Debate over SEC’s in-house courts could go to the Supreme Court

For many months, critics of the in-house courts favored by the Securities and Exchange Commission have sought to usurp their authority through both lawsuits and legislation. But now, those opponents may see their efforts decided by the Supreme Court.

Until recently, legal challenges to the SEC’s administrative courts have gained little traction, but that all changed on Dec. 28 with a ruling by the 10th U.S. Circuit Court of Appeals in Denver. The case, brought by Colorado businessman David Bandimere, raises new questions about the constitutionality of the judges used in the administrative proceedings and could have a broader effect on other regulators.

Over the years, the Securities and Exchange Commission has increased its reliance on the use of in-house judges and self-contained administrative proceedings to adjudicate cases that might otherwise wind up in federal court.

While the Commission sees benefits to the streamlined approach administrative proceedings bring, those subjected to the process have a long list of complaints.

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A common grievance is that the deck is stacked against them and in favor of the Commission. In-house judges, some say, are biased in favor of the agency that employs them, as evidenced by a much higher success rate for the SEC in those venues than it sees in federal courts. Procedural rules are similarly slanted in favor of the prosecution, as is an appeals process that gives Commissioners the final say, detractors lament.

According to research by New York University and Cornerstone Research, in the first half of Fiscal Year 2016, the SEC brought 88 percent of its actions against public company defendants as administrative proceedings, compared to just 33 percent in 2010. The SEC’s success rate hovers in the 90 percent range.

Until recently, that success rate was mirrored by the SEC’s track record in court. Among the notable victories was an August 2016 ruling by the U.S. Court of Appeals for the D.C. Circuit, the first by an appellate court to uphold the legality of those administrative proceedings.

The ruling quashes an appeal brought before it on the grounds that the Commission’s in-house judges are unconstitutional because they were not appointed by the President and confirmed by Congress.

In September 2012, the SEC charged investment adviser Ray Lucia, Sr., a nationally syndicated radio personality and financial advice author, with “spreading misleading information” about an investment strategy he and his company touted at a series of investment seminars. An in-house judge upheld those charges, as did an appeal brought before SEC commissioners. Lucia was barred from the industry and fined $300,000.

In October 2015, Republican Commissioners Dan Gallagher and Michael Piwowar dissented from the enforcement action when it was brought before them on appeal.

“Does every losing party before an ALJ now have grounds to appeal on the basis that the decision entered against him is unconstitutional? It certainly seems that way.”

Judge U.S. Circuit Judge Monroe McKay

“The respondents have raised important issues with respect to whether the administrative law judge overseeing the proceeding was appointed in a manner consistent with the Appointments Clause of the Constitution,” they wrote. “Even though the Commission is free to express its views on Constitutional issues, we recognize and believe it is appropriate that … federal judges ultimately resolve this issue.”

Lucia cited the Appointments Clause in his legal challenge, arguing that the SEC’s administrative law judges were not nominated by the President, nor were they confirmed with the “advice and consent” of the Senate.

The D.C. Circuit ruling dismissed that constitutional challenge, opining that the SEC judges were, in essence, employees of the agency rather than “inferior officers” or an independent judiciary function. Final decisions and actions still rest with politically accountable commissioners, it said.

The SEC commissioners retain powers of delegation with administrative proceedings and retain the ability to accept, reject, or alter any ruling upon appeal, the Court wrote.

The latest legal twist, however, comes courtesy of a split, three-judge panel in the U.S. Court of Appeals for the 10th Circuit in late December. The majority, unlike the court in that previous ruling, deemed the judicial appointments as unconstitutional.

Circuit Judge Scott Matheson wrote for the majority in the case of Bandimere v. U.S. Securities and Exchange Commission.

“When the framers drafted the Appointments Clause of the U.S. Constitution in 1787, the notion of administrative law judges presiding at securities law enforcement hearings could not have been contemplated,” he wrote. 

In considering whether the five administrative law judges working for the SEC are employees or inferior officers, Matheson drew upon precedents set in the case Freytag v. Commissioner of Internal Revenue to conclude that the ALJ who presided over an administrative enforcement action against the petitioner, David Bandimere, was an inferior officer, not constitutionally appointed, and held his office in violation of the Appointments Clause.

In 2012, the SEC brought an administrative action against Bandimere, alleging he violated various securities laws. An SEC ALJ presided over a trial-like hearing.

SEC ON ADMINISTRATIVE PROCEEDINGS

The following is from May 2015 guidance from the Securities and Exchange Commission’s Enforcement Division on its use of administrative proceedings.
The Commission generally is authorized to bring its enforcement actions in either of two forums—a civil action in federal district court or a Commission administrative proceeding (and/or cease-and-desist proceeding) before an Administrative Law Judge—though it has authority to proceed on certain charges or remedies in only one of those forums.
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. The Division’s forum recommendations are in all cases subject to review and approval by the Commission.
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.
Administrative Law Judges and the Commission develop extensive knowledge and experience concerning issues that frequently arise in matters involving registered entities or associated persons.
In general, hearings are held more quickly in contested administrative actions than in contested federal court actions. This may allow the Division to use the Commission’s limited resources more effectively.
When a matter involves older conduct, this may allow for the presentation of testimony from witnesses who have a fresher recollection of relevant events.
This also may permit a more timely public airing, based on evidence offered by all parties to the proceeding, of the facts and circumstances of the conduct and practices at issue in a matter.
The ability to seek and obtain relief in a single proceeding may enable the Commission to use its limited resources more efficiently. This may be possible in district court, for example, when the Division is recommending charges against multiple parties, including relief defendants – claims against relief defendants can only be pursued in district court. This also may be possible in the administrative forum, for example, in the regulated entity/associated person context described above or in situations where we are recommending charges against multiple parties and there may be no single district court that is a permissible venue for an action against each of the parties.
There may be potential efficiencies if the case can be decided on, or the disputed issues narrowed by, a motion for summary judgment in federal court (which generally addresses a broad range of claims and issues) or a motion for summary disposition in the administrative forum (which generally requires leave from the Administrative Law Judge to file and typically addresses a narrower range of claims and issues).
For example, district courts more frequently address and resolve elements of claims (such as whether a statement is false or whether an instrument is a “security”) on summary judgment.
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.
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.
Conversely, where application of state law or other specialized areas of federal law is integral to the matter, district court may be appropriate.
If similar charges are being or have been brought against similarly situated parties (e.g., registered entities or associated persons) in the same or closely-related contested matters, it may be preferable to recommend charges against similarly situated parties in the same forum.
Source: SEC

The initial decision concluded Bandimere was liable, barred him from the securities industry, ordered him to cease and desist from violating securities laws, imposed civil penalties, and ordered disgorgement.

The Commission reviewed the initial decision and reached a similar result in a separate opinion.

During that review, the agency addressed Bandimere’s argument that the ALJ was an inferior officer who had not been appointed under the Appointments Clause. Although the ALJ had not been constitutionally appointed, the Commission rejected Bandimere’s objections because, in its view, the ALJ was not an inferior officer.

Bandimere, in turn, filed a petition for review with the district court, raising his Appointments Clause argument and challenging the SEC’s conclusions regarding securities fraud liability and sanctions.

Matheson’s opinion defines the Appointments Clause, a key component of the case. It states: “[The President] shall nominate, and by and with the advice and consent of the Senate, shall appoint ambassadors, other public ministers and consuls, judges of the supreme Court, and all other Officers of the United States, whose appointments are not herein otherwise provided for, and which shall be established by law: but the Congress may by law vest the appointment of such inferior officers, as they think proper, in the president alone, in the courts of law, or in the heads of departments.”

The term “inferior officer” “connotes a relationship with some higher-ranking officer or officers below the President. Whether one is an inferior officer, in part, depends on whether they have a superior.” Bandimere’s petition stated that: “The SEC’s opinion must be vacated because it resulted from a process in which an improperly appointed inferior officer played an integral role.”

The crux of the debate before the Court is whether ALJs are the equivalent of Commission employees, or something more. It is a legal test complicated by the fact that the Supreme Court has not yet stated a specific test for inferior officer status.

In this case, in Matheson’s opinion, inferior officer status applied.

The SEC has authority to delegate “any of its functions” except rulemaking to its ALJs. Commission regulations task ALJs with “conducting] hearings” and make them “responsible for the fair and orderly conduct of the proceedings,” Matheson wrote. SEC ALJs “have the authority to do all things necessary and appropriate to discharge their duties.” In his view, that was enough to agree that the ALJ in his case held office in conflict with the Appointments Clause.

ALJs, have authority to issue initial decisions that declare respondents liable and impose sanctions, he pointed out. When a respondent does not timely seek agency review, “the action of the ALJ shall, for all purposes, including appeal or review thereof, be deemed the action of the Commission.”

The SEC argued that ALJs do not exercise significant authority when issuing initial decisions because the agency retains a right to review the decisions de novo.

Matheson was not persuaded by that argument. “SEC ALJs exercise significant authority in part because their initial decisions can and do become final without plenary agency review,” he wrote. “Indeed, 90 percent of those initial decisions become final without plenary review.”

“SEC ALJs have power to enter default judgments and otherwise steer the outcome of proceedings by holding and requiring attendance at settlement conferences,” he wrote. “They also have authority to set aside, make permanent, limit, or suspend temporary sanctions that the SEC itself has imposed.”

“It is unclear where the appointment buck stops,” Matheson wrote. “The current hiring system would suffice under the Constitution if SEC ALJs were employees, but we hold … that they are inferior officers who must be appointed as the Constitution commands.”

Matheson added that SEC ALJs “are more than mere aids” to the agency and “perform more than ministerial tasks.”

“The SEC’s power to review its ALJs does not transform them into lesser functionaries,” he added. “Rather, it shows the ALJs are inferior officers subordinate to the SEC commissioners … The SEC ALJ held his office unconstitutionally when he presided over Bandimere’s hearing.”

In the dissent opinion, Judge U.S. Circuit Judge Monroe McKay fretted over the “probable consequences” of the decision.

“It does more than allow malefactors who have abused the financial system to escape responsibility,” he wrote. Under the majority’s reading of Freytag, all federal ALJs are at risk of being declared inferior officers. Despite the majority’s protestations, its holding is quite sweeping, and I worry that it has effectively rendered invalid thousands of administrative actions.”

The judgment is a quantitative one, McKay argued, and “it does not tell us how much authority is too much.”

“It lists the duties of SEC ALJs, without telling us which, if any, were more important to its decision than others and why,” he added. “And I worry that this approach, and the end result, leaves us with more questions than it answers.”

The lingering question raised by the case: Are all federal ALJs constitutional officers?

“Does every losing party before an ALJ now have grounds to appeal on the basis that the decision entered against him is unconstitutional? It certainly seems that way,” McKay wrote.

What’s next? The SEC has 45 days from the date of the ruling in which to ask for an en banc review by all 19 judges of the 10th Circuit. A continued split among the appellate courts could eventually give critics of the administrative proceedings what they have long hoped for: a pathway to the Supreme Court.