Tag Archives: fairness

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

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

Here is what Bloomberg View said:

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

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

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

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

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

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

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

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

See The SEC’s Kangaroo Courts.

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

Straight Arrow

October 27, 2015

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SEC Proposes Amended Rules of Practice in Recognition of Unfair Procedures

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

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

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

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

Straight Arrow

September 24, 2015

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Timbervest Files Complaint and TRO Motion To Halt SEC Proceeding

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

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

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

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

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

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

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

Complaint ¶ 28.

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

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

Straight Arrow

June 12, 2105

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SEC “Invites” ALJ Cameron Elliot To Provide Affidavit on Conversations “Similar” to Those Described by Former ALJ

In the administrative proceeding In the Matter of Timbervest, LLC et al., File No. 3-15519, the SEC issued an order “inviting” ALJ Cameron Elliot to provide an affidavit “addressing whether he has had any communications or experienced any pressure similar to that alleged in the May 6, 2015 The Wall Street Journal article, ‘SEC Wins With In-House Judges,’ and whether he is aware of any specific instances in which any other Commission ALJ has had such communications or experienced such pressure.”  See Order Concerning Additional Submission and Protective Order.  This in response to a motion by Timbervest for discovery into the conversation reported in the Wall Street Journal between former ALJ Lillian McEwen and current Chief Administrative Law Judge Brenda Murray some years ago before Ms. McEwen’s retirement, in which ALJ Murray allegedly said Ms. McEwen’s rulings were not as favorable to the SEC staff as they should be.  See SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case and Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal.

The Commission appears still not to have acted on Timbervest’s motion for discovery into the alleged McEwen conversation, as the most recent order says it does not express the Commission’s views on the disposition on that motion.  But it appears that the Commission is striving to find a way to deny the discovery request by “inviting” ALJ Elliot to deny he ever had such conversations or was aware of similar conversations or “pressures,” after which they will likely deny the request for discovery because it has no bearing on the specific case before them.  Such reasoning would be a wholly inadequate way to address the issue because it relies solely on a voluntary submission by ALJ Elliot without any supporting record, and does address the broader issue of a potential systemic bias that could infect the SEC’s administrative law process.  It would be a grave mistake for the SEC to ignore the “red flag” raised by former ALJ McEwen on the theory that even if the conversation occurred, it is mere history and not relevant unless a presiding ALJ acknowledges to having had a similar discussion.

Instead of taking an open and transparent approach to this issue, the Commission seems to be circling its wagons, looking for any excuse not to examine a serious potential concern about its administrative enforcement process.  This is exacerbated by the unusual step of ordering that any affidavit from ALJ Elliot — which the SEC says he is free not to provide if he prefers not to — must “be maintained under seal in order to provide the affiant confidentiality.”  What need for confidentiality could there be on the issue of whether the presiding ALJ in this case participated in, or is aware of, discussions that suggest ALJs act favorably to the SEC staff in administrative proceedings?

The Commission continues to take the wrong approach here.  It should, like Caesar’s wife, be “above suspicion.”  By failing to pursue this issue thoroughly and openly, and instead trying as hard as possible to cloak it in secrecy, the Commission leaves the sore to fester.

Straight Arrow

June 4, 2015

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SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case

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

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

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

The Commission’s consideration of the Appointments Clause challenge would be assisted by the submission of additional material for inclusion in the record and by the submission of additional briefing.

Accordingly, it is ORDERED that the Division of Enforcement shall by June 4, 2015 file and serve on the parties an affidavit from an appropriate Commission staff member, with supporting exhibits if appropriate, setting forth the manner in which ALJ Cameron Elliot and Chief ALJ Brenda Murray were hired, including the method of selection and appointment.

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

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

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

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

Straight Arrow

May 28, 2015

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