Tag Archives: SEC v. Cuban

Judge Rakoff Slams SEC for Increased Use of Administrative Proceedings

We have previously discussed the controversial decision of the SEC’s Division of Enforcement to move enforcement actions cases from the federal district courts to the SEC’s administrative court process.  This is particularly troubling as to civil prosecutions involving large potential “civil” penalties and ancillary relief like lifetime bars that can be debilitating to individual and corporate respondents.  Serious due process and separation of powers constitutional issues have been raised about this approach.  See our previous posts here, here, and here.

On November 5, 2014, U.S. District Court Judge Jed Rakoff, a constant thorn in the side of the SEC, told a gathering of SEC enforcement lawyers he was troubled by this policy as well.  A copy of Judge Rakoff’s speech is available here: Judge Rakoff PLI Speech.

Judge Rakoff did not venture into the merits of the legal challenges to these proceedings now proliferating in the courts.  Instead, he addressed the wisdom — or lack of wisdom — of the policy decision.  He first placed the SEC’s enforcement powers in historical context, noting that “When the SEC was first created in the 1930’s, its enforcement powers were largely limited to seeking injunctions in federal district courts to enjoin violations of the securities laws, and the only express provision for administrative hearings was to suspend or expel members or officers of national securities exchanges.”  In the next 50 years, expansions of the SEC’s enforcement powers were “tied to the agency’s oversight of regulated entities or those representing those entities before the Commission, and even then was largely ancillary to the broader remedies and sanctions it could obtain only by going to federal court.”  The power to seek monetary relief in these proceedings, in the form of so-called “disgorgement,” was not added until 1990.  And it was not until the Sarbanes-Oxley Act in 2002 that the SEC was accorded the extraordinary “power to employ administrative proceedings to bar any person who had violated the securities laws from serving as an officer or director of a public company.”  Finally, the 2010 Dodd-Frank Act gave the SEC “the power through internal administrative proceedings to impose substantial monetary penalties against any person or entity whatsoever if that person or entity has violated the federal securities laws, even if the violation was unintentional.”

Almost all of these accretions in SEC enforcement power, Judge Rakoff noted, came about “at the request of the SEC, usually by tacking the provisions authorizing such expansion onto one or another statute enacted in the wake of a financial scandal,” based on “a claim greater efficiency.”  Judge Rakoff’s acerbic nature is reflected in his reaction to this: “While a claim to greater efficiency by any federal bureaucracy suggests a certain chutzpah, it is hard to find a better example of what is sometimes disparagingly called ‘administrative creep’ than this expansion of the SEC’s internal enforcement power.”  This “efficiency,” he noted, is achieved by depriving the targets of enforcement actions of key procedural protections.  “Superficial” “streamlining” comes about “for the simple reason that SEC administrative proceedings involve much more limited discovery than federal actions, with no provision whatsoever for either depositions or interrogatories.  Similarly, at the hearing itself, the Federal Rules of Evidence do not apply and the SEC is free to introduce hearsay.  Further still, there is no jury, and the matter is decided by an administrative law judge appointed and paid by the SEC.”  As a result: “It is hardly surprising in these circumstances that the SEC won 100% of its internal administrative hearings in the fiscal year ending September 30, 2014, whereas it won only 61% of its trials in federal court during the same period.”

Beyond this concern, Judge Rakoff identifies another serious policy concern: moving cases from the federal courts to the SEC’s captive administrative court “hinders the balanced development of the securities laws.”  He notes that SEC enforcement actions often involve charges of fraud, which is a concept with little statutory or administrative, as opposed to judicial, development.  “Indeed, the SEC has often resisted any attempt to replace these provisions with something more specific, on the theory that such broad statutory provisions provide the flexibility needed to deal with the new schemes that fraudsters are constantly devising.”

His prime example is the area of insider trading, where the SEC “has repeatedly resisted any effort by Congress to statutorily define insider trading, preferring to leave the concept sufficiently flexible as to be able to adjust to new developments.”  “Fair notice” of what does, and does not, constitute insider trading fraud comes from “federal courts, where the law of insider trading has been developed and elaborated in much-publicized cases.”  Judge Rakoff noted that in two recent insider trading cases, SEC v. Cuban and SEC v. Obus, the SEC suffered “stinging defeats.”  As a result, “the SEC might well be tempted in the future to bring such cases as administrative enforcement actions, and thereby likely avoid the sting of well-publicized defeats.  But the result would be that the law in such cases would effectively be made, not by neutral federal courts, but by SEC administrative judges.”  And the availability of judicial review of these decisions, after they are reviewed by the SEC itself, is extremely limited because the SEC’s decision must be “presumed correct unless unreasonable” under the required appellate review standard.

Here is Judge Rakoff’s devastating conclusion:

In short, what you have here are broad anti-fraud provisions, critical to the transparency of the securities markets, that have historically been construed and elaborated by the federal courts but that, under Dodd-Frank, could increasingly be construed and interpreted by the SEC’s administrative law judges if the SEC chose to bring its more significant cases in that forum.  Whatever one might say about the SEC’s quasi-judicial functions, this is unlikely, I submit, to lead to as balanced, careful, and impartial interpretations as would result from having those cases brought in federal court.

In the short-run, this would be unfair to the litigants.  In the longer-run, it might not be good for the SEC itself, which has its own reputation for fairness to consider.  But, most of all, in the both the short-run and the long-run, it would not be good for the impartial development of the law in an area of immense practical importance. . . .

I see no good reason to displace [the Article III judicial process] with administrative fiat, and I would urge the SEC to consider that it is neither in its own long-term interest, nor in the interest of the securities markets, nor in the interest of the public as a whole, for the SEC to become, in effect, a law onto itself.

Hear, hear!

The plot thickens on the SEC’s enforcement power grab.  Judge Rakoff, who had considerable prosecutorial experience in the securities area before he was appointed to the bench, has an extensive following on the issues of securities law enforcement.  The new Republican Congress is not likely to be enamored of an enforcement process that enhances administrative powers at the expense of individual rights.  SEC Chair Mary Jo White should get prepared for a bumpy ride.

Update on SEC response:

In a panel discussion the next day at the same PLI conference, Andrew Ceresney gave a rejoinder to the Rakoff criticism.  Essentially, he argued that the SEC has no comparative advantage when it litigates in front of its own administrative law judges.  An extended analysis of his arguments can be found here.  In sum, he’s wrong, and badly so.  You can see a description of his comments here.  Cereseny needs to do some homework before he makes comments that show he simply doesn’t understand the issues.

Straight Arrow

November 6, 2014 (updated November 10, 2014)

Contact Straight Arrow privately here, or leave a public comment below:

Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions

In our first blog post in April 2014, we asked: “Why Isn’t the SEC Committed to a Just and Fair Enforcement Process?”.  Several months later, the SEC’s new enforcement director announced the SEC’s plans to bring more prosecutions in its captive administrative court, taking them out of the federal courts.  Whether coincidentally or not, this decision came in the midst of growing publicity on repeated SEC losses in federal court enforcement actions it brought: e.g.SEC v. Stoker; SEC v. Cuban; SEC v. KovzanSEC v. Obus; SEC v. Jensen; SEC v. Schvacho; SEC vSteffesSEC v. Petit (case dropped on eve of trial); SEC v. Graham; SEC v. Moshayedi.  (We wrote posts about ObusGraham, and Moshayedi.)  We questioned this decision as a matter of fairness and public policy in our June 12, 2014 post: “SEC Enforcement Director Announces Future Plans To Avoid Jury Trials.”  In his announcement, the enforcement director acknowledged that the SEC was at least partially motivated by a desire to move cases to a forum more hospitable to the SEC.

The SEC’s use of administrative proceedings to prosecute penal enforcement actions has many of the characteristics of a “Star Chamber” proceeding.

  • The SEC enforcement staff convinces the Commission to bring a case in a private meeting.
  • The case is commenced in a court overseen by an SEC administrative law judge (ALJ), who is hired by, and works in an Office within, the SEC.
  • The case proceeds under Rules of Practice set by the SEC.
  • The respondent in a proceeding has limited rights to gather evidence to defend the case — e.g., there is no right to subpoena evidence from the SEC or third-parties without ALJ approval (which the SEC litigators routinely oppose); there is no right to depose witnesses in advance of trial to learn what evidence they may have; there is no right to challenge the SEC enforcement staff’s unilateral determination of what gets included in the enforcement “file” that gets delivered to the respondent.
  • The respondent must be ready to try the case under an expedited schedule, but the SEC typically has had years to develop and review evidence before the case is brought.
  • The standard rules of evidence do not apply at trial.
  • There is no jury.
  • The judges are of varying quality (never having gone through an independent approval process), have much greater familiarity with the SEC lawyers than defense lawyers, tend to give great leeway (and sometimes deference) to the SEC lawyers, and are forced to decide complex cases under the deadline set by the SEC itself.
  • After the ALJ rules, the right of appeal is to . . .  the SEC.  The very group that authorized bringing the case gets to rule on the appeal sitting in an administrative adjudicative capacity; the prosecutor becomes the judge.
  • Only after that process is complete — and we’re now talking about years into the case with huge costs of defense — does the respondent have a right to appeal the decision to an independent court.  Even then, the appellate court is saddled with a “standard of review” that allows it to overturn the SEC’s determination only if it is “arbitrary,” an “abuse of discretion,” or “contrary to law.”  Essentially, only if no reasonable basis can be found to support the Commission’s findings, they must be affirmed.  As a result, no person outside of the SEC reviews the evidence de novo to decide if it fairly supports findings against the respondents under the applicable burden of proof, or if the sanctions imposed are fair. 

I am not suggesting that SEC administrative law judges knowingly stack the deck against respondents.  I think they try to be fair.  But they cannot alter the fact that the rules of these proceedings are stacked against respondents in the ways described above.  And it is not surprising that they may tend to undervalue due process protections, and evidentiary niceties, that may make their jobs, and the jobs of the SEC litigators, more difficult.  Of course, this is not a true “Star Chamber” because general notions of due process are still recognized, but the proof of the pudding is in the eating, and, there is no doubt that defense counsel prefer a judicial forum, and the SEC’s enforcement director himself noted that the SEC’s administrative courts seem to provide the SEC an advantage over those pesky federal courts.

The advantages to a defendant of a highly-qualified, independent, Article III judge cannot be over-emphasized.  The entire pre-trial process is imbued with disputes about how information and evidence can be gathered and must be shared, as well as what can and cannot be included in the case, and on what issues there actually is disputed evidence that justifies a trial.  And then, of course, there is the administration of the trial and the determination of evidence to be considered.  Most federal district court judges approach these issues seriously, fairly, and with true understanding of the importance in a case brought by the Government that the defendant is getting a “fair shake.”  One recent example of this (discussed in detail here) is Judge Scheindlin’s willingness to reject the SEC’s overbearing and totally unjustified effort to obtain so-called “disgorgement” from the Wyly brothers of $500,000,000 based on near-preposterous arguments about how the amounts they realized from stock options granted to them as management of highly successful companies were derived from non-disclosures about their control of stock held by offshore trusts.  It is rare that ALJ’s repudiate the SEC so thoroughly in administrative cases (although, to be fair, it has happened on rare occasions).

There seems to be a rising sense of abuse of power in the SEC’s announced decision to bring more of its civil prosecutions before its administrative law court.  Several articles or comments addressing this issue are linked in the “SEC Enforcement” section in the right margin of this blog.  One of these articles discusses a recent comment by district court judge Jed Rakoff (a former head prosecutor for securities cases in the U.S. Attorney’s office) asking “from where does the constitutional warrant for such unchecked and unbalanced administrative power derive?”.  Some suggest that the transfer of non-technical securities enforcement prosecutions to this forum to gain the advantage of reduced procedural protections violates due process requirements.  Thus, cases not focused on rules violations like technical broker-dealer or investment advisory rules, but rather on broader accusations of “fraud,” seem suspiciously out of place in an administrative court, the stated purpose of which is to allow the application of special expertise to these cases.

Keep an eye on developments in this area.  The SEC will not get a free ride on this.  In my estimation, the D.C. Circuit court appeals will be considering this issue in the not-too-distant future.

Straight Arrow

August 7, 2014

Contact Straight Arrow privately here, or leave a public comment below:

SEC Is Victorious in Stage 1 of SEC v. Wyly, but the More Interesting Decision Awaits

On May 12, 2014, the SEC scored a significant enforcement victory in the first stage of its enforcement action against billionaire businessmen and investors Charles and Sam Wyly when a jury found they committed securities fraud in failing to disclose the transactions of offshore trusts as their own.  SEC v. Wyly, No. 10 Civ. 5760 (SAS) (SDNY).  (Click here for the original complaint: SEC v. Wyly Complaint.)

But even in victory, the flaws of the SEC enforcement approach are apparent on their face.  The verdict came in an action filed in July 2010 alleging securities law violations in trading activity going back as far as 1992.  Many of the transactions at issue occurred between 1992 and 1999.  One of the original defendants, Charles Wyly, died before the trial commenced (in an auto accident).

The Wyly Brothers (Dallas News)

The Wyly Brothers (Dallas News)

Sam Wyly circa 2002

Sam Wyly circa 2002 (Bloomberg News)

Sam Wyly in 2014 (Lucas Jackson Reuters)

Sam Wyly in 2014 (Lucas Jackson Reuters)

At least this case, as compared to others, involved complex multinational transactions that would take a significant amount of time and effort to unwind and understand.  But 15 to 20 years seems a bit much.

Nevertheless, the victory at least shows that the SEC enforcement and trial lawyers are capable of trying a lengthy and complex case against excellent and well-funded defense lawyers.  That is a welcome relief from some recent trial debacles like SEC v. Cuban and SEC v. Kovzan (recent jury losses), and SEC v. Schvacho (a bench trial loss, which can be found here).

The core issue in the part of the case the jury decided was whether transactions in offshore trusts that were approved by trustees of those trusts were in fact controlled by the Wyly brothers and therefore should have been disclosed by them in SEC filings as the beneficial holders of those securities.  The offshore arrangements were plainly driven by tax considerations, not a desire to hide transactions from investors (the SEC’s “disgorgement” theory of ill-gotten proceeds includes recovery of supposedly improperly unpaid taxes, as discussed here).  But the evidence convinced the jury that the Wylys directed the investment decisions of the offshore trustees and knowingly or recklessly violated SEC disclosure obligations.

As one would expect, the Wylys were well lawyered-up in connection with these complex arrangements, but their defense that they acted in good faith by seeking and following legal advice was not successful.  It is certainly an object lesson for corporations or wealthy investors who think that legal advice can protect them: unless the giving and receiving of advice is clear, the advisors are made fully aware of all of the facts and circumstances, the advisees both document and clearly follow advice given, and government law enforcers don’t assert that the legal advice was really a conspiracy to evade the law, they may well be left out on a limb when things hit the fan.  Sam Wyly was not happy about well-paid lawyers who left him out on that limb, as reflected here.  

From a broader securities law standpoint, the most interesting part of the SEC v. Wyly enforcement case has not yet been decided.  The jury was not asked to decide the novel insider trading theory the SEC concocted against the Wyly brothers.  That will be decided from the Bench by District Judge Scheindlin.

The SEC’s theory in that aspect of the case seems far-fetched, but survived a motion to dismiss.  The SEC contends that when the Wylys, who were Chairman and Vice Chairman of the Board of Sterling Software, Inc. (which they controlled and in which they owned a large amount of stock) formed an intention in their minds to seek to sell Sterling Software to a bidder, they traded on material nonpublic information when they bought additional shares of Sterling Software without disclosing what they had on their minds.  Here is what the SEC alleged as the ground for its insider trading claim in paragraph 89 of its complaint against the Wylys (emphasis added):

At the time the Wylys entered into the equity swap, they were in possession of material, non-public information concerning Sterling Software.  Specifically, the Wylys were aware that they – as Chairman and Vice-Chairman of Sterling Software – had agreed and resolved that the sale of Sterling Software to an external buyer should be pursued.  In particular . . . , Sam Wyly personally decided that both Sterling Software and Sterling Commerce should be sold to external buyers.  Sam Wyly had then obtained the concurrence of his brother, Charles Wyly, who also agreed with Sam Wyly that, although both companies should be sold, the sale of Sterling Commerce should proceed first.

Not a single actual action towards the sale of the company is alleged — no merger negotiations, no initial contacts with buyers, no Board discussions — just a personal decision that the sale of the company should be pursued.  But according to the SEC, the mere fact that the Wylys formulated a personal plan for the future of the company barred them from buying company shares without first disclosing their inner thoughts.  Putting aside the obvious materiality issue, can it be that a director’s or controlling shareholder’s “thoughts” outside of the Board room are “company” information?  How strange is it to treat the shareholder (and his or her thoughts) as owned by the company and not vice versa?

This is truly a bizarre attempt to extend insider trading doctrine to the ultimate concept of equality of information — mere intentions formed in the minds of insiders trigger the so-called “disclose or abstain” rule, which precludes them from buying or selling stock without first disclosing inchoate thoughts or intentions.  But, as we are in the midst of showing in our multi-part post on the development of insider trading enforcement (see The Myth of Insider Trading (Part I)), this represents the extension, arguably to the point of ridiculousness, of the SEC’s long-standing effort to morph section 10(b) into a mandate that fair markets require equal access to information.  Should this theory of insider trading liability be accepted by the court, the SEC will have officially become the securities “thought police.”  Let’s wait to see what Judge Scheindlin does.

Straight Arrow

May 15, 2014

Contact Straight Arrow privately here, or leave a public comment below: