kopstein

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

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

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

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

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

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

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

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

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

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

Anne Small -- SEC General Counsel

Anne Small — SEC General Counsel

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

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

Straight Arrow

September 18, 2015

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

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

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

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

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

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

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

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

The Facts

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

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

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

The Findings

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Id. at 31-32.

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

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

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

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

Johnny Rocco

Johnny Rocco (Key Largo)

(“There’s only one Johnny Rocco.”

“How do you account for it?”

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

“Sure.”

“What’s that?”

“Tell him, Rocco.”

“Well, I want uh …”

“He wants more, don’t you, Rocco?”

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

“Will you ever get enough?”

“Will you, Rocco?”

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

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

Straight Arrow

September 15, 2015

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

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

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

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

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

Opinion at 30-31 (footnotes omitted).

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

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

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

Id. at 32-33 (footnotes omitted).

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

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

Straight Arrow

September 4, 2015

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

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

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

The court then addressed the arguments in greater detail:

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

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

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

. . . .

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

. . . .

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

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

. . . .

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

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

. . . .

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

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

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

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

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

Stay tuned.

Straight Arrow

August 24, 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Cert. petition at 4-8.

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

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

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

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

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

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

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

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

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

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

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

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

Brief of Former Prosecutors and Officials at 2-7.

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

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

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

CACL Brief at 3-4.

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

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

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

. . . .

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

Id. at 6-7, 10.

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

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

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

. . . .

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

. . . .

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

. . . .

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

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

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

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

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

Straight Arrow

August 20, 2015

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