Tag Archives: SEC v. Chau

SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding

On December 11, 2014, Judge Lewis Kaplan ruled that his court lacked jurisdiction to consider Wing Chau’s injunctive action to prevent an SEC administrative prosecution against him on due process and equal protection grounds.  Although the ruling was narrowly confined to the jurisdiction issue, it nevertheless was a significant victory for the Commission.

In October 2013, the SEC commenced an administrative proceeding against Chau and his firm, Harding Advisory, alleging misrepresentations in connection with the sale of collateralized debt obligations (“CDOs”) that imploded during the housing/mortgage crisis.  The allegations essentially charged that Chau and Harding misrepresented the nature of the process for selecting assets that went into the CDOs.  After seeking to work within the administrative process to get the kinds of discovery and preparation time that typically would be available if the action were brought in federal court, Chau and Harding commenced a federal action in the Southern District of New York to stop the administrative proceeding.  They asserted in their complaint (which can be reviewed here: Wing Chau v. SEC), that the SEC administrative action violated due process because it did not allow a fair defense to be developed, and denied equal protection of the law because they were singled out for administrative prosecution when similar actions against other persons were brought in federal court (and two of three were lost by the SEC).

The court had previously denied a temporary restraining order and the administrative trial went forward and was concluded.  The parties are awaiting an ALJ determination.

The threshold issue was whether such an action was permissible — whether the district court had jurisdiction to hear a claim to preempt the administrative action.  Applying the standards set forth in Thunder Basin Coal Co. v. Reich, 510 U.S. 200 (1994), Judge Kaplan ruled there was no jurisdiction because (1) the plaintiffs could get meaningful judicial review in an appeal of the administrative action, (2) the claimed constitutional violations were not wholly collateral to the issues to be decided in the administrative action, and (3) the consideration of due process and equal protection claims were not outside of the SEC’s “expertise.”  A copy of the opinion can be found here: Chau v SEC Opinion.

The court found it significant that the due process claim “has been that the SEC’s procedural rules . . . are unfair in light of ‘facts and circumstances of [their] case'” and not that “the SEC’s rules are unconstitutional in every instance.”  Slip op. at 18-19.  The numerous grounds asserted to show that the respondents had been prevented from presenting a fair defense did not provide jurisdiction because they “all . . . are inextricably intertwined with [the] ongoing administrative proceeding and can be reviewed by a court of appeals.”  Id. at 20.  And because the challenges involve the day-to-day conduct of the proceeding, the due process arguments are not “wholly collateral” to the proceeding under Thunder Basin.  Id.  Finally, “plaintiffs fail to articulate any convincing reason why the SEC lacks the competence to consider the fairness of proceedings before its ALJs.”  Id. at 22.  The issue is the fairness of a particular hearing, not a determination that one of the SEC’s “constituent parts is unconstitutional,” and the “SEC is well equipped to evaluate claims of unfairness in proceedings before its ALJs — and if it fails to do so, the courts of appeals stand ready to correct the error.”  Id. at 22-23.

The equal protection claim yielded the same result.  Although a sister court found jurisdiction for such a claim in Gupta v. SEC, 796 F. Supp.2d 503 (S.D.N.Y. 2011), Judge Kaplan was not convinced to follow that decision.  He found the Gupta allegations of discriminatory conduct stronger, but also did “not find Gupta‘s application fo the Thunder Basin factors persuasive in these circumstances.”  Slip op. at 25.  In essence, he disagrees with the reasoning in Gupta and relied on modestly different facts to rule the other way.  He again also found no basis to conclude that the equal protection claim is outside of the SEC’s “expertise.”  But he did so with a circular argument.  He acknowledged that adjudicating such claims “is ‘not peculiarly within the SEC’s competence,'” but without addressing why equal protection analysis was within the SEC’s competence, stated that the SEC’s attempt to address the equal protection issues in an attempted interlocutory appeal from an ALJ decision “indicate that the SEC is competent to consider plaintiff’s constitutional claims.”  Id. at 31-32. 

At the end of the opinion, the judge noted that plaintiffs’ challenge “[t]aken to its logical conclusion . . . would upend all manner of administrative enforcement schemes.”  Id. at 32. He concluded that because “the normal channels of statutory review are adequate” his court lacked subject matter jurisdiction.

In an epilogue, Judge Kaplan took note that “the growth of administrative adjudication, especially in preference to adjudication by Article III courts and perhaps particularly in the field of securities regulation, troubles some.”  Id. at 34.  He singled out concerns that this approach could “increase the role of the Commission in interpreting the securities laws to the detriment or exclusion of the long standing interpretive role of the courts.”  This is a concern that has been raised by federal district judge Jed Rakoff (see here).  He also mentions concern that such SEC determinations might be accorded “broad Chevron deference to SEC interpretations of the securities laws in the determination of administrative proceedings.”  Id. at 34-35.  Concern about the proper scope of Chevron deference to SEC statutory interpretations was noted recently by Justice Scalia (see here).

Judge Kaplan said “[t]hese concerns are legitimate, whether born of self-interest or of a personal assessment of whether the public interest would be served best by preserving the important interpretative role of Article III courts in construing the securities laws – a role courts have performed since 1933.”  “But they do not affect the result in this case. . . .  This Court’s role is a modest one” — to determine subject matter jurisdiction.  Id. at 35.  In reaching its conclusion, the court “has not considered any views concerning the proper or wise allocation of interpretive functions between the Commission and the courts,” which “are policy matters committed to the legislative and executive branches of government.”  Id. at 35-36.

The takeaway from this decision is limited.  Although the jurisdictional issue required some consideration of the merits of the constitutional claims, the due process and equal protection concerns raised by Chau and Harding plainly were left for another forum to decide.  The very different constitutional issues raised by the plaintiffs in Stilwell v. SEC and Peixoto v. SEC (see here), were not mentioned.  As to those cases, even as to subject matter jurisdiction the analysis would have to be very different because, unlike Chau, they do involve a fundamental challenge to the structure of SEC administrative proceedings, i.e., they do require a determination whether one of the SEC’s “constituent parts is unconstitutional.”  It would be difficult to argue that the structural issues raised about SEC administrative law judges in Stilwell and Peixoto are even arguably within the competence of the SEC to decide for itself.  (For an in depth discussion of the merits of those issues, see here.)

But there remains no doubt that this is an SEC victory that, at a minimum, delays consideration of some aspects of the propriety of shifting SEC enforcement actions to its own administrative courts (see posts on this issue here and here).

Straight Arrow

December 15, 2014

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Peixoto Charges SEC Insider Trading Administrative Action Is Unconstitutional

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

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

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

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

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

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

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

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

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

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

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

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

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

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

We will discuss these complex issues in later posts.

 Straight Arrow

October 21, 2014

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