It is probably not a stretch to say that the Securities and Exchange Commission likes to win every case that it decides to bring.
But a recent push by the agency to bring more cases before its administrative law judges rather than filing charges in federal district court is drawing increased attacks from defense lawyers claiming that the entire process is not just unfair, but also unconstitutional. Those criticisms could call into question the legality of the process used by a number of federal agencies that have in-house judges who decide whether laws were violated.
The issue has come to the forefront at the S.E.C. because of a change made by the Dodd-Frank Act in 2010 that lets the agency bring almost any case before an administrative law judge. Before then, charges over violations to the securities laws that involved corporate officers or those trading on inside information had to be brought in a federal district court, if the agency was seeking a penalty like a fine or ban from serving as an officer or director of a company.
The S.E.C. brings civil cases only, and when they are filed in federal court, defendants can engage in extensive discovery. They can also ask for a jury trial to decide whether a violation occurred. An administrative case allows much less discovery and is decided by an in-house judge, not a jury.
The S.E.C. has almost unfettered discretion to bring a case in either forum, and does not have to explain why it chooses the administrative route in a particular matter. Andrew J. Ceresney, the director of the S.E.C.’s enforcement division, told an American Bar Association meeting in November that “our use of the administrative forum is eminently proper, appropriate and fair to respondents.” Defense lawyers do not see it quite that way.
But simply claiming a procedure is unfair or that a party would prefer the greater protections afforded in a federal lawsuit is likely to fall on deaf ears in the courts. Take, for instance, the comments of a United States district court judge, Lewis A. Kaplan of the Southern District of New York, who recently rejected a challenge to the S.E.C.’s filing of administrative charges. “In the time-honored and entirely appropriate way of so many litigants, they usually want a particular forum, and deride alternatives, for no reason more exalted than self-interest,” Judge Kaplan said.
Two recent challenges by defendants to the S.E.C.’s choice of forum argued that the use of administrative judges violated the constitutional principle of separation of powers that gives the president the power to control the executive branch (under which the S.E.C. falls), including whether its officers should be fired. In an interesting twist, these challenges claim that the S.E.C.’s administrative law judges hearing the cases have too much protection from being removed from office, thus interfering with the president’s authority to control the executive branch.
In one case, a hedge fund manager, Joseph D. Stilwell, and his investment advisory firm asked the United States District Court in Manhattan in October to block the S.E.C. from filing administrative charges after being notified of the agency’s intention to pursue a case. That challenge is delayed as settlement discussions with the S.E.C. may render the issue moot.
In a second case, filed this month, Barbara Duka, a former managing director at Standard & Poor’s, sought to prevent the S.E.C. from filing administrative charges rather than a federal court complaint over her role in S.&P.’s flawed ratings of commercial mortgage-backed securities. The S.E.C. went ahead and filed its case before its administrative law judge on Jan. 21.
We usually think of judges as independent from political considerations, with protections in place to minimize interference from other branches of government and public pressure. The Constitution provides federal judges with lifetime tenure, with removal limited to impeachment for “high crimes and misdemeanors,” and their pay cannot be cut.
There are more than 1,300 administrative law judges employed by 31 of federal agencies. The S.E.C. has five years to hear cases for violations of the securities laws. Although they do not have the same level of protection as federal judges, under the Administrative Procedure Act, these administrative law judges can be removed or suspended by their agency “only for good cause.”
In Free Enterprise Fund v. P.C.A.O.B., the Supreme Court found that the protections afforded to members of the Public Company Accounting Oversight Board (created in the Sarbanes-Oxley Act in the wake of the accounting scandals of the previous decade) was unconstitutional. Its five members were appointed by the S.E.C., and the Supreme Court found that it violated separation of powers that they could not be held accountable by the president as a result of the protections limiting their removal by the S.E.C. to good cause.
This gave the accounting board members a double layer of protection because the S.E.C. commissioners themselves can only be removed for good cause, so that “the president cannot remove an officer who enjoys more than one level of good-cause protection, even if the president determines that the officer is neglecting his duties or discharging them improperly.”
That analysis raises the question of whether administrative judges are too far removed from the president’s oversight to comport with the Constitution. But before reaching that issue, there is a preliminary question whether the federal court has jurisdiction to even hear the challenge or whether that should be left to the administrative process. In other words, the issue is: Who can decide whether there is a constitutional violation, a federal court or the S.E.C. when it reviews the result of the proceeding?
In the Free Enterprise Fund decision, the Supreme Court found that the challenge could be raised in federal court because the question of whether the P.C.A.O.B.’s structure violated the Constitution was “collateral” to any underlying violation that might be raised at some later time. The issue of whether the accounting board’s members could even pursue an investigation and file charges was separate from whether a violation of the law occurred.
An administrative case filed by the S.E.C. may be different, however, because the status of the judge can be considered along with whether there is evidence showing a violation.
Recent decisions by two federal district court judges rejected challenges to the S.E.C.’s decision to move forward in an administrative proceeding.
In Jarkesy v. S.E.C., a United States District Court judge in Washington, Beryl A. Howell, dismissed a challenge to the filing of administrative charges because “the statutory regime embodied in the Securities Act sets forth an exclusive mechanism for the plaintiffs to pursue their claims” by first having the S.E.C. review the case and then by a federal court of appeals. That ruling is now before the Federal Court of Appeals for the District of Columbia Circuit.
Judge Kaplan in Manhattan reached the same result in Chau v. S.E.C. when he concluded that “if plaintiffs lose before the commission, they will have a full opportunity to present their arguments in a court of appeals.”
If a federal district court is willing to address the constitutional issue, then it will have to decide whether administrative judges are sufficiently accountable to the president that there is no violation of separation of powers principles. In the Free Enterprise Fund opinion, the Supreme Court dodged the issue by noting that “our holding also does not address that subset of independent agency employees who serve as administrative law judges.”
The issue of whether the current protections afforded administrative judges is constitutional will have to be decided eventually, whether in a direct challenge to the S.E.C.’s authority to file a case before its in-house judges or in the judicial review of a decision imposing penalties. If a court decides those judges have too much protection in violation of the Constitution, then the effect will be felt far beyond the S.E.C.