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S.E.C.’s In-House Judges Not Too Tough, a Review Shows

The Dodd-Frank Act allowed the Securities and Exchange Commission to bring almost any claim that it can file in a federal court before its own administrative law judges. The agency has since taken up this power against a panoply of inside traders and others accused of securities fraud.

Many targets of S.E.C. administrative law enforcement actions have sued on the grounds of equal protection, due process and separation of powers, seeking to require the agency to bring its claims to court, if at all.

I find these lawsuits unconvincing. Agencies have almost absolute discretion as to whom and how they prosecute, and it would be surprising if administrative proceedings, which have been in existence in their current form for almost 70 years, during which they have been repeatedly reviewed by the Supreme Court, suddenly became unconstitutional. I am accordingly unsurprised that, although a few judges have entertained constitutional claims against the S.E.C.’s administrative proceedings, more have rejected them.

Underlying the suits is, I suspect, less a concern that administrative law judges are unconstitutional, and more a sense that defendants cannot win before them, or at least win in the right way. The S.E.C. has a strong record wherever it files enforcement actions, but if defendants have no hope of obtaining the sweeping, if occasional, discipline that a federal trial judge can impose on the agency, then administrative proceedings look particularly bleak.

To this end, Judge Jed S. Rakoff of the Federal District Court for the Southern District of New York has suggested that administrative law judges can take a “narrow, tunnel-vision view of the law.” A large cast of characters, ranging from the Chamber of Commerce to columnists , have echoed his concerns.

The controversy has surprised administrative lawyers, who, if anything, are used to complaints that the 1,700 administrative law judges who work for the federal government (only five of whom work for the S.E.C.) offer defendants too much process and are too insulated from agency policy-making. They worry that the formal adjudication that administrative law judges provide is overly bureaucratic and inefficient.

Are the critics correct? To find out, I read every decision issued by the S.E.C.’s administrative law judges from the enactment of Dodd-Frank in 2010 to March of this year. Graded toughly – on whether the S.E.C. received everything it wanted from the case – the agency’s rate of success is high, but not unblemished.

In those decisions where at least one of the defendants was represented by counsel, the agency received everything it asked for only 70 percent of the time; that is not too different from the “rule of thumb” rate for victories by any federal agency in a federal court.

Of course, there is not getting everything the agency asks for, and there is losing the case. It is true that S.E.C. administrative law judges are willing to reduce the penalties sought by the agency’s enforcement division, either by reducing the amount of money that the defendant must pay to the S.E.C. or by reducing the length of their bar from practicing in their industry.

But in my sample, the agency rarely lost cases that it pursued to the point at which an administrative law judge would issue a decision. I identified only six of the first 359 decisions issued since Dodd-Frank was enacted that rejected the arguments of the enforcement division wholesale.

In two of these cases, the administrative law judges refused to punish relatively small-time violators more than they had already been punished.

In the other four cases, however, the defendants were prominent and well represented. Perhaps most notably, in 2011, an administrative law judge rejected a case against employees of State Street accused of misleading investors about the extent of subprime mortgage-backed securities held in an unregistered fund. That case set back the agency’s efforts to hold more bankers liable for fraud in the run-up to the financial crisis, and cannot be characterized as a politically popular or supine opinion.

Two other cases excused defendants charged with failing to supervise their subordinates, both of whom were engaged in work intended to comply with S.E.C. rules. One featured a partner at Ernst & Young; the partner’s subordinate was barred from practicing for one year. In the other, charges were dismissed against the chief executive of a large, multinational clearing firm who was accused of failing to supervise the firm’s chief compliance officer.

A final case against relatively high-level UBS financial advisers in Puerto Rico was deemed unproved.

I draw two conclusions from these opinions. The first is that these adjudicators do, in fact, usually rule in favor of the agency if they must issue a decision. But on the other hand, they are capable of reprimanding the agency, and, as the State Street case showed, cutting back on the S.E.C.’s enforcement efforts.

Much of the agency’s success before the administrative law judges, moreover, can be attributed to the routine nature of most of the cases filed administratively.

Administrative law judges write a number of opinions revoking the registrations of companies that fail to file quarterly reports; often these companies do not bother to defend themselves, making revocation all but certain. They also preside over proceedings that follow on from trials in which the defendants were found to have committed securities fraud. The barring from practice imposed by administrative law judges after these verdicts are faits accomplis.

Some securities practitioners have claimed that different administrative law judges hold the agency to different levels of scrutiny. It is possible that the S.E.C.’s current administrative law judges will eventually reveal themselves to be hawks or doves, but based on five years of opinions, it was impossible to identify a statistically significant difference in the agency’s win rate before any of them.

It is not good news to learn that the S.E.C. is bringing a case against you before its in-house judges. But defendants who want to take on the agency are not without hope.

David Zaring is associate professor of legal studies at the Wharton School at the University of Pennsylvania.

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