Thursday, August 13, 2015

SEC ALJs: An Enforcement Fast-Track is Hitting the Constitutional Skids

Guest Bloggers - Peter Hardy, Abe Rein and Carolyn Kendall

On Wednesday, Judge Berman of the Southern District of New York issued an order preliminarily enjoining the SEC from pursuing an administrative proceeding – an in-house trial before an SEC administrative law judge (“ALJ”) rather than an Article III judge – against Barbara Duka, a former Standard & Poor’s executive whom the SEC has accused of securities fraud.  The order finds that the SEC’s process for appointing its ALJs is “likely unconstitutional in violation of the Appointments Clause,” marking the third preliminary injunction issued by a federal district court that has come to the same conclusion in recent months – and the first such injunction issued from the SDNY, the putative center of the universe of securities enforcement.  The constitutionality of SEC ALJs’ appointments is apparently in grave doubt.  This issue has the potential to bring the SEC’s use of administrative proceedings (“APs”) to a halt; indeed, it could impact administrative proceedings in any number of agencies beyond the SEC as well.

The SEC publicly has trumpeted its increased reliance on its ALJ system as part of the agency’s overall goal of pumping up enforcement because of its perceived efficiency – at least from the perspective of the government.  For the past several years, the SEC has brought the vast majority of its enforcement actions before its ALJs. The SEC’s success rate in cases before ALJs has been a startling 90% over the past 4.5 years, compared with 69% in federal court over the same period.  This is perhaps unsurprising, given the procedural advantages the SEC enjoys in its APs: unlike in federal court, SEC APs involve no jury; discovery for respondents is seriously limited – contrasting sharply with the SEC’s ability to collect evidence, sometimes over the course of years, via subpoena; respondents are generally afforded no more than four months to review the case and prepare for trial; the Federal Rules of Evidence do not apply; and traditionally-inadmissible evidence routinely is considered: “[A]ll evidence that can conceivably throw any light upon the controversy at hand should normally be admitted.”  In the Matter of Jay Alan Ochanpaugh, Exchange Act Rel. No. 54363, 2006 SEC LEXIS 1926, *23 n.29 (Aug. 25, 2006) (citing In the Matter of Jesse Rosenblum, 47 S.E.C. 1065, 1072 (1984)).  The SEC has turned to its ALJ system to pursue complex cases, including insider trading cases, that historically had been reserved for resolution in federal district court.  Anecdotal reports also strongly suggest that the SEC has invoked its perceived advantages before ALJs during settlement negotiations with potential respondents.  Thus, the current ALJ system not only provides the SEC with concrete procedural advantages during actual litigation, but the mere threat of the current ALJ system bestows upon the SEC a less concrete but potentially extremely potent weapon to use, behind the scenes, to convince its targets to never litigate in the first place.

Against this backdrop, parties threatened with or subject to SEC administrative proceedings recently have argued, inter alia, that the SEC’s ALJ appointment process violates the Constitution’s Appointments Clause of Article II, which requires that “inferior officers” of the United States be appointed by the President, a Court of Law, or the Head of a Department.  This argument should prevail if both (1) SEC ALJs are indeed “inferior officers,” and (2) they are not appointed by the President, a Court, or the Head of a Department.  As to the second question, the SEC already has conceded that its ALJs are appointed via a selective service process, which “would be inconsistent with the terms of the Appointments Clause” if the ALJs are inferior officers.  And as to the first question – whether the SEC ALJs are inferior officers – the Northern District of Georgia, and now the Southern District of New York, have confirmed in separate cases that closely-analogous Supreme Court precedent “mandates a finding that the SEC ALJs . . . [are] inferior officers.”  Hill v. SEC, No. 15-cv-1801-LMM, 2015 U.S. Dist. LEXIS 74822, at *52 (N.D. Ga. June 8, 2015); Gray Financial Group v. SEC, No. 15-cv-492-LMM (N.D. Ga. Aug. 4, 2015); Duka v. SEC, No. 1:15-cv-357 (S.D.N.Y. Aug. 12, 2015).  The Supreme Court precedent at issue is Freytag v. Comm’r, 501 U.S. 868, 881 (1991), in which the Court held that special tax trial judges, due to their ability to “exercise significant discretion,” are inferior officers under Article II.  The legal conclusion by Judge Berman that SEC ALJs are inferior officers draws particular strength from Second Circuit precedent: in Samuels, Kramer & Co. v. Commissioner of Internal Revenue, 930 F.2d 975 (2d Cir. 1991), the Second Circuit anticipated the Supreme Court’s decision in Freytag, issued only three months later, when it addressed the same issue and reached an identical holding, through similar reasoning.

This legal conclusion is also entirely consistent with the actual powers enjoyed by ALJs, which are parallel to those of a trial court judge presiding over a bench trial:  he or she has the power and discretion to rule on any motions, including pre-trial motions for summary disposition;  conduct trials and take testimony;  order production of evidence  and rule on admissibility questions;  issue subpoenas and rule on applications to quash;  sanction parties if they are in contempt;  enter orders of default;  take notice, where appropriate, of facts not appearing in the record;  and grant extensions of time and dismiss for failure to meet deadlines. The SEC ALJ decides whether the respondent has violated the law.   That decision is appealable to the Commission itself, although in many cases the Commission can simply deny a petition for review.   If the decision is not appealed, or if the Commission declines to review the ALJ’s decision, the SEC enters an order that the ALJ’s decision has become final.  The respondent then may appeal to the federal Court of Appeals, albeit on a standard of review that is generally very favorable to the SEC, which so far has entirely handled the proceeding.

The issue is still working its way through the courts – no Court of Appeals has yet weighed in – but it is gaining traction.  What is the potential practical effect if the courts ultimately conclude that the SEC’s ALJs are unconstitutionally appointed? This is a complex question, on which we already have written at length.  In short, it appears that parties who have lost on appeal, or whose time to appeal has expired, likely will be unaffected.  However, parties whose adjudications are not yet final may be able to void their adjudications.  As to parties against whom the SEC may in the future bring APs, the SEC theoretically has available the easy fix of simply re-appointing its ALJs under a constitutionally-adequate process and proceeding as normal.  But this issue has been percolating for months, and the SEC – represented by the DOJ –has declined to exercise this option.  Indeed, in its response to an order in the Duka case which “allow[ed] the SEC the opportunity to notify the Court of its intention to cure any violation of the Appointments Clause,” the SEC was conspicuously silent as to any plan to address the issue.  Thus, it appears that the SEC will continue, at least for the foreseeable future, to employ an enforcement process that runs a significant risk of being declared entirely unconstitutional.

One potential explanation for the SEC’s reticence to cure its growing problem is that any such move could be perceived as a concession that past practices were improper.  Moreover, the government at large, including the DOJ, which often serves as the litigation arm for many different agencies and departments, may face a more global quandary because this issue is not necessarily limited to just SEC ALJs; rather, it may imperil the legitimacy of many ALJs across the government.  Until the SEC – and possibly other agencies and departments – resolve this problem, bringing enforcement actions in federal court may be the only way to ensure that resources are used effectively, rather than pursuing judgments that ultimately may be voided.

(ph, ar, & ck)

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