Tag Archives: discovery

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

December 3, 2015

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

This is the third in a series of posts addressing the SEC’s proposals for revising the Rules of Practice in its administrative court.  These proposals purport to modernize antiquated procedures in that forum.  Our first two posts addressed two blatant inadequacies in the SEC’s proposals: (1) requiring that respondents plead in their answers certain defense theories that are not “affirmative defenses” required to be pled in response to complaints filed by the SEC in the federal courts; and (2) providing for a discovery process limited to a maximum of 5 depositions, requiring that those be shared among multiple respondents, allowing the Division of Enforcement an equal number of depositions (in addition many investigative depositions taken before the case was filed), and limiting the scope of witnesses that respondents could depose within the tiny allotment provided.  You can review these comments here (Part I), and here (Part II), respectively.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

November 18, 2015

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

June 16, 2015

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Timbervest Files Complaint and TRO Motion To Halt SEC Proceeding

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

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

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

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

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

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

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

Complaint ¶ 28.

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

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

Straight Arrow

June 12, 2105

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SEC ALJ Cameron Elliot Declines To Submit Affidavit “Invited” by the Commission

On June 4, 2015, we discussed the SEC’s Order in In the Matter of Timbervest LLC “inviting”  administrative Law judge Cameron Elliot to submit 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, ‘SEC Wins With In-House Judges,’ and whether he is aware of any specific instances in which any other Commission ALJ has had such communications or experienced such pressure.”  See SEC “Invites” ALJ Cameron Elliot To Provide Affidavit on Conversations “Similar” to Those Described by Former ALJ.  Well, ALJ Elliot either doesn’t think that fits his job description, or he just doesn’t like the idea of providing a sworn declaration to the SEC.  On June 9, after considering the matter for four days, he tersely declined the invitation, saying only “I respectfully decline to submit the affidavit requested.”  (This does suggest that, at least as to this ALJ, the President or his proxies at the Commission do not have much sway over an ALJ who has multiple layers of protection against being fired.)

That would seem to leave the SEC in a bit of a pickle.  The Commissioners obviously thought there would be some value in gathering information on the issue of pressure on ALJs to act favorably to the Commission, which was raised by former ALJ Lillian McEwen with Wall Street Journal reporter Jean Eaglesham.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.  The invitation to ALJ Elliot to supply data specific to him has now been rejected.  The Commission apparently still has not acted on respondent Timbervest’s request for discovery on the issue.  So what next step can the Commission take that doesn’t smack of arbitrarily ignoring the question, even after acknowledging it could be relevant?  We can only wait and see.  The Wall Street Journal reported that in a recent interview, Ms. McEwen explained that a sitting SEC judge would have difficulty discussing whether he or she felt pressure to favor the SEC, but that she said “she would ‘of course’ be happy to give evidence about her own experience” to the commissioners “if the agency decided to ask her for that.”  See SEC Judge Declines to Submit Affidavit of No Bias.

We’ve called for the Commission to commence an open, independent, and transparent inquiry into what is now at least a potential appearance of bias in its administrative process.  If that kind of review is occurring, it certainly is not open and transparent to interested observers.  The outward appearance is that there is a strange paralysis on the issue.  The longer the silence prevails, the more the appearance of this being a real issue has a chance to develop.  With the courts now for the first time showing a willingness to scrutinize the SEC administrative law process in response to challenges raised by respondents (see Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding), paralysis — or stonewalling, if that’s what it is — would seem to encourage continued chaos.  (Speaking of chaos, doesn’t it seem a little strange that in the wake of Judge May’s decision in Hill v. SEC that the appointment of ALJ James Grimes violated the constitution’s appointments clause, the SEC has taken no steps to address that issue?  Instead, following Judge May’s ruling, ALJ Grimes was appointed to preside over a new proceeding: see Order Scheduling Hearing and Designating Presiding Judge in In the Matter of R. Scott Peden.)

Straight Arrow

June 11, 2015

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SEC ALJ James Grimes Denies Request To Certify Discovery Ruling for Interlocutory Appeal

We reported several days ago that SEC administrative law judge James Grimes approved a subpoena to the SEC for materials relating to the allegations by former SEC ALJ Lillian McEwen that she was pressured as an ALJ to issue favorable rulings for the SEC staff.  See SEC ALJ James Grimes Issues Important Discovery Order Against SEC.  The SEC’s Office of General Counsel (OGC) was not pleased.  It asked ALJ Grimes to certify an interlocutory appeal to the Commission itself to challenge the discovery order.  On June 1, 2015, ALJ Grimes rejected that request for an interlocutory appeal.  His order can be read here: Order Denying Certification.

The OGC argued “that Mr. Hill’s request is “extraordinary,” and contrary to “the presumption that administrative law judges are unbiased.”  But the OGC did “not assert that Mr. Hill seeks irrelevant information.”  ALJ Grimes noted that “Mr. Hill has a due process right to an unbiased adjudicator and the media article to which he refers raises concerns about that right,” even though “the Office of the General Counsel is correct that administrative law judges are presumed to be unbiased.”  He also observed that “the conversation that is alleged in the media article must have occurred at least ten years ago — if it ever occurred at all,” and “Mr. Hill has done little to tie that alleged conversation to his proceeding.”  That’s not totally correct, since the person who allegedly pressured Ms. McEwen, Brenda Murray, is currently the Chief ALJ for the SEC — what additional connection could Mr. Hill supply without any discovery?

In any event, ALJ Grimes rejected the request because “[t]he initial opposition to Mr. Hill’s request, however, was based only on an argument that the request sought irrelevant information. The opposition made no mention of the arguments the Office of the General Counsel now raises. The Commission, however, has made clear that a litigant ‘may not rely upon . . . arguments’ not previously raised ‘as a basis for urging interlocutory review.’”  Because “the current basis for seeking interlocutory review was not previously raised, the request for certification is denied.”

ALJ Grimes did stay the obligation to comply with the subpoena until June 4, 2105, to allow the OGC “time to determine whether to seek interlocutory review absent certification.”

Straight Arrow

June 2, 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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