Tag Archives: Enforcement Division

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

Today we present Part II of our discussion on the proposed changes offered by the SEC to the Rules of Practice governing its administrative proceedings.  Those proposals can be reviewed here.  They purported to be an effort to modernize rules adopted many years ago, long before significant changes to both the nature of litigated proceedings (based primarily on the enormous increase in evidentiary material available in the digital era), and the nature of the specific proceedings before the SEC’s administrative courts (based on jurisdictional changes over time, most recently the addition of new authority under the Dodd-Frank Act).

The proposals are patently inadequate to address the current problems in the administrative court, virtually all of which have the effect of tilting those proceedings against respondents and in favor of the prosecutor, which is the SEC’s Division of Enforcement.  The reasons why the current procedural rules are unfair have been discussed at length over the past two years, including on several occasions in this blog.  (See Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions, and Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions.)  The reasons why these proposed changes fail to come close to solving those fairness problems are the subject of the multi-part discussions here.

In Part I, we described one of the more blatant flaws in the proposal, by which the SEC actually seeks to increase the advantage the Division of Enforcement has in the administrative court versus federal court proceedings – the proposed new requirement that in their Answers, respondents must disclose certain defense theories even though they are not “affirmative defenses,” including defenses based on “reliance.”  See Why the SEC’s Proposed Changes to Its Rules of Practice Are Woefully Inadequate — Part I.

Today we address another one of the major shortcomings of the new proposal – the proposed limits on depositions of witnesses or potential witnesses.  The proposal is described by the SEC as follows:

Rule 233 currently permits parties to take depositions by oral examination only if a witness will be unable to attend or testify at a hearing.  The proposed amendment would allow respondents and the Division to file notices to take depositions.  If a proceeding involves a single respondent, the proposed amendment would allow the respondent and the Division to each file notices to depose three persons (i.e., a maximum of three depositions per side) in proceedings designated in the proposal as 120-day cases (known as 300-day cases under current Rule 360).  If a proceeding involves multiple respondents, the proposed amendment would allow respondents to collectively file notices to depose five persons and the Division to file notices to depose five persons in proceedings designated in the proposal as 120-day cases (i.e., a maximum of five depositions per side).  Under the amendment, parties also could request that the hearing officer issue a subpoena for documents in conjunction with the deposition.

This proposal lacks any reasoned support — and really any attempt to provide reasoned support.  It ignores historic practices in federal courts, which have had to address this issue for many years.  Instead of adopting a flexible set of principles or guidelines that can be applied in different ways under varying facts and circumstances, it picks a magic number of depositions that applies to all cases without regard to variations in cases.  But alas, the magic of the number is never described.  And it makes assumptions about how the magic number is to be applied that (a) fly in the face of reality, and (b) act as a potential severe hardship on the defense when there are multiple defending respondents, without any discussion whatsoever of those issues.  The only apparent guiding principle is to assure that the SEC staff’s well-known — and now documented (see Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal) — advantage in the administrative court will continue.  The proposal is successful in only one respect: it provides a textbook case of arbitrary and capricious rulemaking.

Where the Parties Start Matters

To evaluate this proposal, we need to consider some context.  We need to understand that when an enforcement proceeding of any type – judicial or administrative – begins, the parties are not even close to equally prepared to litigate the case.  That is because one party – the Division of Enforcement – has already been gathering and examining evidence for years, while those accused of violating the law have had very limited access to information, and have been focused on avoiding an enforcement action, not litigating one.  Any set of litigation rules that ignores this basic fact is destined to be biased in favor of the party given a multi-year head start.

An SEC enforcement proceeding, whether brought in federal court or the SEC’s administrative court, occurs only after an extensive investigation by the Division of Enforcement.  That investigation may last years, and usually does.  In that investigation, the SEC staff has virtually unlimited subpoena power, both to seek documents to obtain sworn investigative testimony from anyone the staff chooses.  It is not unusual for serious investigations involving contested issues to go on for more than three years.  Lots of documents may be produced – in corporate cases, often millions of pages of materials are produced to the SEC by various parties.  Many persons may be required to testify – 15 to 30 would not be unusual – and several of them will be required to testify on multiple occasions.  In addition to this, the SEC staff will interview other witnesses or potential witnesses without recording their testimony.

The “investigative testimony” is controlled by the SEC staff.  It often is not clear whether individuals are being targeted for possible action, and if so, which ones.  As a result, witnesses are vulnerable to manipulation because their objective is to avoid being accused of violations, and they are concerned that appearing combative and “pushing back” on questions will undercut that goal.  And manipulation does occur.  Witnesses may be (and are) bombarded by questions from several examiners at once; questions may be (and are) leading; questions may be (and are) deceptive, in an effort to induce responses the staff may be looking for; witnesses are not given advance access to materials to allow them refresh their memory or think about (or look for) other relevant materials that could place documents in their proper context; the examiners pick and choose the exhibits they use, and often do so as a means of influencing the testimony (e.g., they will use an email out of context when the broader context shows the content in a very different light); the examiners may (and do) suggest answers and pressure witnesses to change their testimony when the answers they receive do not match their perceptions or contentions; and the examiners do not typically pursue lines of examination designed gather information about defenses to possible violations.  Defense counsel is given an opportunity to ask questions, but without access to the evidence is limited in doing so.  The end result of these examinations is often a transcript of testimony that is designed to support the staff’s “going in” theory of violations of law that they are considering to pursue with the Commission.

[To those who may be skeptical that these questionable practices really occur, I can only say that I witnessed each of them on many occasions as a practicing securities defense counsel.  Not all SEC enforcement staff lawyers do these things, but many do, and they are not subject to meaningful controls by their supervisors.]

The only outside person who may be given a copy of testimony by the staff is the person testifying.  Even that occurs under rules set by the SEC, and a transcript can be denied to a witness if the staff objects, although that is rare.  Only to the extent that witnesses agree to share transcripts might they be able to get an understanding of the testimony of other witnesses.  That often occurs among witnesses with parallel interests, but it is rare that those being investigated have anything approaching a complete record of what people said before a case is brought.

When a case is brought, the SEC staff turns over to the accused what they consider to be non-privileged portions of the formal investigative file.  That normally includes all transcripts of investigative testimony, and all documents obtained by subpoena or other staff solicitations, but not records of witness interviews or compilations of relevant materials gleaned from all of the produced documents, which the staff almost always treats as privileged.  The investigative file is also narrowly defined as the materials specifically developed for the case against the accused.  It does not include other relevant documents that may be in the SEC’s possession that were obtained in other ways – perhaps, for example, in the course of other investigations on the same general subject matter.  For example, if the SEC staff is investigating a particular accounting practice and decides to bring an enforcement action alleging the practice was wrong, or even fraudulent, the “investigative file” produced would exclude all materials the SEC gathered about the use of that same accounting practice by other persons, whether or not they might provide valuable evidence in the specific proceeding brought.  But the SEC staff always has access to that additional data to the extent they choose to use it.

As noted, the SEC staff is typically involved in an investigation for years.  But the persons sued learn that they are targets only when they are asked for a “Wells Submission” (or sometimes a “pre-Wells Submission”). (A pre-Wells Submission is a relatively recent practice in which the staff advises a target of a potential action and gives an opportunity to respond, but does not label it a so-called “Wells Call.”  That happens because many companies now treat the formal request for a Wells Submission as an event that should be disclosed publicly, and even the SEC staff understands that it might be irresponsible to take steps requiring the public disclosure of possible violations identified in the midst of an investigative process.)  The Wells Submission process is one in which the staff informs targets of its conclusion that violations of law occurred and intent to seek approval from the Commission to prosecute, describes the alleged violations, and gives the accused persons a chance to prepare a submission that would accompany that memorandum to the Commission.  In practice, the Wells (or pre-Wells) Submission also serves as the first chance for a target to try to convince the staff that he or she did not violate the law as alleged by the staff.  The Wells Submission process is mandatory – the staff cannot avoid it.  But when the Wells Submission is drafted, the accused only has access to whatever materials he or she has been able to gather without any subpoena authority – either from those that may have submitted them to the SEC, if they choose to share them, or those the SEC staff agrees to allow them to see.

(As an aside, historically, Wells Submissions “back in the day” were often helpful in convincing the staff not to move forward with the charges, or least to mitigate them.  But in more recent years, Wells Submissions are much less likely to succeed at avoiding a proceeding along the lines originally proposed by the staff.  In fact, many experienced members of the securities defense bar now advise that no submission be made because it mostly provides the staff with a roadmap of a future defense of the accused.)

The end result is that when an enforcement proceeding is commenced, the SEC staff has already, usually for several years, been: (1) reviewing a large amount of relevant evidence; (2) developing an “investigative record” molded to support their charges; (3) producing witness testimony that often is slanted in favor of the staff’s theories because of the way those examinations are conducted; (4) gathering information about likely testimony of potential additional witnesses in secret interviews that are not transcribed; and (5) obtaining information about the likely defenses of the accused violators through the Wells Submission process.  In contrast, the accused violators have limited information. Indeed, in many cases, their defense counsel was often not even involved in the investigation because it was not until a late stage (a Wells Call) that the actual targets were identified, and often only at that time do they obtain separate counsel to defend the threatened case against them.

The SEC’s New Proposed Discovery Rules Are Plainly Unfair

This context makes it painfully clear that the current discovery provisions for administrative proceedings in the SEC’s Rules of Practice are designed to handcuff defense counsel and prevent a fair opportunity to develop a reasonable defense.  We won’t here belabor the shortcomings of those existing rules.  The facts speak for themselves.  Defense counsel are given an extremely limited period to learn the record and develop a defense, even in cases in which millions of pages of documents were produced, and the SEC staff has had years to sift through and analyze them. Defense counsel has no right to depose any witness except in very limited circumstances.  Investigative transcripts are typically admitted into evidence with no right to cross examination on the fiction that they provide a reliable picture of the facts.  The SEC staff is rarely required to provide access to its non-transcribed interviews, and often is not even required even to identify the people that were interviewed.  Relevant evidence in the SEC’s possession is rarely required to be produced if it lies outside the narrow confines of the so-called “investigative record,” even when the SEC staff has access to plainly relevant materials located elsewhere.  None of these limitations applies if the case is brought in federal court.

The new proposed rules do almost nothing to remedy this.  They allow an arbitrary number of depositions that is divorced from any analysis of what cases really require, and from any recognition that these are far from “one size fits all” cases.  They allow only modest and plainly insufficient increases in time to prepare the case for trial.  The periods chosen fail to take account of the fact that the SEC staff has years to prepare a case and the defense merely months.  They also reflect no effort to analyze the trial preparation needs of these cases in federal courts, at least as a baseline for figuring out what might be reasonable in the administrative forum.  Amazingly, no effort is made to analyze whether the demonstrable advantage the SEC staff has in access to evidence and witnesses, and in preparation time, may impact the fairness of the proceedings.  These failures are quintessential examples of arbitrary and capricious decision-making under the Administrative Procedure Act.

This post is focused on the inadequacy of the proposed revisions to Rule of Practice 233 with regard to the provision for depositions.  The proposed new Rule 233 would allow depositions as follows:

(1) “If the proceeding involves a single respondent . . . , the respondent may file written notices to depose no more than three persons, and the Division of Enforcement may file written notices to depose no more than three persons”; and

(2) “If the proceeding involves multiple respondents, the respondents collectively may file joint written notices to depose no more than five persons, and the Division of Enforcement may file written notices to depose no more than five persons. The depositions . . . shall not exceed a total of five depositions for the Division of Enforcement, and five depositions for all respondents collectively.”

This proposed provision is arbitrary, capricious, and blatantly unfair in several respects.

First, without any consideration or analysis of the imbalance between the SEC staff and the respondents in case preparation and access to evidence and potential witnesses, it assumes that the SEC staff and the respondents (as a group) should be entitled to an equal number of depositions.  By ignoring the fact that the SEC staff previously had access to many witnesses, perhaps on multiple occasions, and the defense had no such access, the proposal’s determination that an equal number of depositions for the prosecution and defense is appropriate is purely arbitrary, lacking any supporting analysis or explanation.  Indeed, it is not clear, nor discussed, why the SEC staff needs to take any depositions after having had unrestricted access to subpoenaed, sworn witness testimony during the entire investigative process.

Second, apart from that fundamental shortcoming, the determination that in cases with multiple respondents, the SEC staff should be entitled to five depositions while the respondents as a group must split five depositions (i) lacks any basis or analysis; (ii) places respondents in a position of having to compete for limited depositions without any discussion of why this is appropriate; (iii) assumes – without support in either theory or common practice – that the respondents as a group will be able to agree on how to divide the five depositions, and fails to discuss the impact of potential conflicts among the respondents; and (iv) ignores a wealth of experience about fair ways to divide limited numbers of depositions among a plaintiff and multiple defendants.  It also chooses an approach that differs greatly from what typically is adopted in the courts in similar situations, without any indication that the Commission has even considered those precedents, or why, if that consideration occurred, the judicial precedents were ignored.  The notion that in a proceeding brought by the SEC against five respondents, the SEC staff is entitled to five depositions while each respondent is entitled to only one defies logic or common sense, and the Commission attempts to provide no reasoned explanation for this arbitrary decision.

Third, even apart from the division of depositions among the parties, no rationale or reasoned explanation is given for the number of depositions permitted.  One would expect that a reasoned process would develop data about the historic need for deposition discovery in comparable cases in federal court, along with analysis of whether reductions in those numbers could be justified in the name of efficiency without sacrificing fairness.  There is no indication by the Commission that it undertook any such analysis or made any such considerations.  In fact, in factually challenging cases, it would not be unusual to have ten to thirty fact depositions in a federal court case, followed by at least two expert depositions per side.  Perhaps some of these could be avoided, but there is no analysis of either the common practice in federal court, or how that could be improved upon in the administrative court.

Out of curiosity, I did a little research to see how many depositions are permitted by the courts — usually based on a stipulation between the SEC and defendants — in SEC enforcement actions in federal court.  As noted above, this certainly is an analysis the Commission should have done before picking its own number.  My research was limited to a few of the enforcement cases reported to have been litigated by the SEC in recent years.  I did not find any case that did not permit at least 10 fact depositions for each side (expert depositions would be additional).  The number could be much larger.  In SEC v. Cuban (N.D. Tex.), each side was permitted 10 fact depositions, by mutual agreement; in SEC v. Steffes (N.D. Ill.), each side was permitted to depose “more than ten witnesses”; in SEC v. Kovzan (D. Kan.), each side was permitted 15 fact depositions; in SEC v. Anselm Exploration (D. Col.), each side was permitted 20 depositions, by mutual agreement; in SEC v. Collins & Aikman Corp. (S.D.N.Y.), the parties proposed that the SEC could notice 25 depositions and multiple defendants could notice 50, and the court allowed 15 fact depositions by the SEC and 20 fact depositions by defendants; in SEC v. Jensen (C.D. Cal.), each side was permitted 30 fact depositions, by joint agreement; in SEC v. Moshayedi (C.D. Cal., each side was allowed 25 fact depositions, by joint agreement; and in SEC v. Mudd (S.D.N.Y.), each side was permitted 75 fact depositions by joint agreement, plus as many expert depositions as there were experts designated.

Another possible approach, would be to look at the number of investigative witnesses examined by the SEC staff in these cases, plus the number of witnesses subject to informal SEC interviews, as a starting point for figuring out how many examinations the defense should be permitted.  There is no indication that the Commission did any such analysis, or even took that factor into account.

So where, exactly, is origin for the notion that five depositions (including expert depositions) is fair and sufficient?   We don’t know, because no effort is made to explain, or justify, the choice.  There is simply a number (the number 5) plucked out of the air.  Perhaps a commissioner was a fan of the famous William Carlos Williams poem “The Great Figure”:

Among the rain
and lights
I saw the figure 5
in gold
on a red
firetruck
moving
tense
unheeded
to gong clangs
siren howls
and wheels rumbling
through the dark city.

 

Or perhaps a commissioner was fond of the painting by Charles Demuth in the Metropolitan Museum of Art, “The Figure 5 in Gold,” made in homage to the Williams poem (see Where Paint and Poetry Meet).  I could understand that, because that was my favorite artwork as a kid.

Charles Demuth - The Figure 5 in Gold

Charles Demuth – The Figure 5 in Gold

Whatever may have occurred to yield the number 5, nothing we have been told suggests anything other than purely arbitrary decision-making.

Fourth, choosing a number as small as five for the number of depositions permitted (and even fewer per respondent for multiple respondents) obviously advantages the party with more access to information and witnesses outside of the deposition process, which is the SEC staff.  If a larger, and more reasonable, number were chosen, at least the defense might have an opportunity to catch up to the SEC in access to possible witnesses, learning the facts and evidence, and preparing for trial, by taking full advantage of its allocation.  But with at most five depositions permitted, this will almost never occur because most of these cases have many more potential fact witnesses (not to mention experts).

Fifth, even within the limited number of depositions, the proposed new rules also hamstring the defense of cases by limiting the witnesses the defense may subpoena.  Remember, the SEC staff has free-ranging access to witnesses during its investigation using its subpoena power, without having to sustain the burden of showing why those witnesses should be examined.  But the Commission’s proposed limit on who can be deposed places a burden and limitation on the defense, even beyond the meager numbers, because it requires that motions to quash deposition subpoenas be granted unless the party can show that the proposed deponent (i) “was a witness of or participant in any event, transaction, occurrence, act, or omission that forms the basis for any claim asserted by the Division of Enforcement, or any defense asserted by any respondent in the proceeding”; (ii) “is a designated as an ‘expert witness’” [sic]; or (iii) “has custody of documents or electronic data relevant to the claims or defenses of any party.”  The rationale given for this limitation is that: “This provision should encourage parties to focus any requested depositions on those persons who are most likely to yield relevant information and thereby make efficient use of time during the prehearing stage of the proceeding.”  But the limited number of depositions already creates ample pressure to make the best use of them, and if the defense values a deposition sufficiently to use a precious slot on a deponent even if he or she is not “a witness or participant” in the matters at issue, or a designated expert, the Commission provides no rational reason why that should not be permitted.

For example, in cases involving allegations of scienter based on a theory that the respondent’s conduct was “reckless,” the critical issue in the case may be determining the appropriate industry standard against which the judge could compare the conduct proved to determine whether it departs from that standard so egregiously that it was “reckless.”  A key witness on that issue may be one who has knowledge of the industry standard or practice — not necessarily as an expert, but as an industry participant giving fact testimony.  In fact, the fact testimony of several such witnesses could be highly relevant, until they became unduly cumulative, by which time the key factual point would be made.  Under the SEC’s limitation, such a person, who was not “a witness or participant” in an act that forms the basis for the claim, could not be deposed.  But it is hard to imagine any rational reason why that deposition testimony should be barred.  Indeed, it would seem likely that providing such evidence to the ALJ by means of a deposition transcript would be much more efficient and economic than hearing the testimony live.

Finally, there is no discussion at all about why it is appropriate to choose a single number for depositions without regard to the nature of the case, the complexity of the facts, the number of experts to be used, the length and complexity of the investigation, or any of the myriad of factors that differentiate cases from one another.  In other words, the very decision of choosing a single maximum number of permitted depositions for all cases lacks any discussion or support.  It also flies in the face of reason, reality, and years of litigation experience.  There is a reason why the number of depositions in federal court civil cases is a discovery issue to be discussed by the parties and ultimately decided by the presiding judge.  As the precedents discussed above show, cases differ, and discovery needs differ with them.  The decision to choose a single maximum number for all cases regardless of their nature and needs is by all appearances a capricious choice, even without regard to the fact that the number chosen is unconscionably low.

There no doubt are more reasons why the arbitrary choice of five depositions, to be divided among all of the respondents, lacks any reasonable basis.  But the point is sufficiently made already.  The Commission’s proposal on depositions reflects more whim than anything else.  The level of analysis of the issue and reasoned consideration of the options is pathetic.  The retention of an inherently unfair process that favors the SEC staff and undermines the defense is so clear that one can only assume it was intended.  If adopted by the Commission in a final rule, it should be challenged, and should be overturned by the court of appeals.

In Part III of our analysis of the SEC proposal, we will examine some of the other respects in which the Commission’s proposed rule changes assure that the SEC staff will continue to have a distinct advantage over respondents in the SEC’s administrative proceedings.

Straight Arrow

November 5, 2015

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

On September 24, 2015, the SEC proposed changes to its Rules of Practice governing administrative proceedings, which Chair Mary Jo White said “seek to modernize our rules of practice for administrative proceedings.”  After resisting immediate comment pending a careful review of the proposals and underlying explanations, a considered evaluation can now be made.  Unfortunately, this proposal represents so feeble an effort at modernizing the Commission’s dated Rules of Practice that only one judgment is justified.  If the provision of fair and “due” process to respondents in these actions is the standard, the Commission’s grade is an “F+.”  If providing a reasoned and rational explanation for the proposals is the standard (i.e., do they pass muster under the Administrative Procedure Act), the Commission’s grade is an “F.”  In fact, the only way this set of proposals gets anything more than a “D+” is if the objective was to create a proposal that could act as a Potemkin Village for arguments that the Commission is acting responsibly, and even in that regard, what the Commissioners came up with was a pretty shoddy Potemkin Village.

The proposals do not even begin to analyze or address in any substantive way the issues raised in depth by commentators over the 15 months since the SEC’s General Counsel acknowledged the existing rules are plainly insufficient to adjudicate complex cases.  See, for example, Chamber of Commerce Report Details Concerns with SEC Enforcement and Proposed Reforms.

The proposed revisions to the Rules of Practice can be reviewed here: Proposed amendments to SEC Rules of Practice.

Far from representing a good faith attempt to provide procedures that would allow fair proceedings on a somewhat more expedited basis than most federal courts, the proposals do nearly nothing to alter the pro-prosecution tilt that currently exists. That tilt is well-understood by the securities bar, and was documented statistically by the Wall Street Journal.  See Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.  Virtually nothing in these proposals changes that.  In fact, there are as many changes designed to give even greater advantages to the SEC prosecutorial staff as there are even minor attempts to give respondents a fighting chance.

The next several Securities Diary blogs will address various aspects of the SEC’s proposal and explain why (1) they do not represent a good faith effort at creating a modernized administrative adjudicative process designed to be fair to all parties, including respondents; (2) they are not supported by anything approaching reasoning or analysis that shows the changes proposed are well-designed to achieve identified goals, but instead represent fiats by the Commission that have no support beyond an arbitrary or capricious Commission determination; and (3) they include “goodies” for the benefit of SEC prosecuting staff that achieve no meaningful goal other than to make it easier for the Division of Enforcement to win.

Today we will start with an example so egregious that it is astonishing it got past whatever (apparently feckless) legal quality control was used to winnow out staff requests for new “goodies” that cannot be reasonably justified.

One of the SEC proposals is to amend Rule 220 of the Rules of Practice to mandate that “a respondent must affirmatively state in an answer whether the respondent is asserting any avoidance or affirmative defense, including but not limited to res judicata, statute of limitations, or reliance.” Proposal at 17.  The Commission explains: “This proposed amendment would not change the substantive requirement under the current rule to include affirmative defenses in the answer.  Instead, it is intended to clarify that any theories for avoidance of liability or remedies, even if not technically considered affirmative defenses, must be stated in the answer as well.  Timely assertion of affirmative defenses or theories of avoidance would focus the use of prehearing discovery, foster early identification of key issues and, as a result, make the discovery process more effective and efficient.”  Id.

Current Rule 220 says this about pleading affirmative defenses: “A defense of res judicata, statute of limitations or any other matter constituting an affirmative defense shall be asserted in the answer.”  This provision is roughly consistent with the Federal Rules of Civil Procedure, which require that a defendant’s Answer notify the plaintiff of all affirmative defenses he intends to present.  Importantly, “affirmative defenses” include only those on which the defendant bears the burden of proof, like res judicata, assumption of risk, statute of limitations, and the like.  In court, a defendant is not required to identify the ways in which he intends to introduce evidence counteracting elements on which the plaintiff has the burden of proof.

The SEC’s new proposal seeks to change this long-standing pleading standard by requiring that defendants identify not only “affirmative defenses” (on which they have the burden of proof), but also inform the SEC staff of the ways in which they intend to defend against the charges by refuting elements on which the Division of Enforcement has the burden of proof.  The Commission describes these as “theories for avoidance of liability or remedies, even if not technically considered affirmative defenses.”  This is an insidious “goody” to provide the prosecuting staff with (a) the right to learn defense theories of defense in advance, and (b) presumably the right to preclude certain defense theories if they are not disclosed in advance.

It is not clear what “theories for avoidance of liability” this meant to include, with one exception – the specific reference to requiring that a respondent plead in his answer any defense theory of “reliance.” This is the “tell” that shows you that the SEC staff provided a list of substantive “goodies” it wanted out of this supposed reform of obsolete procedures.  Forgive me, but understanding why this is so requires a little background.

Most of the major cases the SEC litigates involve allegations of fraud.  Fraud requires proof of scienter, that is a state of mind showing that the respondent knowingly violated the law.  The SEC, and all federal appellate courts other than the Supreme Court (which has not ruled on the issue), allow proof of “reckless” conduct to establish the required intent.  But in all instances it is the prosecutor’s (or plaintiff’s) burden to prove scienter.  It is not an “affirmative defense” because it is not a defense on which the respondent bears the burden of proof.  The prosecutor or plaintiff, here the SEC Division of Enforcement, must introduce evidence that the respondent acted with intent, and in the end, the court (or jury) can rule against the respondent only if a preponderance of all of the evidence on that issue supports a finding that the respondent acted with scienter.

The SEC staff often lacks direct evidence showing the respondent acted with scienter.  In those cases, the staff relies on their portrayal of the circumstances to show that a respondent acted with scienter, typically arguing that under the circumstances (as they portray them), the respondent “must have” acted with intent because it was obvious that they were engaging in wrongful conduct, or ignoring whether the conduct was right or wrong.  But the Staff often is faced with a problem: evidence, usually developed by the people it prosecutes (the SEC staff rarely tries to develop a complete record on this during its investigation) that (a) they did not know they were violating the law, and (b) they acted on the basis of information or advice received from others which in fact allowed them to believe reasonably that what they were doing was lawful.  Such evidence undercuts the staff’s circumstantial arguments and tips the scale against finding that the respondent knowingly or recklessly violated the law.

One, but certainly not the only, way this occurs is when respondents want to offer proof that they received legal advice that gave them comfort that what they were doing did not violate the law.  This sometimes is referred to by the staff as a “reliance on counsel” defense, but in fact it is nothing more than introducing additional circumstantial evidence that may weigh in favor of concluding that the respondent did not intentionally violate the law.  The same type of evidence could involve advice or communications from accountants or other professionals, communications from government officials (including SEC officials themselves), and even information conveyed by people with whom the respondent worked, and who could reasonably be expected to provide accurate or reliable information or advice.

(As an aside, the Commission proposal says in footnote 28: “some might argue that ‘reliance on counsel’ is not a formal affirmative defense, but a basis for negating liability.”  That is a blatant misstatement of the law.  This is not a “some might argue” issue.  There is no doubt in the law that “reliance on counsel” is not an affirmative defense – formal or informal.  Accordingly, there is no obligation in federal court to include “reliance on counsel” in the affirmative defenses in the Answer to a Complaint.  Indeed, such a purported affirmative defense could be stricken as improper.  Reliance on counsel is a form of evidence providing a strong inference that the defendant did not act with scienter because he received, and acted in conformity with, advice provided by well-informed legal counsel.)

In court, no aspect of this type of defense needs to be included in the Answer to the Complaint.  And the same is (or should be) true under the current formulation in SEC Rule of Practice 220.  But the staff hates that.  They want to know what theories the defense will use to undermine scienter, but most especially what evidence might be used to show that the respondent reasonably relied on input from another person to believe he was acting properly.  So, lo and behold, a requirement to notify the staff of any such intended theory of “reliance,” gets included in the proposed revised Rules of Practice.  Voila! One of the SEC staff’s greatest banes is removed – poof!

And what is the reasoning provided for making this major change that advantages the SEC staff in these cases?  Try this: “Timely assertion of affirmative defenses or theories of avoidance would focus the use of prehearing discovery, foster early identification of key issues and, as a result, make the discovery process more effective and efficient.”  Proposal at 17.  That is pure blather.  More of a rationale – much more of a rationale – is needed to support a basic, significant change in pleading burden for respondents that gives a major tactical advantage to the prosecution (which we know in these proceedings hardly needs additional advantages).

Slipping this change into the proposed Rules of Practice is an insidious effort to put an additional thumb on the scale in favor of the prosecution in SEC administrative cases.  If adopted in the final rules, it should challenged as, at a minimum, a significant departure from long-standing procedures that is designed to assist the SEC prosecutorial staff but lacks any grounding in a valid objective of the Rules of Practice, and hence is arbitrary and capricious.

Next time: why allowing a maximum of three depositions in a complex case (or five in a case with multiple respondents) (a) fails to achieve any semblance of fairness, (b) is proposed without any supporting analysis suggesting it accomplishes any stated goal, and (c) therefor is arbitrary and capricious as proposed.

Straight Arrow

October 8, 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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