Tag Archives: enforcement director

Peixoto Charges SEC Insider Trading Administrative Action Is Unconstitutional

In a recent post we described the SEC’s aggressive theory in an action brought against Jordan Peixoto for alleged insider trading involving securities of Herbalife Ltd.  See SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.  Mr. Peixoto will not “go gentl[y] into that good night,” and instead will “rage against the dying of the light,” that is, if the light is the Constitution of the United States.  See Peixoto v. SEC, 14 CV 8364 (S.D.N.Y.).

Stating a claim for a declaratory judgment largely identical to the recent action filed by Joseph Stilwell against the SEC in Stillwell v. SEC, 14 CV 7931 (S.D.N.Y.), Peixoto contends that his SEC administrative proceeding is unconstitutional because the SEC’s administrative law judges are executive branch “officers” within the meaning of Article II, but are improperly protected against removal by the President.  This allegedly renders the proceedings they oversee unconstitutional.

Another SEC administrative respondent raised constitutionality issues challenging the fairness of the administrative proceeding in Wing Chau v. SEC, 14 CV 1903 (S.D.N.Y.).  That claim is founded on alleged disparate treatment of Wing Chau and Harding Advisory LLC in being prosecuted in the SEC’s administrative court rather than in federal district court.  The plaintiffs allege that by doing so, the SEC imposes an unacceptably short schedule to trial in a complex matter, prevents discovery of an allegedly tainted SEC official’s misconduct during the investigation, and avoids a jury because the SEC previously lost two of three cases on similar issues tried to juries.  The case involves complex collateralized debt obligation (CDO) transactions for which Harding Advisory was the collateral manager.  The SEC filed a motion to dismiss in that case, which according to court records is fully briefed and awaiting a decision.  In the meantime, the administrative trial in that case has been completed and a decision from the ALJ should be forthcoming soon.

These assertions of constitutional violations all stem from the SEC’s decision to use its captive administrative law court as the forum for major enforcement actions rather than sticking to the more limited traditional role of those courts of adjudicating SEC actions against securities industry regulated persons.  We have discussed this decision, and how harmful it is to enforcement defendants, in earlier posts.  See Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions and SEC Enforcement Director Announces Future Plans To Avoid Jury Trials.

Mr. Peixoto’s action is founded on the alleged Article II shortcoming, but it plainly is motivated by concern that the SEC is trying to gain an unfair advantage by choosing the administrative forum for an insider trading case.  His allegations are focused on equal protection and due process concerns.  For example, he notes that the SEC almost never brings insider trading cases as administrative actions, and that with the exception of two cases (the forum for one of which was changed), “the Commission has filed all litigated insider trading proceedings against non-regulated defendants in district court since the passage of Dodd-Frank in July 2010.  This means the Commission has gone to district court to make allegations against 156 non-regulated insider trading defendants since Dodd-Frank.”

He then suggests the reason for departing from this norm was to deprive him of due process:

Mr. Peixoto denies all allegations of wrongdoing and stands ready to mount a defense against each and every one of the Commission’s allegations.  Yet, under current Commission rules, Mr. Peixoto would be deprived of a jury trial, the right to use the discovery procedures of the federal court to shape his defense, and the protections of the Federal Rules of Evidence which were crafted to bar unreliable evidence.  The Commission is denying Mr. Peixoto these rights, even though the General Counsel of the Commission, Anne K. Small, specifically acknowledged in a public forum merely four months ago speaking to members of the District of Columbia bar that the current administrative proceeding rules are inadequate for an insider trading case.  In a question and answer session between Small and members of the District of Columbia Bar, Small stated that 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,” especially as the rules do not consider complex matters such as insider trading cases.

(See an article about Ms. Small’s speech here: SEC Administrative Case Rules Likely Out Of Date.)

Mr. Peixoto also notes that Andrew Ceresney, the SEC’s Director of Enforcement, acknowledged that the reason the SEC was using the administrative forum was to gain leverage against defendants when he said: “I will tell you that there have been a number of cases in recent months where we have threatened administrative proceedings, it was something we told the other we were going to do and they settled.”  (See the discussion of Mr. Ceresney’s comments in SEC Enforcement Director Announces Future Plans To Avoid Jury Trials.)  Mr. Peixoto concludes: “In other words, the Commission itself unashamedly and, importantly, unlawfully wields the sword of an improper proceeding against defendants to compel settlement.  The Commission is fully aware and has acknowledged that the administrative process is a star chamber where only the Commission emerges as the victor and the defendant is defenseless.  The mere specter of the process renders submission from the defendant because the process is rigged against him.  Here, the Commission is consciously doing exactly what the SEC Director of Enforcement indicated, by attempting to unfairly force Mr. Peixoto to settle, despite his case for innocence and without regard to the disparate treatment established by the data, thus, establishing discriminatory intent and impact.”

The constitutional issues surrounding the SEC’s enforcement powers in both district court and administrative actions are not trivial.  They raise serious issues involving the separation of powers issues, Article II tenure, and due process.  They have been litigated in various forms over many years, but the Supreme Court has never considered the viability of the “civil” prosecutorial scheme for enforcement actions brought by the SEC, which was originally created as an administrative agency designed to be “independent” of both the President and the Congress.

The Article II issue is real, not fabricated, and requires more elaborate discussion in a separate post.  If Administrative Law Judges are inferior executive “officers” in the Article II sense, their shielding from discipline by the President could well violate Article II.

Likewise, there are real due process issues attached to the use of administrative courts to impose substantial penalties.  The timing requirements for hearing of claims and making decisions that are imposed by the SEC may be inconsistent with a fair trial on complex issues.  In addition, the SEC Commissioners who approve filing the claims (and consider proposed settlements of the claims) are the same people who must review the initial decision of the administrative law judges.  The only non-SEC review is on appeal, where the court of appeals applies a deferential review standard and therefore cannot consider the complex findings of fact that are critical to these cases.  Whether this satisfies due process in light of the built-in conflict of interest the SEC Commissioners have as prosecutors and adjudicators is a serious matter.

Finally, the Supreme Court has never considered whether, under the standards set forth in Morrison v. Olson, 487 U.S. 654 (1988), the SEC violates the separation of powers doctrine when it brings civil law enforcement actions because the Commissioners do not serve at the will of the President.  The SEC is designed to be an “independent” administrative agency that functions above (or at least beyond) the political fray, but that may not be consistent with the directive that the Executive Branch is to make law enforcement decisions.  Morrison, which sustained the constitutionality of the independent prosecutor statute, laid out specific factors that must be considered to determine when prosecutors shielded from Executive control may exercise prosecutorial authority without violation the separation of powers doctrine.  The validity of the SEC’s authority has not been considered by an appellate court since Morrison was decided.  

As the SEC’s enforcement tactics become more aggressive (and questionable), these fundamental issues about the lack of checks and balances on SEC prosecutorial power and authority become all the more critical.

We will discuss these complex issues in later posts.

 Straight Arrow

October 21, 2014

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Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions

In our first blog post in April 2014, we asked: “Why Isn’t the SEC Committed to a Just and Fair Enforcement Process?”.  Several months later, the SEC’s new enforcement director announced the SEC’s plans to bring more prosecutions in its captive administrative court, taking them out of the federal courts.  Whether coincidentally or not, this decision came in the midst of growing publicity on repeated SEC losses in federal court enforcement actions it brought: e.g.SEC v. Stoker; SEC v. Cuban; SEC v. KovzanSEC v. Obus; SEC v. Jensen; SEC v. Schvacho; SEC vSteffesSEC v. Petit (case dropped on eve of trial); SEC v. Graham; SEC v. Moshayedi.  (We wrote posts about ObusGraham, and Moshayedi.)  We questioned this decision as a matter of fairness and public policy in our June 12, 2014 post: “SEC Enforcement Director Announces Future Plans To Avoid Jury Trials.”  In his announcement, the enforcement director acknowledged that the SEC was at least partially motivated by a desire to move cases to a forum more hospitable to the SEC.

The SEC’s use of administrative proceedings to prosecute penal enforcement actions has many of the characteristics of a “Star Chamber” proceeding.

  • The SEC enforcement staff convinces the Commission to bring a case in a private meeting.
  • The case is commenced in a court overseen by an SEC administrative law judge (ALJ), who is hired by, and works in an Office within, the SEC.
  • The case proceeds under Rules of Practice set by the SEC.
  • The respondent in a proceeding has limited rights to gather evidence to defend the case — e.g., there is no right to subpoena evidence from the SEC or third-parties without ALJ approval (which the SEC litigators routinely oppose); there is no right to depose witnesses in advance of trial to learn what evidence they may have; there is no right to challenge the SEC enforcement staff’s unilateral determination of what gets included in the enforcement “file” that gets delivered to the respondent.
  • The respondent must be ready to try the case under an expedited schedule, but the SEC typically has had years to develop and review evidence before the case is brought.
  • The standard rules of evidence do not apply at trial.
  • There is no jury.
  • The judges are of varying quality (never having gone through an independent approval process), have much greater familiarity with the SEC lawyers than defense lawyers, tend to give great leeway (and sometimes deference) to the SEC lawyers, and are forced to decide complex cases under the deadline set by the SEC itself.
  • After the ALJ rules, the right of appeal is to . . .  the SEC.  The very group that authorized bringing the case gets to rule on the appeal sitting in an administrative adjudicative capacity; the prosecutor becomes the judge.
  • Only after that process is complete — and we’re now talking about years into the case with huge costs of defense — does the respondent have a right to appeal the decision to an independent court.  Even then, the appellate court is saddled with a “standard of review” that allows it to overturn the SEC’s determination only if it is “arbitrary,” an “abuse of discretion,” or “contrary to law.”  Essentially, only if no reasonable basis can be found to support the Commission’s findings, they must be affirmed.  As a result, no person outside of the SEC reviews the evidence de novo to decide if it fairly supports findings against the respondents under the applicable burden of proof, or if the sanctions imposed are fair. 

I am not suggesting that SEC administrative law judges knowingly stack the deck against respondents.  I think they try to be fair.  But they cannot alter the fact that the rules of these proceedings are stacked against respondents in the ways described above.  And it is not surprising that they may tend to undervalue due process protections, and evidentiary niceties, that may make their jobs, and the jobs of the SEC litigators, more difficult.  Of course, this is not a true “Star Chamber” because general notions of due process are still recognized, but the proof of the pudding is in the eating, and, there is no doubt that defense counsel prefer a judicial forum, and the SEC’s enforcement director himself noted that the SEC’s administrative courts seem to provide the SEC an advantage over those pesky federal courts.

The advantages to a defendant of a highly-qualified, independent, Article III judge cannot be over-emphasized.  The entire pre-trial process is imbued with disputes about how information and evidence can be gathered and must be shared, as well as what can and cannot be included in the case, and on what issues there actually is disputed evidence that justifies a trial.  And then, of course, there is the administration of the trial and the determination of evidence to be considered.  Most federal district court judges approach these issues seriously, fairly, and with true understanding of the importance in a case brought by the Government that the defendant is getting a “fair shake.”  One recent example of this (discussed in detail here) is Judge Scheindlin’s willingness to reject the SEC’s overbearing and totally unjustified effort to obtain so-called “disgorgement” from the Wyly brothers of $500,000,000 based on near-preposterous arguments about how the amounts they realized from stock options granted to them as management of highly successful companies were derived from non-disclosures about their control of stock held by offshore trusts.  It is rare that ALJ’s repudiate the SEC so thoroughly in administrative cases (although, to be fair, it has happened on rare occasions).

There seems to be a rising sense of abuse of power in the SEC’s announced decision to bring more of its civil prosecutions before its administrative law court.  Several articles or comments addressing this issue are linked in the “SEC Enforcement” section in the right margin of this blog.  One of these articles discusses a recent comment by district court judge Jed Rakoff (a former head prosecutor for securities cases in the U.S. Attorney’s office) asking “from where does the constitutional warrant for such unchecked and unbalanced administrative power derive?”.  Some suggest that the transfer of non-technical securities enforcement prosecutions to this forum to gain the advantage of reduced procedural protections violates due process requirements.  Thus, cases not focused on rules violations like technical broker-dealer or investment advisory rules, but rather on broader accusations of “fraud,” seem suspiciously out of place in an administrative court, the stated purpose of which is to allow the application of special expertise to these cases.

Keep an eye on developments in this area.  The SEC will not get a free ride on this.  In my estimation, the D.C. Circuit court appeals will be considering this issue in the not-too-distant future.

Straight Arrow

August 7, 2014

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