SEC’s Clause for Concern? Law Firms on Recent Decisions Re Div. of Enforcement Forum Selection

September 24, 2015

4541A recent spate of law firm memos alerted us to the unsettled state of the law regarding Securities and Exchange Commission (SEC) enforcement proceedings. In recent months, several respondents in SEC enforcement actions have brought suit in federal court seeking to preliminarily enjoin the administrative proceedings the SEC brought against them as unconstitutional, and a few have succeeded. We found this particularly exciting because securities lawyers don’t often get to argue constitutional law.

Over the last few decades, a string of statutes have expanded the scope and power of the SEC’s administrative proceeding process. Most recently, the Dodd-Frank Act increased the agency’s authority to impose monetary penalties on persons and entities violating the securities laws. With this most recent expansion, the SEC can through administrative action reach most of the parties and levy most of the penalties it could until recently get only in court. SEC administrative proceedings are brought in front of administrative law judges (ALJs), who are employed and paid by the SEC and lack the lifetime tenure and independence of federal judges.

As a result, the Division of Enforcement now has significant discretion to choose where to bring enforcement actions – and it has made clear its intention to favor administrative proceedings over court actions. In 2013, Andrew Ceresney, the director of the Division of Enforcement, said his “expectation is that we will be bringing more administrative proceedings given the recent statutory changes” (At the S.E.C., a Question of Home-Court Edge, New York Times, Oct. 5, 2013). In May 2015, the SEC published written guidance on the main considerations that generally inform its choice of forum for enforcement actions. However, the agency is not required to follow this guidance (SEC: Division of Enforcement Approach to Forum Selection in Contested Actions (May 2015)).

Unsurprisingly, the SEC’s exercise of its new powers has triggered a flurry of objections.

Mortgage-backed securitiesThe SEC’s principal argument for favoring administrative proceedings over court actions has been that administrative actions enhance the “effectiveness and efficiency” of the Division of Enforcement (Statement of Robert Khuzami to the US Senate Committee on the Judiciary, Dec. 9, 2009 (2009 WL 4757499)), but as many commentators, including the Southern District of New York Judge Jed Rakoff, have pointed out, some of these efficiencies come at the expense of due process. For instance, SEC administrative proceedings allow very limited discovery compared to federal court actions, and none of the protections of the Federal Rules of Evidence (SEC Rules of Practice require merely exclusion of evidence that is irrelevant or unduly repetitious). In addition to these procedural shortcomings, Judge Rakoff noted that the SEC wins more often in front of ALJs than in federal court, and although SEC administrative decisions are subject to federal court review, as agency rulings they are accorded judicial deference when interpreting the federal securities laws (Is the S.E.C. Becoming a Law Unto Itself? Speech by Jed S. Rakoff at the 46th Annual Securities Regulation Institute Conference (Nov. 5, 2014)).

In June, a more concrete threat to the SEC’s new enforcement powers arrived when a federal judge in the Northern District of Georgia preliminarily enjoined an administrative proceeding on the ground that the SEC’s process for hiring ALJs violates the Appointments Clause of the Constitution (Hill v. SEC, No. 1:15-CV-1801-LMM, 2015 WL 4307088 (N.D. Ga. Jun. 8, 2015) (Hill)).

For those whose constitutional law is rusty, the relevant portion of the Appointments Clause lays out the process for appointing “inferior” officers of the United States. Congress is empowered to “vest the Appointment of such inferior Officers … in the President alone … or in the Heads of Departments” (U.S. Const. art. II, § 2, cl. 2). This is the “exclusive means” for appointing inferior officers (Freytag v. Comm’r Internal Revenue, 501 US 868 (1991)). The Hill court found that SEC ALJs are inferior officers and must therefore be appointed by the “head” of the SEC, i.e. the Commissioners. Right now, they aren’t. In August, another federal judge, in the Southern District of New York, concurred with the holding in Hill and issued a preliminary injunction concerning another SEC administrative proceeding on the same Appointment Clause ground (Duka v. SEC, No. 1:15-CV-00357 (S.D.N.Y. Aug. 12, 2015) (Duka)). The SEC has appealed both decisions.

By contrast, some courts faced with the same argument have demurred from ruling on the constitutional issue, holding instead that they do not have the power to adjudicate collateral attacks on SEC proceedings. On August 24th, the Seventh Circuit affirmed the dismissal of a request to enjoin an SEC proceeding on Appointment Clause grounds. The court concluded that Congress did not intend to grant federal courts jurisdiction to hear collateral attacks on SEC proceedings. Section 78y of the ’34 Act provides that “[a] person aggrieved by a final order of the Commission … may obtain review of the order in the United States Court of Appeals” (15 U.S.C.A. § 78y). The Seventh Circuit held that it was Congress’ intention that Section 78y be the exclusive mechanism for court oversight of SEC enforcement actions (Bebo v. SEC, No. 15-1511, 2015 WL 4998489 (7th Cir. Aug. 24, 2015) (Bebo)). The Seventh Circuit’s decision is in accord with a June decision in the Southern District of New York holding that the “exclusive avenue of review of an ALJ’s decision is through the administrative process, with subsequent judicial review by a federal court of appeals” (Tilton v. SEC, No. 15-CV-2472(RA), 2015 WL4006165 (S.D.N.Y. Jun. 30, 2015)). The Duka court, ruling before the decision in Bebo, considered this argument, but found “persuasive the reasoning in Hill … [that] …‘Congress did not intend to … prevent Plaintiff from raising his collateral constitutional claims in the district court,’)” (Duka v. SEC, No. 15-CV-00357, 2015 WL 4940057 (S.D.N.Y. Aug. 3, 2015)).

Given the unsettled state of the law, and the SEC’s determination to use its new power, it appears likely that more analysis will be forthcoming.

To learn more, please join us on September 29, 2015 for a free webinar on using the Business Law Center on WestlawNext to research SEC enforcement actions.

Law Firm Memoranda & Blog Posts

Akin Gump discusses SDNY Judge Berman Enjoining SEC Administrative Proceeding as “Likely Unconstitutional,” The CLS Blue Sky Blog (Sep. 3, 2015)

Seventh Circuit: Respondents in Pending SEC Administrative Proceedings May Not Bypass the Judicial Review Process Established in 15 U.S.C. § 78y by Bringing Constitutional Challenges to the SEC’s Authority Directly in Federal Court, Simpson Thacher Securities Law Alert (Aug. 31, 2015)

John J. Falvey, Jr., and Daniel J. Tyukody, Federal Court Injunction Against SEC Prosecution, Harvard Law School Forum on Corporate Governance and Financial Regulation (Aug. 30, 2015)

Seventh Circuit Rejects Court Challenge to Pending SEC Administrative Enforcement Proceeding, Proskauer Client Alert (Aug. 25, 2015)

SDNY enjoins SEC from pursuing administrative hearing on constitutional grounds: setback for enforcement strategy, DLA Piper Securities Litigation Alert (Aug. 14, 2015)

Recent Cases Consider Challenges to Constitutionality of SEC Administrative Law Judges, Cahill Firm Memoranda (Jul 3, 2015)

District court says appointment of SEC administrative law judge was likely unconstitutional, DLA Piper Securities Enforcement Alert (Jun. 9, 2015)

Administrative Proceedings vs. Federal Court: The SEC Provides Limited Transparency Into Its Choice of Forum, Morrison Foerster Client Alert (May 11, 2015)