The Securities and Exchange Commission has suffered a potentially crippling blow to its controversial use of in-house administrative law judges.

Over the years, the 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. A common grievance among defendants is that the deck is stacked against them with in-house judges they claim are biased in favor of the agency. Procedural rules are similarly slanted in favor of the prosecution, as is an appeals process that gives commissioners the final say.

Score one for the critics. The Supreme Court, on June 21, announced a 7-2 vote ruling that the SEC’s selection of its five current administrative law judges was unconstitutional because they were chosen—and could be dismissed—through a civil service process, rather than by a quorum of commissioners acting as a presidential stand-in. The Court ruled that they are “inferior officers” and subject to the appointments clause of the U.S. Constitution. Justice Elena Kagan wrote the majority opinion.

The Commission has statutory authority to enforce securities laws and one way it can do so is by instituting an administrative proceeding against an alleged wrongdoer. In most cases, the Commission delegates the task of presiding over such a proceeding to an administrative law judge (ALJ).

An ALJ assigned to hear an SEC enforcement action has the “authority to do all things necessary and appropriate” to ensure a “fair and orderly” adversarial proceeding. At the end of a hearing, the ALJ issues an initial decision. The Commission can review that decision. If it opts against a review, it issues an order that the decision has become final. The initial decision is “deemed the action of the Commission.”

A challenge to that process, Lucia v. SEC, was argued before the Supreme Court on April 23, 2018.

The SEC charged petitioner Raymond Lucia with violating securities laws and assigned ALJ Cameron Elliot to adjudicate the case. Following a hearing, Judge Elliot issued an initial decision concluding that Lucia had violated the law and imposed sanctions.

On appeal to the SEC, Lucia argued that the administrative proceeding was invalid because Elliot had not been constitutionally appointed.  According to Lucia, SEC ALJs are subject to the Appointments Clause. Under precedent, only the president, “courts of law,” or “heads of departments” can appoint such “officers.”  None of those actors had made Elliot an ALJ.

The SEC and the Court of Appeals for the D. C. Circuit rejected Lucia’s argument, holding that SEC ALJs are not “officers,” but mere employees with lesser responsibilities who are not subject to the Appointments Clause.

An appeal once again argued that Elliot heard and decided Lucia’s case without a constitutional appointment.

The Supreme Court agreed with Lucia’s argument and that the appropriate remedy for an adjudication tainted with an appointments violation is a new hearing before a properly appointed official.

“We will have to watch ongoing litigation to see how this issue plays out. Because the opinion has several concurrences, there is some room for creative argument in future cases.”
Trace Schmeltz, Partner, Barnes & Thornburg

“In this case, that official cannot be Judge Elliot, even if he has by now received a constitutional appointment,” Kagan wrote. “Having already both heard Lucia’s case and issued an initial decision on the merits, he cannot be expected to consider the matter as though he had not adjudicated it before.” To resolve the constitutional error, another, appropriately appointed ALJ (or the full Commission) must hold the new hearing.

That part of the ruling referenced an SEC attempt to provide a fix by retroactively ratifying the appointments by a November 2017 vote by Commissioners.

“This has been an issue and decision that’s been a long time coming,” says Kit Addleman, chair of the law firm Haynes and Boone’s SEC Enforcement Defense Practice Group and former director of the Atlanta Regional Office of the SEC. “ALJs yield a significant amount of power and the process for appointing them needed to be one that was more formalized and rigorous, rather than simply calling an ALJ an employee.”

“In terms of its effects on defendants there are so many unanswered questions as a result of this ruling, because it is very narrow,” she adds. “The justices declined to take on, for example, issues around removal. Without addressing that issue, it begs the question of whether ALJs are truly constitutionally empowered if they can still be removed [by a civil service process and Merit Systems Protection Board, not an executive branch decision].

On Friday, the SEC attempted to deal with some of the fallout.

“In light of the Supreme Court’s decision in Lucia v. SEC, we find it prudent to stay any pending administrative proceeding initiated by an order instituting proceedings that commenced the proceeding and set it for hearing before an administrative law judge, including any such proceeding currently pending before the Commission,” it wrote in a bulletin.

The stay is effective immediately and will remain operative for 30 days “or further order of the Commission.”

In any applicable matter pending before an administrative law judge, that judge is directed to issue a notice indicating that the proceeding has been stayed. The order does not preclude the Commission from assigning any proceeding currently pending before an administrative law judge “to the Commission itself or to any member of the Commission at any time.”

There had been speculation that, because the SEC has ratified the appointment of its present ALJs and had them re-open and review their cases after ratification, the SCOTUS decision was unlikely to affect current cases before the Commission, says Trace Schmeltz, a partner at law firm Barnes & Thornburg. “One could argue that the ‘re-opening’ process was insufficient to remove the taint of decisions made by an improperly appointed ALJ.”

“We will have to watch ongoing litigation to see how this issue plays out,” he adds. “Because the opinion has several concurrences, there is some room for creative argument in future cases. For example, Justice Breyer noted that foes of the administrative state will be heartened by his concern that, by considering whether ALJs are ‘officers’ separately from whether they can be removed for any reason, ‘the Court risks unraveling, step-by-step, the foundations of the Federal Government’s administrative adjudication system as it has existed for decades.’” 

Schmeltz’s advice for those facing one of the SEC’s administrative proceedings, or had a case that has gone to judgment, “you can and should challenge the case and the ruling and ask to reopen it. You would have the right to seek a new hearing with a different ALJ than the one you had in your original matter.”

“What do you do if you are in the midst of litigation, and the Commission has ratified the appointment of the ALJ and told them to reopen anything that is in the file, look at any order that has been handed down, and rethink it? Is that sufficient? The Supreme Court didn’t address that question,” Schmeltz adds.

“Sure as rain, anyone who thinks it is valuable leverage will suggest that their case hasn’t been sufficiently sanitized,” he says. “What the Supreme Court has said is that you need to get a different ALJ all together. Having an ALJ, who was subsequently ratified, look over their findings is not going to be helpful. What are they going to say? ‘I did it right the first time when I was improperly ratified, and it is still right now that I am properly appointed.’ The Supreme Court said you need to have a second set of eyes, so that is where a lot of the action is.”

When it ratified the appointment of its ALJs in November, the Commission ordered them to reconsider pending cases, including 100 or so in which an initial decision had been made, to allow for the submission of new evidence, providing the opportunity to determine whether to revise or ratify prior actions, says Chris Veatch of the law firm Perkins Coie.

“While the reconsideration process will consume ALJ resources short term, it should not be crippling to the process long term,” he says.

Veatch adds that other agencies with ALJs put in place by similar appointments and authorities “would be wise to adopt the SEC’s remedial measures going forward.”

Included on that list are the Internal Revenue Service, Social Security Administration, and National Labor Relations Board. The Commodities Futures Trading Commission also uses administrative proceedings, but typically outsources the work to the ALJs of other agencies.

“The SC ruling makes it abundantly clear that anyone in the position of ALJ who, effectively has a policy-setting function, is subject to the appointments clause,” Schmeltz says. “This ruling will have an effect on every agency that relies upon administrative law judges in a similar structure.”

Ken Berg, a partner with Ulmer & Berne, agrees with those assessments.

“The Court’s decision will likely leave open more questions than it will answer,” he says. “Which other federal agencies have appointed their ALJs improperly? Is the process for removing ALJs also constitutionally flawed? How many other defendants barred from the securities industry by SEC ALJs are entitled to reinstatement with or without a new hearing?”

When the SEC ratified its judges last November they, “in essence, appointed the five ALJs and sent everybody back to the same ALJ they had before. That’s going to be a problem based on this opinion,” Berg says.

Another problem “is something the SEC can’t really do anything about: the removal issue. The Supreme Court, in a footnote, said it was not going to address that issue.

“There is a pretty good argument that the way ALJs are removed is unconstitutional,” he adds. “That means, from now until the next time the Court sees this question—which could be three to five years—the SEC is going to be using ALJs and everything they do might not be constitutional because of the issue with removal. As I understand it, the SEC can’t fix the removal issue; it would need to be fixed by Congress.”

As for Congress, some lawmakers are itching for a chance to dismantle the in-house judicial process.

The nearly 600-page CHOICE Act, currently in legislative limbo, includes language to end the SEC’s administrative proceedings.

Also, responding to both internal and external complaints, the SEC in 2016 offered its own reforms.

In response to the growing outcry, on July 13, the SEC adopted amendments updating its rules of practice governing its administrative proceedings. It codifies proposals to modify the rules of practice that were unveiled in September 2015.

Changes included: extending the potential length of the prehearing period from four months to a maximum of 10 months; and clarifying the types of dispositive motions that may be filed at various stages of proceedings.

Topics