Tag Archives: jury trial

Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding

In a breakthrough development, Northern District of Georgia federal district judge Leigh Martin May found that Charles Hill, a respondent in a pending SEC administrative proceeding, had a “substantial likelihood of success” of showing that the proceeding against him is unconstitutional because the appointment of the administrative law judge presiding over his case violated the appointments clause of Article II of the Constitution.  That is one of several arguments that have been made against the legality of the SEC’s administrative enforcement proceedings, and this is the first court to treat any of those arguments seriously.

Judge May’s decision is here: Order in Hill v. SEC.

 

Judge Leigh May. Photo by John Disney/Daily Report.

Judge Leigh May. Photo by John Disney/Daily Report.

The opinion, while tempered, is an eye-opener for the SEC, which has so far convinced other courts (and no doubt themselves) either not to consider these arguments or give them short shrift.  The Commission now has no choice but to reconsider whether its recent determination to shift important enforcement cases from federal courts to its administrative courts still makes sense.  One can assume there will be every effort to appeal this decision and get this decision overturned on an expedited basis, but that could take months, even in an accelerated proceeding, and the Eleventh Circuit might end up agreeing with Judge May.  The availability of a stay pending appeal may be in doubt because the order only halts the one proceeding against Mr. Hill, making the need for a stay questionable.  Alternatively, the Commission could expedite its own consideration of this issue in the pending Timbervest administrative proceeding (see SEC Broadens Constitutional Inquiry into Its Own Administrative Judges in Timbervest Case), rule in its own favor, and possibly get the issue to an appellate court with an added argument that the SEC’s decision is entitled to some deference.  Since Timbervest is located in Atlanta, that may also end up before the Eleventh Circuit.  In the meantime, there is a cloud over the entire SEC administrative enforcement process, although, as noted, Judge May’s order itself only halts the impending adminsitrative trial of Mr. Hill.

Judge May’s opinion was careful and thorough.  In the end, it came down to a single issue: whether the SEC’s administrative law judges are “executive officers” subject to the appointments clause and other Article II limits on diminishing executive power.  Some time ago, we wrote that this was a serious issue on which Supreme Court precedent seemed likely create problems for the SEC.  See Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit.  Until now, however, no court has been willing to give the argument thorough consideration.  See In Duka v. SEC, SDNY Judge Berman Finds SEC Administrative Law Enforcement Proceedings Constitutional in a Less than Compelling Opinion.

The opinion begins with a discussion of many of the respects in which “SEC administrative proceedings vary greatly from federal court actions.”  Slip op. at 4.  These include: the rules of evidence do not apply; respondents “are generally barred from taking depositions”; “SEC administrative proceedings also occur much more quickly than federal court actions”; “[c]ounterclaims are not permissible”; there is no equivalent of Rule 12(b) motions “to test the allegations sufficiency”; and “there is no right to a jury trial.” Id. at 4-5.

It then discusses the respective powers of the ALJ and the SEC: the presiding ALJ is selected by the chief ALJ, presides over the matter and issues an initial decision; the SEC may order interlocutory review of any ALJ decision during the proceeding; the initial decision can be appealed by either party or reviewed by the SEC on its own initiative; a decision is not final until the SEC issues it, but if there is no appeal and the SEC does not review an ALJ decision “it is deemed the action of the Commission,” and the SEC issues an order making that decision final; SEC review is de novo and new evidence can be heard, but “the SEC will accept the ALJ’s ‘credibility finding, absent overwhelming evidence to the contrary.’”  An SEC decision can be appealed to a federal court of appeals (either the D.C. Circuit or the Circuit where the respondent resides).  On appeal, the “SEC’s findings of facts are ‘conclusive’ ‘if supported by substantial evidence.’” Id. at 5-7.

The court then describes that SEC ALJs “are ‘not appointed by the President, the Courts, or the [SEC] Commissioners.  Instead, they are hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions, and the Office of Personnel Management.’”  Id. at 7.  Congress authorized the SEC to delegate any of its functions to an ALJ, and the SEC promulgated regulations making ALJs responsible for the “fair and orderly conduct” of proceedings and giving them the authority to: “(1) Administer oaths and affirmations; (2) Issue subpoenas; (3) Rule on offers of proof; (4) Examine witnesses; (5) Regulate the course of a hearing; (6) Hold pre-hearing conferences; (7) Rule upon motions; and (8) Unless waived by the parties, prepare an initial decision containing the conclusions as to the factual and legal issues presented, and issue an appropriate order.”  Id. at 8.

The court then moved to the specifics of Mr. Hill’s prosecution, noting that he moved for summary disposition on constitutionality grounds but that ALJ James Grimes ruled that he lacked the authority to address two of the three grounds asserted: that “Congess’s delegation of authority to the SEC to pursue cases before ALJs violates the delegation doctrine in Article I of the Constitution,” and that “Congress violated his Seventh Amendment right to jury trial by allowing the SEC to pursue charges in an administrative proceeding.”  Id. at 10.  See SEC ALJ Says He Lacks Authority To Decide Key Constitutional Challenges.  Mr. Hill sought relief from the federal court to prevent the proceeding on these constitutionality grounds, and later amended his complaint to assert that the proceeding was also unconstitutional because “the SEC ALJ’s appointment violated the Appointments Clause of Article II as the ALJ is allegedly an inferior officer and he was not appointed by the President, the courts of law, or a department head.”  Slip op. at 10-11.

Turning to the legal determinations, Judge May first rejected the SEC’s contention that the court lacked jurisdiction to hear the case.  The SEC made this argument successfully in cases previously brought by other respondents, including Wing Chau and Laurie Bebo.  See SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding; Court Dismisses “Compelling and Meritorious” Bebo Constitutional Claims Solely on Jurisdictional Grounds.  The SEC argued “that its election to pursue claims against Plaintiff in an administrative proceeding, ‘channels review of Plaintiff’s claims through the Commission’s administrative process, with review in the courts of appeals,’” that is, “judicial review can only come from the courts of appeal following the administrative proceeding and the SEC’s issuance of a final order in Plaintiff’s case.”  Slip op. at 11-12.  The court found this “in tension with 28 U.S.C. § 1331, which provides that federal district courts ‘have original jurisdiction of all civil actions arising under the Constitution, laws, or treaties of the United States,’ and 28 U.S.C. § 2201, which authorizes declaratory judgments.”  Id. at 12.  The court rejected the SEC’s argument that “Congress declared its intent for the administrative proceeding to be the exclusive forum for judicial review for these cases by allowing the SEC to make the administrative proceeding its forum choice,” finding instead that “Congress’s purposeful language allowing both district court and administrative proceedings shows a different intent.  Instead, the clear language of the statute provides a choice of forum, and there is no language indicating that the administrative proceeding was to be an exclusive forum.”  Id. at 13.

Moving beyond this point to the issue addressed previously by two other courts in the SEC’s favor – whether Supreme Court precedent on the issue supports a finding that Congress did withdraw jurisdiction – Judge May found otherwise because:

(1) “If Plaintiff is required to raise his constitutional law claims following the administrative proceeding, he will be forced to endure what he contends is an unconstitutional process.”  Slip op. at 15.  Critically, Mr. Hill “does not challenge the SEC’s conduct in that proceeding or the allegations against him—he challenges the proceeding itself” (id. at 17).  “Waiting until the harm Plaintiff alleges cannot be remedied is not meaningful judicial review.”  Id. at 18.

(2) The constitutional challenge is “wholly collateral” to the merits of the proceeding itself.  “Plaintiff is not challenging an agency decision; Plaintiff is challenging whether the SEC’s ability to make that decision was constitutional.  What occurs at the administrative proceeding and the SEC’s conduct there is irrelevant to this proceeding which seeks to invalidate the entire statutory scheme.”  Id. at 20.

(3) The constitutional issues are outside the SEC’s expertise.  “Plaintiff’s constitutional claims are governed by Supreme Court jurisprudence, and ‘the statutory questions involved do not require technical considerations of agency policy.’”  Id. at 21.

This aspect of the opinion is consistent with Judge Richard Berman’s decision in Duka v. SEC (SDNY).  Judge Berman, however, went on to reject Ms. Duka’s constitutional argument, finding the she was “unlikely to succeed on the merits” of that claim.

Having likewise found her court had jurisdiction over Mr. Hill’s claim, however, Judge May went in a different direction on the merits of the preliminary injunction sought by Mr. Hill.  The critical issue was whether Mr. Hill had “a substantial likelihood to succeed on the merits” on his constitutional claims.

Judge May found no such likelihood of success for the argument that the power given to the SEC in the Dodd-Frank Act to bring these cases in its administrative court was an unconstitutional delegation of legislative power.  Instead, she found this authority was a form of prosecutorial discretion that is an executive power, not a delegated legislative power.  “When the SEC makes its forum selection decision, it is acting under executive authority and exercising prosecutorial discretion. . . .  Because Congress has properly delegated power to the executive branch to make the forum choice for the underlying SEC enforcement action, the Court finds that the Plaintiff cannot prove a substantial likelihood of success on the merits on his non-delegation claim.”  Slip op. at 23-29.

On the Seventh Amendment jury trial issue, the court likewise found no substantial likelihood of success.  Judge May found Supreme Court precedent on this controlling because SEC prosecutions involve “public rights,” since the SEC “is acting as a sovereign in the performance of its executive duties when it pursues an enforcement action.”  The controlling Supreme Court case, Atlas Roofing Co. v. Occupational Safety & Health Review Comm’n, 430 U.S. 442 (1977), rejected the jury trial argument in administrative enforcement actions brought by OSHA.

One might question whether this addresses the true jury trial issue in SEC cases.  Unlike the OSHA case, the SEC traditionally prosecuted alleged violations of the securities laws by unregulated persons in federal court actions, in which there is a jury trial right as to non-equitable claims.  Only after Dodd-Frank was enacted was the SEC permitted to commence the same actions in its administrative courts.  That means the SEC was given the power to deny a defendant what for many years has been a jury trial right, and, because there are no standards governing how to go about doing this, currently does so without any enforceable or predictable guidelines for the decision.  That raises a combination of jury trial, equal protection, and arbitrary and capriciousness arguments that the Atlas Roofing case does not begin to address.  I expect a more definitive consideration of the jury trial issue is yet to come.   

Judge May did ultimately find a substantial likelihood of success on one of Mr. Hill’s constitutional arguments, which raises the question of whether it was prudent to decide these first two constitutional issues when they did not, in the end, have a bearing on her decision.  Normally, a court strives to avoid constitutional issues if possible.

But the blockbuster part of the opinion is certainly the discussion of the alleged Article II violations.  Judge May did find a substantial likelihood of success on at least one of Mr. Hill’s alleged violations of Article II – whether the appointment of ALJ Grimes violated the appointments clause in Article II, section 2, clause 2.  (Having reached that conclusion, she found it unnecessary to decide the other Article II issue – whether the double layer of tenure protection for SEC ALJs unacceptably encroached on the President’s executive power.  Why was that given different treatment than the delegation and jury trial issues?)

The threshold question for each of these arguments was whether SEC ALJs are “executive officers” within the meaning of Article II.  We previously discussed this issue at length (in the aforementioned Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit), and expressed the view that Supreme Court precedent in Freytag v. Commissioner, 501 U.S. 868 (1991), strongly suggested that the SEC ALJs were, indeed, “inferior officers” within the meaning of Article II.  Judge May agreed that Freytag was effectively controlling, as follows:

The issue of whether the SEC ALJ is an inferior officer or employee for purposes of the Appointments Clause depends on the authority he has in conducting administrative proceedings. . . .  The Appointments Clause . . . creates two classes of officers: principal officers, who are selected by the President with the advice and consent of the Senate, and inferior officers, whom “Congress may allow to be appointed by the President alone, by the heads of departments, or by the Judiciary.” . . .  The Appointments Clause applies to all agency officers including those whose functions are “predominately quasi judicial and quasi legislative” and regardless of whether the agency officers are “independent of the Executive in their day-to-day operations.” . . .

“[A]ny appointee exercising significant authority pursuant to the laws of the United States is an ‘Officer of the United States,’ and must, therefore, be appointed in the manner prescribed by § 2, cl. 2, of [Article II].” . . .  By way of example, the Supreme “Court has held that district-court clerks, thousands of clerks within the Treasury and Interior Departments, an assistant surgeon, a cadet-engineer, election monitors, federal marshals, military judges, Article I [Tax Court special trial] judges, and the general counsel for the Transportation Department are inferior officers.” . . .

Plaintiff claims that SEC ALJs are inferior officers because they exercise “significant authority pursuant to the laws of the Unites States” while the SEC contends ALJs are “mere employees” based upon Congress’s treatment of them and the fact that they cannot issue final orders and do not have contempt power. . . .  The Court finds that based upon the Supreme Court’s holding in Freytag, SEC ALJs are inferior officers.

 In Freytag, the Supreme Court was asked to decide whether special trial judges (“STJ”) in the Tax Court were inferior officers under Article II. . . .  The Government argued, much as the SEC does here, that STJs do “no more than assist the Tax Court judge in taking the evidence and preparing the proposed findings and opinion,” id., and they “lack authority to enter a final decision.” . . .  The Supreme Court rejected that argument. . . .

The Court finds that like the STJs in Freytag, SEC ALJs exercise “significant authority.” The office of an SEC ALJ is established by law, and the “duties, salary, and means of appointment for that office are specified by statute.” . . .  ALJs are permanent employees—unlike special masters—and they take testimony, conduct trial, rule on the admissibility of evidence, and can issue sanctions, up to and including excluding people (including attorneys) from hearings and entering default. . . .

Slip op. at 35-38 (citations omitted).

Judge May went on to consider the divided decision of a D.C. Circuit panel in Landry v. Federal Deposit Insurance Corp., 204 F.3d 1125 (D.C. Cir. 2000), that ALJs at the FDIC were not executive officers.  She was convinced that the concurring minority opinion in that case was more true to Freytag than the majority of the panel, and, like the concurring judge in Landry, concluded “that the Supreme Court in Freytag found that the STJs powers—which are nearly identical to the SEC ALJs here—were independently sufficient to find that STJs were inferior officers.”  Slip op. at 40.

Judge May also rejected the SEC’s argument that the court “should defer to Congress’s apparent determination that ALJs are inferior officers” because “Congress is presumed to know about the Appointments Clause, and it decided to have ALJs appointed through OPM and subject to the civil service system,” and therefore “intended for ALJs to be employees.”  Id. at 41.  Because the appointments clause “prevents Congress from dispensing power too freely,” Judge May found that argument unacceptable: “Congress may not ‘decide’ an ALJ is an employee, but then give him the powers of an inferior officer; that would defeat the separation-of-powers protections the Clause was enacted to protect.”  Accordingly, the court found “that SEC ALJs are inferior officers.”  Id.  Moreover, because the SEC “concedes that Plaintiff’s ALJ, James E. Grimes, was not appointed by an SEC Commissioner,” he “was not appointed by the President, a department head, or the Judiciary” as the appointments clause requires.”  As a result, “[b]ecause he was not appropriately appointed pursuant to Article II, his appointment is likely unconstitutional in violation of the Appointments Clause.”  Id. at 42.

We might add that by all appearances ALJ Grimes’s treatment of the constitutional challenges to the proceeding before him has been handled responsibly, even to the point of granting a subpoena on the SEC sought by Mr. Hill relating to a due process challenge on the basis of possible systemic bias in the administrative court.  See SEC ALJ James Grimes Issues Important Discovery Order Against SEC.

Judge May went on to find the other requirements for a preliminary injunction satisfied (id. at 42-43), and ruled that “a preliminary injunction is appropriate to enjoin the SEC administrative proceeding and to allow the Court sufficient time to consider this matter on the merits.”  Id. at 44.

The judge’s final words addressed whether all of this was important enough to support potentially debilitating relief (and least in the short term):

The Court notes that this conclusion may seem unduly technical, as the ALJ’s appointment could easily be cured by having the SEC Commissioners issue an appointment or preside over the matter themselves.  However, the Supreme Court has stressed that the Appointments Clause guards Congressional encroachment on the Executive and “preserves the Constitution’s structural integrity by preventing the diffusion of appointment power.” Freytag, 501 U.S. at 878.  This issue is “neither frivolous or disingenuous.” Id. at 879. The Article II Appointments Clause is contained in the text of the Constitution and is an important part of the Constitution’s separation of powers framework.

In addition, the Appointments Clause may not be waived, not even by the Executive.  Id. at 880 (“Neither Congress nor the Executive can agree to waive this structural protection.”).  As this likely Appointment Clause violation “goes to the validity of the [administrative] proceeding that is the basis for this litigation,” id. at 879, it is hereby ORDERED that Defendant, the Securities and Exchange Commission, is preliminarily enjoined from conducting the administrative proceeding brought against Plaintiff . . . including the hearing scheduled for June 15, 2015, before an Administrative Law Judge who has not been appointed by the head of the Department.

Slip op. at 44.

The SEC is likely unprepared for this occurrence.  But, as we previously wrote, the case law strongly supported the view that SEC ALJs are, indeed, inferior executive officers, and serious constitutional issues flow from that, including the appointments clause issue now decided against the SEC.

As the court notes, there may be some tweaks that could clear up this issue, although they may well require action by Congress amending the statutory provisions governing the appointment of administrative law judges (an issue I’ve not looked at).  But even if a “cure” is possible with such tweaks, they would not address the more fundamental question of whether the SEC is doing the right thing by bringing serious prosecutorial actions like these against persons not subject to SEC regulatory oversight in the administrative court.  The lengthy list given by Judge May of the respects in which respondents are impeded from presenting a defense in the administrative forum, as compared to federal courts, should give a fair-minded Commission pause about whether its recent policy of increased administrative enforcement actions needs to be reconsidered.  See Former SEC Enforcement Leaders Urge SEC To Reform Administrative Enforcement Process.  The bottom line is that when unregulated persons are prosecuted for alleged violations and face debilitating demands for penalties and purported “disgorgement,” plus the usual SEC effort to bar these people from future employment as officers or directors of public companies, perhaps the “right” thing to do is allow them to defend themselves in a forum that provides a more level playing field.  Is it really that hard to “do the right thing”?

Straight Arrow

June 9, 2015

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Former SEC Enforcement Leaders Urge SEC To Reform Administrative Enforcement Process

Two former high-level SEC enforcement officials took on the SEC today in the Wall Street Journal, addressing “how to rein in” the SEC’s move towards shifting enforcement actions from federal courts to the SEC’s own administrative courts.  See How To Rein in the SEC.  The two officials, one of the most highly regarded former Directors of the Division of Enforcement, William McLucas, and a recent SEC chief litigation counsel, Matthew Martens (both now partners at the WilmerHale law firm), note that “[a]dministrative proceedings involving litigation of independent agency enforcement actions have been part the regulatory landscape for decades,” and “it would be easy for the SEC to take comfort in both the court rulings to date and its own sincere belief that its proceedings are fair.”  But they argue that “legitimate questions loom regarding the agency’s authority to sit as prosecutor, judge and appellate tribunal on its own cases,” and “when those regulated by the SEC—a broad swath of the population—begin to view the exercise of governmental power as potentially unfair, there is a problem” because “Democratic self-governance requires that the governed be generally convinced of the system’s evenhandedness.”

They note that the “timing” of the decision “to move toward more in-house proceedings couldn’t have been worse” because it immediately followed several stinging federal court defeats, most notably the jury verdict in favor of Mark Cuban, who was prosecuted civilly by the SEC for alleged insider trading violations.  They gently observe that some could question the rationale of SEC officials for making an important policy change at this time to keep more cases away from the federal courts – and juries – when the authority to make such a move remained largely dormant until the SEC’s court losses started to proliferate.  They conclude: “One need not be a conspiracy theorist to wonder whether at least part of the SEC’s rationale was to avoid the federal courts. In government as in comedy, timing is everything.  And here the SEC’s timing raises serious questions about the agency’s move toward the in-house forum.”

The solution, they suggest, is for the SEC to “reclaim the high-ground in this debate and demonstrate the legitimacy of its in-house proceedings” by taking several steps:

  1. To develop “meaningful criteria for exercising its discretion to bring matters in-house,” meaning “objective criteria to guide the choice of forum” which would be determined only after considering “comments from interested parties, including the defense bar.”  This is an implicit swipe at the Division of Enforcement’s feckless attempt to describe a process for determining when to use its administrative courts, which commentators, including yours truly, universally saw as so vague and ridden with caveats that it served only as a transparent effort to justify the Commission’s continued unfettered discretion to decide where to commence its cases.  See Upon Further Review, SEC Memo on Use of Administrative Courts Was Indeed a Fumble.
  2. “[T]o modernize the rules of procedure governing its in-house proceedings,” which the SEC’s General Counsel recognized a year ago were antiquated.  They explain: “With cases now brought in-house that involve evidentiary records spanning millions of pages and testimony gathered over several years by the SEC’s enforcement staff, it is unfair to force a respondent to trial with, at most, 120 days to prepare.”  A respondent’s “limited ability to obtain documents needed for a defense, with no opportunity to depose witnesses like the SEC did during the often multiyear investigation leading to the charges, and with insufficient time to locate defense expert witnesses to respond to the SEC’s experts,” leave these proceedings “stacked in favor of the SEC.”  This only touches upon the many respects in which the Division of Enforcement has a huge advantage against respondents when prosecuting SEC cases on the administrative forum.  See Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions.
  3. “SEC commissioners should avoid finding, on appeal, additional violations and imposing additional penalties beyond those assessed by the administrative law judges.”  Unlike the SEC itself, the ALJs who preside over the SEC’s in-house cases are independent government employees, have no role in authorizing the charges against defendants, and hear the evidence directly from the witnesses in the hearings. . . .  The commission, by contrast, is the same body that brought charges against the respondent,” and it “never hear[s] from witnesses themselves.”  That makes it “troubling” if the “commission, acting as an appellate body, [goes] further than the findings of the ALJ who conducted the hearing to find new violations and penalties.”

The authors conclude: “The Supreme Court has, for nearly 40 years, authorized federal agencies to use administrative proceedings to pursue enforcement cases.  But the agencies must use that power in judicious ways.  The SEC’s approach to administrative proceedings leaves something to be desired. It isn’t too late to fix that.”

These are not new points and new arguments.  Several commentators have raised these and other issues over the last year, and Andrew Ceresney, the Director of the Division of Enforcement, repeatedly responds by extolling the quality of the Emperor’s clothes . . . that is, insisting that the SEC is acting fairly, impartially, and in the public interest, and that its litigators have no material advantage over the defense in the SEC’s home court.  What is new here – or almost new (former Director of Enforcement George Canellos made similar comments recently — see SEC ex-enforcement chief calls for reforms to system of in-house judges) – is that respected former officials are telling Mr. Ceresney to open his eyes, get off his soap box, and work with the General Counsel and the Commission to fix what is a real problem.

One respect in which Messrs. McLucas and Martens give their former employer too much deference is their apparent acceptance of the view that it is settled law that the SEC can be lawfully empowered to bring enforcement actions in its administrative courts against persons the SEC does not oversee as a regulator.  There remain serious questions whether the powers granted by Congress to the SEC in the Dodd-Frank Act to commence such actions are constitutionally sustainable.

The “40 years” of Supreme Court authority for “federal agencies to use administrative proceedings to pursue enforcement cases” that the authors mention twice in their article is a judicial authority originally founded in the context of enforcement actions for the purpose of implementing and enforcing specific regulatory authority conferred on the agency.  Persons who engage in the regulated conduct effectively consent to resolve regulatory disputes in the agency’s forum of choice.  The Supreme Court has never approved the notion that Congress is empowered to transfer law enforcement prosecutions outside of those agency regulatory boundaries from Article III courts to administrative fora, which have no juries, and the decisions of which are reviewed by the agency itself.

Indeed, this issue is apparent from the Supreme Court’s most recent consideration of the exercise of judicial authority by non-Article III courts to decide common law disputes that arise in the course of bankruptcy proceedings.  In Wellness Int’l Network, Ltd., et al v. Sharif, 575 U.S. ___ (2015), the Court held that there is no violation of the separation of powers doctrine when a bankruptcy court, an Article I court, adjudicates claims normally required to be decided by Article III courts, as long as the parties mutual waive any objections to the use of the bankruptcy court for this purpose.  Even in that circumstance, Chief Justice Roberts vociferously objected to the decision, which he said allowed for the possibility of a piece-by-piece dismantling of exclusive Article III judicial powers.  And the recent Supreme Court case normally cited in support of allowing administrative courts jurisdiction over Article III cases and controversies itself also depended to a significant extent on the waiver of any objection to the proceeding.  See Commodity Futures Trading Comm’n v. Schor, 478 U. S. 833 (1986).

To be sure, the authors are correct that the SEC should – must – take compelling action to make its enforcement adjudication process fair, and to subject the exercise of discretion over the forum to be used for these cases to reasoned limits.  But even if this occurs, there remain serious due process, equal protection, jury, and separation of powers issues that may ultimately require this Dodd-Frank experiment with broadened administrative adjudication to be overturned.

Straight Arrow

June 3, 2015

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SEC ALJ Says He Lacks Authority To Decide Key Constitutional Challenges

On May 14, 2014, in In the Matter of Charles L. Hill, Jr., File No. 3-16383, SEC administrative law judge James Grimes ruled that he had no authority to decide that a portion of the Dodd-Frank Act allowing the SEC to commence civil actions against unregulated persons in its administrative law court was unconstitutional.  That could have a bearing on the issue of the standing of SEC administrative targets to bring federal court challenges to those proceedings.  ALJ Grimes did decide that he could address the constitutionality of the double layer of tenure protection provided to SEC ALJs against Presidential removal power, and, not surprisingly, ruled that he held his position constitutionally.  But he declined to offer any view on Mr. Hill’s arguments that the Dodd-Frank Act improperly delegated authority to the SEC, and that he had been denied a Seventh Amendment right to a jury trial.  The Order is available here: Order Denying Respondent’s Motion for Summary Disposition on Constitutional Issues.

On the issue of his authority to rule, he wrote:

After receiving Mr. Hill’s motion, I directed the parties to address “whether I have the authority to rule on Mr. Hill’s constitutional challenges.” . . .  The Division responded that I have authority to rule on Mr. Hill’s challenges. . . .  Mr. Hill disagrees. . . .

Subsequent to instructing the parties to address my authority to rule on Mr. Hill’s constitutional challenges, it came to my attention that the Commission has repeatedly held that it lacks the authority “to invalidate the very statutes that Congress has directed [it] to enforce.” . . .  It has recently reaffirmed this interpretation of its authority. . . .  The Commission thus operates on the assumption that its “governing statutes are constitutional” “[u]nless and until the courts declare otherwise.”

It follows from the foregoing that I lack the authority to rule on the constitutionality of particular provisions of the Exchange Act.

ALJ Grimes nevertheless concluded that he could address the issue of constitutionality of the double-layer of tenure protection afforded to SEC ALJs because that involved protections under 5 U.S.C. § 7521, which is not part of the Exchange Act.  He did so even though: “It would be incongruous . . . if I were unable to address the constitutionality of a provision of the Exchange Act, an Act I am regularly required to construe, but able to address the constitutionality of Section 7521, a provision I do not normally encounter.”

Turning to the double-layer of tenure protection, he “assumed” that ALJs are “inferior officers” of the Executive Branch, noting that “[b]oth parties have presented strong arguments in support of their positions.”  Nevertheless, he found that the double-layer of protection given to SEC ALJs against removal by the President does not make them unconstitutional because SEC ALJs “exercise only adjudicatory functions” that are “limited to a specific subject matter.”  In doing so, he relied almost exclusively on the Supreme Court’s decision in Morrison v. Olson, 487 U.S. 654 (1988), which addressed the constitutionality of the independent special prosecutor statute, and said “the real question is whether the removal restrictions are of such a nature that they impede the President’s ability to perform his constitutional duty, and the functions of the officials in question must be analyzed in that light.”  Id. at 691.  Because “the Commission’s administrative law judges exercise only adjudicatory functions,” and “their jurisdiction is limited to a specific subject matter and they ‘lack[] policymaking or significant administrative authority'” (quoting Morrison), “the dual-tenure protection afforded administrative law judges does not unconstitutionally impair the President’s ability to remove executive branch officials because those particular officials do not perform functions ‘central to the functioning of the Executive Branch'” (again quoting Morrison).

ALJ Grimes concludes: “Furthermore, taken to its logical end, Mr. Hill’s argument would mean that almost no independent agency could use administrative law judges.  If “‘a page of history is worth a volume of logic,’” however, it is unlikely this could be the case.”  Although he says that SEC ALJs are “not among ‘those who execute the laws,’” he does not address at all the critical role of SEC ALJs as part of what is probably the second most significant law enforcement agency in the federal government — the SEC — and the many respects in which SEC ALJs exercise significant discretion in the operation of that law enforcement process.

But ALJ Grimes chose not to offer any view on the other two constitutional challenges raised by Mr. Hill: (1) that “by giving the Commission the discretion to choose whether to seek civil penalties against unregulated individuals either administratively or in district court, Congress impermissibly delegated legislative power to the Commission”; and (2) that “by giving the Commission authority to bring an administrative action against an unregulated individual, Congress infringed on his Seventh Amendment right to a jury.”

On these issues, ALJ Grimes concluded that the limits on his authority to address constitutional issues preclude him from addressing those arguments.  Interestingly, in reaching this conclusion, he also implicitly holds that the SEC itself has no power to reach those issues, because the grounds for limiting his authority apply equally to the Commission.  That gives significant ammunition to those trying to get judicial review of these constitutional issues, because the standing to do so depends in part on whether the SEC has the power to address them as part of the normal administrative adjudication process.

Straight Arrow

May 15, 2015

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Some SEC Administrative Law Judges Are Thoughtful and Even Judicious

We have now on several occasions bemoaned the fate of Laurie Bebo, former CEO of Assisted Living Concepts, Inc., to be forced to litigate her professional future before SEC Administrative Law Judge Cameron Elliot, whom we believe to be, shall we say, not the brightest star in the firmament.  See SEC ALJ Cameron Elliot Shows Why In re Bebo Should Be in Federal Court; Bebo Case Continues To Show Why SEC Administrative Proceeding Home Advantage Is Unfair; and SEC ALJ in Bebo Case Refuses To Consider Constitutional Challenge and Denies More Time To Prepare Defense.  And we have argued that the SEC’s home administrative law court is not a fair forum for the resolution of career-threatening enforcement actions against non-regulated defendants, notwithstanding that the Dodd Frank Act permits such cases to go forward.  See Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit; Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions; and Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions.  That might make a reader think we believe that all SEC ALJs lack the ability or temperament to preside over and decide important cases.  So, to set that record straight, allow us to say that, like almost almost any other place, the SEC administrative law courts are administered by appointees with a range of abilities and demeanors.  It is not the lack of judicial ability that makes the SEC’s administrative courts a poor forum for such cases, it is that the forum is bereft of procedural protections that enhance the chance that a respondent will get a fair shake even when the presiding ALJ is one of poor judicial timber.

In federal court, there are also good judges, bad judges, and a range in between.  But the scales of justice have calibrating factors other than the judge.  In a federal court, equal access to potential evidence through liberal discovery; equal opportunity to develop familiarity with the record over a reasonable period of time; evidentiary rules designed to assure that unreliable evidence, and excessively prejudicial evidence, is excluded; and, of course, the fact that a jury sits to consider the evidence, and use their combined common sense to find facts, all combine to make it possible for a defendant to overcome poor judging.  There is a vacuum of such protections in the administrative law court.  That makes the quality, or questionable quality, of the judge/trier of fact, much more important.  When the judge fails to understand, or care, that he or she is essentially the only factor between a fair proceeding and one tilted in favor of the prosecutor, justice suffers.

So, in celebration of the new baseball season, I’d like to throw a change-up today and discuss an SEC administrative law judge who, although appointed only recently, is showing great potential to be worthy of his position.  I’ve not seen SEC ALJ Jason Patil in the courtroom, but I’ve been very impressed with his approach in some recent cases.  He’s shown he can act with independence, thoroughness, attention to detail, and a strong dose of common sense.  So this blog post is to give credit where credit is due.

All the more credit is due because Jason Patil is the proverbial “new kid on the block.”  He was appointed to the SEC’s ALJ bench on September 22, 2014, after receiving a Stanford degree in political science in 1995, a law degree from from the University of Chicago Law School in 1998, and an L.L.M, from Georgetown University Law Center in 2009.  He served at the Department of Justice for 14 years.

Fewer than 3 months after ALJ Patil started at the SEC, the Second Circuit rocked the boat of the DOJ and the SEC with its insider trading decision in United States v. Newman.  ALJ Patil had to consider the impact of that decision in a case before him: In the Matter of Bolan and Ruggieri.  The SEC’s enforcement lawyers made every effort to obtain an early, post-Newman ruling from ALJ Patil in that case that would limit the scope of the Newman opinion through the adoption of a standard that would not apply Newman‘s holding to insider trading cases based on the misappropriation theory, rather than the so-called “classical” insider trading theory on which the Newman and Chiasson prosecution was founded.  ALJ Patil resisted the SEC’s full-court press to make him an early adopter of an approach that essentially ignored key language in the Second Circuit opinion.  He rejected that effort, ruling that, as the Newman court said, the standard for liability was the same under either the classical or misappropriation insider trading theory.  See SEC ALJ in Bolan and Ruggieri Proceeding Rules Misappropriation Theory Mandates Proof of Benefit to Tipper.

That showed intelligence, independence, and, to be frank, guts, for a newly-appointed ALJ.  But it was a later decision that showed me that ALJ Patil seems to have the stuff of a good judge.  In the Matter of Delaney and Yancey, File No. 3-15873, was not a high profile insider trading case, but it was apparent from the Initial Decision he wrote that he was able and willing to evaluate cases fairly and decisively.  His decision in that case is available here: ALJ Initial Decision in the Matter of Delaney and Yancey.  In that case, he wrote a careful opinion, weighing the evidence, distinguishing between the roles and conduct of the respondents, weighing expert testimony, considering (and often rejecting) varying SEC legal theories, and applying a strong dose of common sense.

The case was a technical one, involving charges against two individuals, the President and CEO of a broker-dealer that was a major clearing firm for stock trades (Mr. Yancey), and that firm’s Chief Compliance Officer (Mr. Delaney).  The SEC alleged many violations by the firm of SEC regulations governing the settlement of trades.  Mr. Delaney was charged with aiding and abetting, and causing, numerous violations of SEC regulations by virtue of his conduct as the Chief Compliance Officer.  Mr. Yancey was charged with failing adequately to supervise Mr. Delaney and another firm employee, allowing the violations to occur.  ALJ Patil exhaustively reviewed the evidence to reach reasoned decisions, with cogent explanations supporting his views.  In doing so, he was not shy about chiding the SEC for fanciful theories and woefully unsupported proposed inferences.

The opinion is long, detailed, and more in the weeds than many of us like to get.  The aiding and abetting charge against Mr. Delaney required proof that he assisted the violations through either knowing or extremely reckless conduct (i.e., scienter).  The SEC enforcement staff is quick to accuse people of knowing or reckless misconduct, and is often willing to draw that inference with little in the way of supporting evidence.  ALJ Patil’s review of the evidence presented in support of the scienter element was precise and thorough.  He dissected the evidence piece-by-piece, in impressive detail.  Here is some of what he said:

The Division has failed to show that Delaney acted with the requisite scienter, and
therefore its aiding and abetting claim against Delaney fails.  As an initial matter, I note that the Division is unable to articulate or substantiate a plausible theory as to why Delaney would want to aid and abet [his firm’s violations].  While the Division correctly argues that motive is not a mandatory element of an aiding and abetting claim, numerous courts have noted its absence when finding that scienter has not been proven. . . .    The Division also failed to establish that Delaney had anything to gain from the alleged misconduct.  The Division’s original theory was a wildly exaggerated belief that [the] . . . violations resulted in millions of dollars of additional profits. . . .  The Division was forced to abandon that theory, and in the end agreed that the “only specifically quantified benefit” to [the firm] . . . was a meager $59,000.  I do not find that sum would have given Delaney any motive to aid and abet the . . . violation. . . .  Although the Division also argues that there would have been “substantial costs to [the firm] . . . that . . . could expose the firm to significant losses,” the Division produced no evidence to quantify the costs or losses, and the testimony to which the Division points is general and speculative. . . .  As the Division did not provide any evidence quantifying the purported costs or losses, I am unable to determine whether there were any.

One of the SEC’s major points was the contention that Mr. Delaney’s knowing misconduct was apparent because he was shown to be a liar by misstatements in the Wells Submission submitted to the SEC on his behalf by his lawyers.  ALJ Patil forcefully torpedoed this theory:

I disagree with the Division’s conclusion that “Delaney has not been honest or
truthful” and “[i]nstead . . . has been evasive and inconsistent.”. . .  The Division’s
primary evidence for this alleged dishonesty are statements made in Delaney’s Wells
submission.  The Division argues, “either the statements Delaney approved about his knowledge and actions were lies to the Commission in his Wells submission or his repudiation of those statements are lies to the Court now.”. . .  Based on my careful review of that document, I conclude that it is primarily comprised of argument by counsel and grounded in incomplete information. . . .  It is based not just on Delaney’s understanding at that time, but on his counsel’s characterization of other evidence selectively provided to Delaney by the Division. . . . .  In contrast to that argumentative submission, Delaney testified five times under oath, including at the hearing. . . .  I find that Delaney’s testimony was overwhelmingly consistent, and the handful of inconsistencies alleged by the Division in such testimony either do not exist or are easily explained by the circumstances. . . .  In this case, where Delaney testified multiple times under oath at the Division’s request, as did other witnesses, I have decided to base my decision on that testimony and other documents in the record, which I find more probative than past characterizations made by Delaney’s counsel. . . .  I do not accept the Division’s insistence that everything in the [Wells Submission], particularly the statements in the legal argument section, should be taken, in essence, as testimony of Delaney.

Perhaps most telling was ALJ Patil’s careful review of supposed inconsistencies in testimony by Mr. Delaney.  His evaluation of that testimony reflected thoughtful consideration of the facts and circumstances both when the events at issue occurred, and when the testimony was given.  The decision took the SEC lawyers to task for arguing that testimony was inconsistent when the supposed inconsistencies were more plausibly explained by poor questioning by the SEC staff during their numerous examinations of him:

To the extent that Delaney’s testimony could be at all be characterized as “evasive” or
“inconsistent” . . . , it may be because he lacks a completely clear recollection of what
took place years ago regarding his alleged conduct.  Delaney credibly and convincingly
explained that his initial testimony was given with virtually no preparation or opportunity to
review documents, thus preventing him from having a full and fair recollection of the events he was asked about. . . .  While his conduct with respect to [the Rule at issue] is especially
important in the present action, at the time of such conduct, Delaney was in the business of
putting out “fires,” . . . and [the Rule], though undeniably important, was most assuredly not the top priority for the compliance department. . . .  [T]he Division argues that “Delaney quibbled about whether he had seen the release [for the Rule] in the same exact format as that in the exhibit used at the hearing and during his testimony.” . . .  Several exhibits copy or link to the text of the releases . . . with the appearance and formatting of each differing dramatically from the way the text of such releases is ultimately arranged in the printed version of the Federal Register, the document Delaney was shown at the hearing. . . .  When someone is testifying about a document that may not look anything like the version he had read, it is not “quibbling” to explain that one has never seen something that looks like the exhibit.  I in fact thought that the Federal Register version of the releases looked considerably different from the other copies and would have been hesitant to say I had read the exhibit without first looking it over. . . .  Despite his exasperation at the Division’s repeated insinuations that he was lying, I found Delaney a credible and convincing witness. My perception, that his hours of testimony were sincere and truthful, is consistent with the attestation of all the hearing witnesses regarding Delaney’s honesty and integrity.

Finally, the Division asserts that Delaney contradicted himself because, on the one hand,
in August 2012 he did not recall being concerned about the contents of [a FINRA letter] and, on the other hand, in July 2013 he testified that a disclosure in that letter would be a big deal for [his firm]. . . .  However, because Delaney was asked somewhat different questions on the two different occasions (as opposed to being asked the same question on both occasions), his answers were consistent.  In August 2012, Delaney was asked whether he was concerned about the letter, not the conduct at issue. . . .  When asked about the purported contradiction at the hearing, Delaney reasonably explained that he was not concerned about the letter disclosing the conduct, which was accurate as he understood it, but at the same time was concerned about the underlying rule violations. . . .  It is telling that the Division, who has had Delaney testify so often, seizes on such minor supposed contradictions.  I find all of the purported inconsistencies identified by the Division are
either immaterial or have been adequately explained by Delaney.  I found, on the whole,
Delaney’s testimony to be credible, with the exception, noted previously, that he may not recall comparatively minor events and discussions that took place up to six years before the hearing.

Having found no evidence of knowledge, ALJ Patil went on to reject the SEC staff’s suggestions that Mr. Delaney’s conduct was nevertheless “reckless.”  He carefully distinguished between evidence of negligence and “extreme recklessness.”  He then dissected individual emails presented by the staff as “red flags” to show, one-by-one, that they were no such thing.

ALJ Patil nevertheless found Mr. Delaney liable for “causing” some of the firm’s violations, based on his conclusion that Mr. Delaney acted negligently.  He found violations “because the evidence supports that Delaney contributed to [the firm’s] violations and should have known he was doing so.”  He did so on the basis of testimony “that according to SEC guidance, in situations ‘where
misconduct may have occurred’– as opposed to ‘conduct that raises red flags’ – compliance
officers should follow up to facilitate a proper response.”  He provided a lengthy and lucid explanation of why he reached the conclusion that Mr. Delaney faced such a situation and failed to act prudently.

The case against Mr. Yancey failed entirely.  ALJ Patil found that Mr. Yancey, as CEO, was Mr. Delaney’s supervisor, but the evidence did not show intentional conduct by Mr. Delaney, and a supervisory violation can occur only when “[t]he supervised person must have ‘willfully aided, abetted, counseled, commanded, induced, or procured’ the securities law violation.”  But even if Mr. Delaney had willfully aided an abetted the firm’s rules violations, “the Division has failed to show that Yancey did not reasonably supervise Delaney . . . because “[a] firm’s president is not automatically at fault when other individuals in the firm engage in misconduct of which he has no reason to be aware.”  He concluded: “Yancey had no reason to believe that any ‘red flags’ or ‘irregularities’ were occurring at [the firm] that were not already the subject of prompt remediation.  Given the absence of such evidence, I find that the Division did not prove that Yancey failed reasonably to supervise Delaney, even were such a claim viable here.”

As for the supervisory charge regarding the second firm employee, who was a registered representative who did act willfully, Yancey “persuasively dispute[d]” that the employee was not subject to the CEO’s “direct supervision.”  “[A]s an initial matter, a president of a firm ‘is responsible for the firm’s compliance with all applicable requirements unless and until he or she reasonably delegates a particular function to another person in the firm, and neither knows nor has reason to know that such person is not properly performing his or her duties.’ . . .   I find that Yancey is not liable for [the employee’s] intentional misconduct because the record supports that Yancey reasonably delegated supervisory responsibility over [him] . . . and then followed up reasonably.”  ALJ Patil rejected several theories of the SEC staff why Mr. Yancey should nevertheless be considered a supervisor.  He ultimately found no liability for Mr. Yancey.

On the issue of sanctions, ALJ Patil did not rubber stamp SEC staff requests.  He gave a reasoned explanation for issuing a cease and desist order against Mr. Delaney, found he could not issue a bar order against him because he did not act willfully, and imposed what seem to be reasonable civil penalties, totaling $20,000, for the conduct involved.  His order on the SEC’s disgorgement request was, perhaps unintentionally, amusingly tongue-in-cheek: “I have opted not to order disgorgement in this case, because the amount at issue is negligible. The Division contends, in effect, that Delaney must pay back the portion of his $40,000 in bonuses during the relevant time period that arose from the Rule 204T/204 violations.  The quantified benefit of the violations, $59,000, is approximately 0.008 percent of [the firm’s] revenue during that period. . . .  Even if all of Delaney’s bonuses were based on [the firm’s] performance (which, they are not, since the parties seem to be in general agreement that such performance was only one of three factors in bonuses), based on the preceding figures, the percentage of Delaney’s bonuses tied directly to the quantifiable benefit . . . is three dollars and twenty cents.  Even accounting for prejudgment interest, a disgorgement order is unwarranted.”

Kudos to ALJ Patil for what appears to be a fine job of adjudicating a tiresome case.  In a careful ruling, he handed the SEC a substantial defeat and a partial victory.  If he keeps this up in his tenure as an SEC ALJ, we should see some high-quality, thoughtful, and independent decisions penned by him.

Straight Arrow

April 14, 2015

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SEC Suffers Another Major Loss in Willie Gault Case

A jury ruled against SEC charges of fraud against former pro football player Willie Gault, another in a string of embarrassing high-profile litigation losses in cases tried by the SEC.  The jury found Gault liable for lesser charges of false SOX certifications and circumventing internal controls.  Director of the Division of Enforcement Andrew Ceresney gave a faux victory statement that he was “pleased with the jury’s verdict holding Willie Gault accountable for securities law violations.”  And perhaps the jury’s findings represent somewhat more than the defense counsel’s post-trial description of “the equivalent of a traffic ticket.”  But make no mistake, this is another troubling trial loss for the SEC because the fraud charges are what these cases are all about.  It is highly likely the case could have been settled a long time ago on the lesser charges (and at much less expense for both the Government and the defense).

The SEC’s use of major resources in the effort to “get” Gault on the fraud charges should be seriously re-examined by Ceresney and other key enforcement managers.  Instead, Ceresney may well chalk this up as another example of a flawed jury being unable to understand the evidence, or unwilling to see the case as the SEC staff does, and therefore representing another reason why such cases should be directed to the SEC’s administrative court to avoid independent fact-finding.

The case involved an alleged “pump and dump” of Heart Tronics, Inc. stock, orchestrated by the company’s former outside counsel, Mitchell Stein.  Stein was previously convicted of criminal securities fraud and is in prison.  The SEC contended that Stein “installed” Gault “as a figurehead co-CEO . . . in order to generate publicity for the company and foster investor confidence,” and “orchestrat[ed] a campaign of misinformation designed to inflate the price of Heart Tronics stock” before selling some of his wife’s stock in the company.  She owned 85% of the company’s stock.

The SEC’s complaint described in detail the steps of an elaborate scheme by Stein, but says precious little about Gault’s supposed role in the scheme.  In fact, the SEC’s theory against Gault with regard to the alleged pump and dump scheme seemed to be no more than the contention that he “rarely questioned Stein’s direction,” “abdicated [his] fiduciary responsibilities to Heart Tronics shareholders, ” and “signed, or unlawfully authorized to be signed, public Commission filings containing false statements about the Company’s purported sales.”  It appears that the only serious fraud theory against Gault was not participation in Stein’s extensive stock scheme, but that Gault allegedly assisted in an effort to induce a single investor to loan money to the company based on misrepresentations, and then diverted some of those funds for personal use.  Pre-trial motions to exclude these separate transactions from the case as not involving securities were denied by the district court.  A copy of the complaint can be found here: Complaint in SEC v. Heart Tronics et al.

One might question the wisdom of pursuing a fraud case against someone who could easily be argued to be a victim of the fraud, not one of its perpetrators.  If the SEC lacked any real evidence that Gault participated in the pump and dump fraud scheme, no case should have been brought on that theory.  Arguing to the jury that Gault was a fraudster without real evidence to support that charge could easily cause the jury to distrust the SEC and its trial counsel.  This may be another example of the SEC overcharging its case by imprudently focusing on fraud charges.  See SEC’s Single-Minded Focus on Fraud Theory Results in Loss on Appeal.  In any event, we know from our own experience that the SEC will move to trial on fraud cases with scant evidence that the defendant actually participated in a fraud, based on the personal views (or even pique) of enforcement lawyers, rather than a serious, disinterested evaluation of the evidence a jury will see.

Hopefully, we will learn over time more about why the jury didn’t buy the SEC’s case.  Often, an effort to prove fraud based solely on neglect and breach of fiduciary duty (neither of which constitutes “fraud”), based on an expansive theory of “recklessness,” will, and should, be unsuccessful.  And the specifics of Gault’s role in the one investor’s loan to the company may well have been less important than the SEC alleged, or the jury may just have questioned its significance in the context of a case focused on a broader alleged scheme in which Gault was not even alleged to be a meaningful participant.

Whatever the reason, the loss, along with other recent losses, should cause management in the SEC’s Division of Enforcement to engage in serious self-examination about the cases the Division brings to trial, and its process for deciding whether they are truly trial-worthy.  That would be a much more sensible reaction than simply trying to shift more cases to the administrative court in order to avoid the annoyance of independent juries.

Straight Arrow

March 19, 2015 

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SEC Commissioner Michael Piwowar Comments on Increased Use of Administrative Enforcement Actions

At the 2015 SEC Speaks PLI Conference, Commissioner Michael Piwowar devoted part of his address to the SEC’s decision to make increased use of administrative proceedings in its enforcement actions.  He advocated that “In order to ensure that the Commission does not engage in arbitrary or capricious conduct in enforcement matters, the Commission should formulate and adhere to a consistent set of guidelines when conducting our enforcement proceedings.”  Here is what he said on the subject (footnotes omitted):

Our enforcement program could also benefit from a look through the lens of fairness.  In order to ensure that the Commission does not engage in arbitrary or capricious conduct in enforcement matters, the Commission should formulate and adhere to a consistent set of guidelines when conducting our enforcement proceedings.

Commission staff has recently indicated that they will recommend instituting more enforcement matters, including insider trading cases, through administrative proceedings rather than going through the federal district courts.  Announcement of this plan to increase the use of administrative proceedings in insider trading cases followed the Commission’s loss in two insider trading cases in federal district courts.  Regardless of whether these circumstances are linked, this change has the appearance of the Commission looking to improve its chances of success by moving cases to its in-house administrative system.

Even prior to the staff announcement, more cases were being brought in administrative proceedings as a result of the enactment in 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd‑Frank Act).  Prior to the Dodd-Frank Act, the Commission only had the authority to seek monetary penalties in administrative proceedings against regulated entities and would have needed to file an action in federal court to obtain a monetary penalty against any other person.

In administrative proceedings, there is no jury and cases are presented to administrative law judges that are employees of the Commission.  In addition, discovery available to defendants is more limited.  The Commission has an extremely high success rate when litigating through administrative proceedings.  One Article III federal judge has stated that in fiscal year 2014 the SEC won 61 percent of federal court trials but was successful in 100 percent of its administrative proceedings.  To avoid the perception that the Commission is taking its tougher cases to its in-house judges, and to ensure that all are treated fairly and equally, the Commission should set out and implement guidelines for determining which cases are brought in administrative proceedings and which in federal courts.

The lack of any standards governing the SEC’s determination when to use the administrative process instead of the federal courts to pursue enforcement actions is one of the grounds used to challenge the constitutionality of those proceedings.  It is argued that according the SEC unfettered discretion over when to allow an enforcement target the right to a jury trial violates the Seventh Amendment and the equal protection clause of the Constitution, and also results in arbitrary and capricious agency decision-making.  Commissioner Piwowar’s suggestion does not vitiate the fundamental problem of denying key substantive and procedural rights to SEC enforcement targets by circumventing the federal courts, but it represents at least a small step in the direction of limiting unbridled power in the decision whether to strip an enforcement defendant of those rights.

The full speech is available here: Remarks at the “SEC Speaks” Conference 2015: A Fair, Orderly, and Efficient SEC.

Straight Arrow

February 23, 2015

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SEC To Hear Wide Range of Constitutional Challenges to Administrative Proceeding in Jarkesy Case

Having just escaped district court consideration of constitutional challenges to the SEC’s use of an administrative proceeding in the Chau/Harding Advisory case, the SEC will now review a number of similar challenges to its administrative adjudicatory process in In re Jarkesy, SEC File No. 15255.   The petition for review of respondents John Thomas Capital Management Group and George Jarkesy, which the Commission agreed to hear on December 11, 2014, will be the first opportunity for SEC consideration of a number of constitutional issues since the recent hubbub about the increased use of the administrative court for these kinds of cases.  A copy of the Petition for Review is available here: Jarkesy Petition for Review.

The issues raised in the petition are extensive.  They include:

  1. The administrative proceeding is invalid because the Commissioners issued findings of fact and conclusions of law in advance of the hearing.
  2. The administrative proceeding is invalid because the Commission exercises unguided discretion on the choice of forum for its prosecutions even when they do not involve subject matters outside of the conventional experience of Article III judges, which violates the separation of powers doctrine.  
  3. The decision to require respondents to defend themselves in the administrative court violated the equal protection clause because others similarly situated have not been required to do so and they were deprived them of a Seventh Amendment right to jury trial, which they contend is a fundamental right.
  4. The assignment of their case to the administrative court violates the equal protection clause under the “class of one” doctrine.
  5. The proceeding is invalid because ex parte communications between the Division of Enforcement and the Commission were permitted during the discussions of settlements with co-respondents, which violates due process rights to an impartial forum.
  6. The effective denial of rights under the doctrine of Brady v. Maryland because relevant documents were hidden in a 700gb “document dump” incapable of being reviewed violates due process.
  7. The refusal to allow respondents to create a record for review of violations of rights is itself a due process violation.
  8. The requirement that respondents defend themselves within a “truncated” time-period prevented discovery of relevant facts or the opportunity to prepare a defense, which violated due process rights.

Whether any of this stocks is another question entirely.  Of course, we can be virtually certain that the Commission itself will give these arguments short shrift.  But where the appeals court comes out may be another question.   That would be either the Court of Appeals for the D.C. Circuit, or, it would appear, the Fifth Circuit, since the respondents appear to be located in Texas.

Straight Arrow

December 15, 2014

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