Tag Archives: Mary Jo White

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

December 3, 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

November 18, 2015

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Straight Arrow

October 8, 2015

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SEC Inspector General Reveals Investigation into Possible Bias of SEC ALJs

The Inspector General of the SEC issued an Interim Report on August 7, 2015 which indicated that he is in the midst of an inquiry into allegations that SEC administrative law judges may have been subjected to pressure from other in the performance of their duties.  According to the Interim Report, the “investigation was initiated on June 30, 2015, based on information provided by Erica Williams, Deputy Chief of Staff, Office of the Chair, concerning alleged potential issues of fairness and bias in the SEC’s administrative proceedings, including those introduced in the Timbervest, LLC (Timbervest) matter.”  On receipt of this information, the “OIG determined it would investigate allegations of bias on the part of Administrative Law Judges (ALJ) in the Commission’s administrative proceedings.”

The information that stirred the inquiry included the May 6, 2015 Wall Street Journal article by Jean Eaglesham, which reported that the SEC’s Division of Enforcement prevailed in about 90% of the cases sent to the SEC administrative law judges (see SEC Wins With In-House Judges: Agency prevails against around 90% of defendants when it sends cases to its administrative law judges), and a Securities Diary June 30, 2015 blog post entitled “SEC Bumbles Efforts To Figure Out How Its Own Administrative Law Judges Were Appointed.”  The Interim Report also referenced another, May 7, 2015 Securities Diary post “Fairness Concerns About Proliferation of SEC Administrative Prosecutions Documented by Wall Street Journal,” which reported on the content of the May 6 Wall Street Journal article.

Ms. Williams told the OIG that “Chair Mary Jo White requested an OIG investigation of the alleged bias issue because the identified concerns could impact all ALJs and the SEC administrative proceedings.  The Interim Report can be read here: Interim Report of Investigation by SEC Office of Inspector General into Possible SEC ALJ Bias.

The Interim Report says:

The OIG reviewed the Securities Diary and WSJ news articles that Williams identified, which included the following statements attributed to former ALJ McEwen: she thought the system was slanted against defendants at times; she came under fire from Chief ALJ Murray for finding too often in favor of defendants; Chief ALJ Murray questioned McEwen’s loyalty to the SEC; McEwen retired as a result of the criticism; and SEC judges were expected to work on the assumption that “the burden was on the people who were accused to show that they didn’t do what the agency said they did.”

The Interim Report discussed an OIG interview with ALJ Cameron Elliot, who presided over the Timbervest administrative trial, and described that interview as follows:

The OIG interviewed ALJ Elliot concerning allegations of potential issues of fairness and bias in the SEC’s administrative proceedings.  Elliot denied bias during his reviews and rulings and stated that he independently made his decisions.  Concerning his decision not to provide an affidavit after being invited to do so by a Commission order, Elliot said he received the invitation to provide an affidavit from the Office of the Secretary.  He said that he informed Chief ALJ Murray of the existence of the invitation.  However, he said he adhered to the instructions in the order which requested him to “not consult with anyone at the Commission in the preparation of his affidavit concerning the substance thereof.”  Elliot said that he strictly followed those instructions and that he informed Chief ALJ Murray of the existence of the instructions.  At an office meeting, he informed everyone in the Office of ALJ that he had responded to the order.  When asked, Elliot said he did not receive any direction or guidance from anyone, including Chief ALJ Murray, on how he should respond to the invitation.  Elliot said he had declined to provide an affidavit, stating he had “multiple reasons why [he] decided not to provide a response” but declined to provide any of those reasons to the OIG.  Furthermore, Elliot denied being influenced by anyone on “how to decide [his] cases or suggest or make [him] biased in any fashion.”

The OIG also interviewed ALJ Brenda Murray, who “denied influencing matters before the ALJs and explained that she is responsible only for assigning the ALJs’ workload.”  She also “stated that there was no merit to the allegations of bias as alleged in the WSJ article.”

Regarding the status of the investigation, the OIG reports that it “remains ongoing,” and it “is still gathering additional facts and completing investigative steps, and new information will be reported accordingly.”  At this point, however, “the OIG has not developed any evidence to support the allegations of bias in ALJs’ decisions in the Commission’s administrative proceedings.”

It is troubling, however, that there is no reference to any effort to interview former ALJ Lillian McEwen, who made the troubling statements to the Wall Street Journal.  Ms. McEwen later reportedly said that she would be willing to be interviewed on this matter by the Commissioners.  It is important for the OIG to lay out precisely what efforts have been made to flesh out her views on this issue before issuing any clean bill of health for the SEC’s administrative process.

In addition, the statistics showing an unusually high success rate for the Enforcement Division should be confirmed or rejected through a thorough analysis, and if a statistically significant higher success rate is found for administrative proceedings over the Division’s federal court prosecutions, it is essential that the OIG make every effort to determine that the source of that differential is not, even in part, attributable to inherent biases in either the ALJs themselves or the process they use to reach their results.  Anything short of this will not put the serious due process and fairness issues to rest.  The courts — including the Supreme Court in a key employment discrimination case this past term — often accept that a statistically provable disparate impact can provide evidence of underlying concerns.  That is certainly not a precise analogy for what may be happening here, but if there is a compelling statistical case (and a 90% win rate, or even 100% for some judges, suggests there may be), it should not be ignored.

This being said, it is encouraging that Chair Mary Jo White has seen fit to cause this inquiry to occur.  The apparent determination not to make the existence of the inquiry public is a little perplexing, given the publicity surrounding the accusations.  Nevertheless, she should get credit where it is due.  Those facing prosecution in a possibly biased forum argue, however, that it is not enough to turn to an in-house IG to investigate possible in-house bias.  Lynn Tilton, who is challenging the constitutionality of her administrative enforcement action, tweeted in response: “This defendant feels no comfort that the SEC’s Internal IG investigates bias by its own Judges in its own Courts.”  This skepticism that the SEC’s IG can perform a truly independent investigation must be met by an investigative process so thorough and informed that it is beyond reproach.

Straight Arrow

August 10, 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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Upon Further Review, SEC Memo on Use of Administrative Courts Was Indeed a Fumble

Penalty Flag“Upon further review,” as they say in the NFL, was the SEC’s recent “Division of Enforcement Approach to Forum Selection in Contested Actions,” entitled to a better call than we gave it in our Friday post: SEC Attempts To Stick a Thumb in the Dike with New Guidelines for Use of Administrative Court?  The definitive answer is: “No.”  The SEC clearly fumbled the ball with this publication, and made itself look pretty silly doing it.  I’m going to add a penalty flag.

SEC Chair Mary Jo White (Courtesy Salon) Her approval is inexplicable and depressing

SEC Chair Mary Jo White (Courtesy Salon)
Her approval is inexplicable and depressing

Our Friday post did not discuss any of the SEC’s vague descriptions, all-encompassing caveats, prevarications, and self-congratulatory pats on the back (to itself) in this document, so we will address some of them here.  This SEC memo is the equivalent of one of those “what were they thinking?” moments we now see on the internet all of the time, like a selfie someone might take (and actually post for all to see) of the author grinning before some solemn background, like the Vietnam War Memorial.  It’s an embarrassment for what it says and what it fails to say about the serious issue of assuring due process and fair treatment in SEC enforcement actions, particularly as to non-regulated persons.

“When recommending a contested enforcement action to the Commission, the Division recommends the forum that will best Utilize the Commission’s limited resources to carry out its mission.”

A false and misleading statement in at least two respects.  The Director of the Division of Enforcement already admitted that the Division chooses its administrative forum to pressure targets into settlement (“I will tell you that there have been a number of cases in recent months where we have threatened administrative proceedings, it was something we told the other side we were going to do and they settled”), and that he believed federal court juries were not properly adhering to the required burden of proof (“Frankly, I think juries, while they’re instructed that we have a preponderance standard, I think apply a higher standard to us than preponderance”).  See SEC Could Bring More Insider Trading Cases In-House.  That has nothing to do with “best utilizing resources”; it has to do with maximizing the chance to win or force a settlement on SEC terms.  One of the key reasons for choosing the administrative forum is because it has a better chance of winning there, not to make careful use of enforcement resources.  And, as the Wall Street Journal recently documented, that is precisely the result.  The Division also makes no real effort to “best utilize” its resources in any other enforcement context.  It badly allocates its ample staff resources on investigative matters that have little overall public policy consequence.  That includes the  so-called “broken windows” approach to enforcement, which focuses staff attention on what the SEC itself describes as minor violations.  But it also includes expensive litigated cases involving trivial violations of law, even if all the allegations could be proved.  (See There They Go Again: SEC Wasting Taxpayer Dollars on Trivial Perquisite Enforcement Litigation in SEC v. Miller.)

“There is no rigid formula dictating the choice of forum.  The Division considers a number of factors when evaluating the choice of forum and its recommendation depends on the specific facts and circumstances of the case.  Not all factors will apply in every case and, in any particular case, some factors may deserve more weight than others, or more weight than they might in another case.  Indeed, in some circumstances, a single factor may be sufficiently important to lead to a decision to recommend a particular forum.  While the list of potentially relevant considerations set out below is not (and could not be) exhaustive, the Division may in its discretion consider any or all of the factors in assessing whether to recommend that a contested case be brought in the administrative forum or in federal district court.”

A long-winded way of saying: “We are going to list a whole lot of factors below, but there is no way to know which ones we will decide are important, or whether we will decide other unmentioned factors are more important.  That is, the Division will choose a forum on whatever basis it thinks makes sense, and we are not going to give you any way of predicting or understanding that decision”

“The Division may in its discretion consider . . .  [t]he cost ‐ , resource ‐ , and time ‐ effectiveness of litigation in each forum. . . .  In general, hearings are held more quickly in contested administrative actions than in contested federal court actions. . . .   When a matter involves older conduct, this may allow for the presentation of testimony from witnesses who have a fresher recollection of relevant events.”

In other words, since administrative proceedings move more quickly, that can justify our choice of that forum in pretty much any case.  And in an “older case” — which means, by the way, cases that Division of Enforcement lawyers have sat on for years on end — because our dilatory investigation makes it virtually impossible for any witness to remember accurately what really happened, we will lean towards the administrative forum because, in our discretion, we now think it is important to move at a breakneck pace, and not allow the defense the time to develop a complete understanding of the record or what witnesses may say at trial.

“The additional time and types of pre‐trial discovery available in federal court may entail both costs and benefits, which should be weighed under the facts and circumstances of a case.  Although pre‐trial discovery procedures exist in both administrative proceedings and district court actions, the mechanisms of discovery are different.  For example, in administrative proceedings, the Division must produce to respondents all non‐privileged documents from its case file and the Division has Brady and Jencks obligations, requirements that do not exist in civil district court litigation.  On the other hand, depositions are available in district court but generally not in administrative proceedings.”

This is no more than a transparent effort to create the misleading impression that a sow’s ear could be something other than a sow’s ear.  No aspect of the discovery limits in administrative proceedings are beneficial to a respondent.  The restrictions on discovery may be the single-most unfair aspect of these proceedings, but the SEC portrays them here as cutting both ways.  Hogwash! (In keeping with the sow metaphor.)  The lack of depositions, the inability to pursue reasonable discovery against the SEC, the more restrictive approach to third-party discovery (including that every subpoena must get prior approval from the ALJ, inevitably over opposition from the Division), and the incredibly short time-frame for doing any independent development of evidence, all mire the administrative respondent in a sloppy mud pen.  The SEC, however, had many years to develop its own case (and now uses its own delay as a reason to avoid court!), and no obligation to do so in a way that actually makes a fair record (in investigative testimony, leading and misleading questions, hiding key evidence from witnesses, vague questions that can be later misconstrued, and avoiding any discussion of exculpatory evidence, are the norm).  So the much-touted production of “all non-privileged documents from its case file” is a laugher as a benefit to the respondent.  The same production would be required in court (and typically is made by the SEC at the outset without waiting for a request), and intelligent discovery requests will be able to garner all Brady and Jencks material as well.  Not to mention the fact that the Division’s concept of what is “non-privileged” means they often refuse to produce many materials based on privilege claims (attorney-client, work-product, and the all-encompassing “deliberative process privilege”) that would not (and do not) withstand challenge in court.  But administrative judges are much more reluctant to force discovery on the Division, or the SEC more broadly, than federal court judges.

“Administrative Law Judges, who adjudicate securities law cases, and the Commission develop extensive knowledge and experience concerning the federal securities laws and complex or technical securities industry practices or products. . . .  If a contested matter is likely to raise unsettled and complex legal issues under the federal securities laws, or interpretation of the Commission’s rules, consideration should be given to whether, in light of the Commission’s expertise concerning those matters, obtaining a Commission decision on such issues, subject to appellate review in the federal courts, may facilitate development of the law.”

The hubris!  This could be the most offensive factor of all.  It suggests that administrative law judges and SEC Commissioners are better-suited to decide “unsettled and complex legal issues” to “facilitate development of the law” than federal court judges.  Let me see if I have this right.  An appointee not required to meet anything close to the standards that apply to federal judges is better to decide complex issues and the development of the law?  And Commissioners, who have virtually no adjudicative experience at all when they are appointed, all of a sudden become better at considering “complex and unsettled legal issues” when they are confirmed?  I think not.  Nor does district judge Jed Rakoff, who gave the exact opposite view on this issue (moving cases from the federal courts to the SEC’s captive administrative court “hinders the balanced development of the securities laws”).  See Judge Rakoff Slams SEC for Increased Use of Administrative Proceedings.

The SEC was not content here to talk about technical applications of SEC rules in the securities industry — as to which they could at least have a theoretical basis for making such an argument based on supposed agency expertise.  They argue here that ALJs and Commissioners may be viewed as better able to decide complex legal issues wholly apart from technical SEC regulatory compliance issues — for example, whether a non-regulated corporate official engaged in fraud in some respect or another.  There is no way to support the argument that ALJs or SEC Commissioners are better situated to decide complex and unsettled issues involving fraud allegations than federal judges.  The obvious example is insider trading cases, as to which the law is so nuanced, and so bound up in considerations of fraud and fiduciary obligation, that federal court judges are much more likely to get it right.  (The exact view expressed by Judge Rakoff: see Judge Rakoff PLI Speech.)  That doesn’t even take into consideration the fact the federal judges (and juries) are not conflicted on these cases like the SEC Commissioners are.  Only after having first approved the filing of a prosecution, and likely having rejected a proffered settlement as insufficient, do the Commissioners decide these cases, including whether to adopt views of the facts or the law that may be inconsistent with their own decision to prosecute.

As an attempt to make public policy, this document is an embarrassment.  Its objective is not to determine when an administrative forum is a fairer and more appropriate forum in which to litigate enforcement actions against non-regulated persons.  It is to provide a justification for any decision the SEC may make about where to litigate its cases, and to be able to argue that those decisions deserve deference because they reflect a reasoned agency determination under an adopted set of guidelines

The fact that Chair Mary Jo White signed off on such an atrocity is depressing, and, frankly, inexplicable.

Straight Arrow

May 11, 2015

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