SEC changes to its administrative “in-house” proceedings fail to protect fundamental fairness



July 26, 2016

Securities Litigation Alert

Author(s): Stephen M. LaRose, Brian T. Kelly, Kathleen Ceglarski Burns

The SEC recently amended its rules regarding enforcement actions in administrative proceedings, but defendants will likely continue to long for true protections of due process. This alert discusses what businesses and individuals need to know about the new rules.

After substantial public clamoring against the Securities and Exchange Commission’s (SEC) handling of enforcement actions as administrative in-house proceedings, the SEC recently amended its rules of practice governing such proceedings. Though a step in the right direction, the amendments are not substantial and fail to address several of the fundamental flaws that leave defendants without many of the protections of a full and fair trial.

Background

In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which greatly expanded the SEC’s power to pursue enforcement actions in administrative proceedings (or as they are colloquially called, “in-house” proceedings), instead of in federal court. Since passage of the Dodd-Frank Act, the SEC pursued thousands of defendants using in-house proceedings.

The shift in forum created new difficulties for defendants. For example, in-house proceedings lack several procedural elements—such as jury trials, meaningful discovery and application of the Federal Rules of Evidence—that ordinarily protect defendants from arbitrary or incomplete decisions. The timelines in the administrative forum are also significantly unfavorable to defendants, with most cases heard in only a matter of months. As a result, defendants subject to in-house proceedings are required to answer and prepare for hearings with minimal information and limited preparation time. Similarly, because the Federal Rules of Civil Procedure do not apply, defendants could not file dispositive motions, serve written interrogatory questions or depose key witnesses. Complicating these inequities further was the SEC’s practice of producing to the defendant at the last minute hundreds of thousands (if not millions) of documents acquired by the SEC during its investigation as part of its pre-hearing disclosure requirements. This potent combination hamstrung defendants and oftentimes forced them to waste valuable time sifting through meaningless documents to evaluate the strength and weaknesses of the SEC’s case. Finally, as if the deck wasn’t already stacked against these defendants, the proceedings are presided over by an in-house administrative judge who is an employee of the SEC.

Over the past several years, the SEC increasingly took advantage of the procedurally favorable in-house forum, with great success. Since Dodd-Frank’s passage in 2010, the total number of enforcement actions steadily increased. In 2014, the SEC brought approximately 80% of its enforcement actions as administrative proceedings, rather than federal court cases, a figure that is up from less than 50% ten years earlier.[1] The SEC won in-house cases 90% of the time in matters brought since 2010, but was only successful 69% of the time if the enforcement action was handled in federal court—subject to the Federal Rules of Civil Procedure, Federal Rules of Evidence and a jury.[2] No one is surprised that the SEC favors prosecuting cases where it has a better chance to win.

The recent amendments

Following consistent public criticism, the SEC is offering in the recent amendments some additional procedural protections that may afford defendants the semblance of a more level playing field. Among other changes, the amendments:

  • Extend the potential length of prehearing periods for certain cases;
  • Permit the taking of depositions in cases designated for 120-day timelines;
  • Provide for three separate dispositive motion options, and the procedures and legal standards that apply to such motions; and
  • Require defendants to assert whether they intend to rely upon an advice of counsel or other similar affirmative defense in their answer to the order instituting proceedings.
  • The SEC’s amendments go into effect sixty (60) days after being published in the Federal Register, and will apply only to proceedings initiated on or after that date. While the changes are productive and do address some concerns, the changes are nonetheless insufficient in light of the important protections afforded to litigants in the federal courts.

Further attention to fundamental rights is necessary

Major constitutional issues remain with the SEC’s conduct of matters in administrative proceedings, which, until resolved, will continue to overshadow the process. For example, the arbitrary manner in which the SEC chooses its forum—in-house or in federal court—remains a key concern and may give rise to constitutional challenges under the equal protection clause. Defendants selected for an administrative proceeding are left asking, “Why me?”

The fact that the judges are SEC-hired employees is a second source of significant concern. Defendants do not feel (and the statistics support their concerns) that their cases are heard by an impartial jurist. The Constitution has numerous protections geared to provide impartiality and fundamental fairness, including the Appointments Clause, which provides that only the president, the courts or the heads of departments may appoint “inferior officers” like the SEC administrative judges. See U.S. Const. art. II, § 2, cl. 2. Because SEC administrative judges are not appointed by one of the three designated offices, several federal judges have enjoined a number of SEC in-house proceedings on that basis.[3]

Similarly, the in-house system improperly limits the president’s constitutional authority to remove inferior officers and the fundamental constitutional system guaranteeing separation of powers. SEC administrative judges are protected from removal by two levels of tenure protection that prevent the president from exercising legitimate oversight over the enforcement of law, once again calling into question the impartiality of those making the decisions.

Finally, the recent amendments do not address perhaps the most pervasive inequity of in-house proceedings: the lack of a trial by jury. Presently, in-house proceedings are adjudicated by judges whose jobs are created by, paid for and maintained by the SEC, instead of an impartial jury of our peers. The SEC may argue in response that securities cases cannot be adjudicated by non-expert laypersons—an argument that is not compelling in our eyes, given the complexity of issues facing many juries today.

Conclusion

The SEC’s changes are a sign of some progress and a small improvement on the current system. Yet, it is unlikely that the recent amendments provide a fully level playing field to defendants accused of securities violations, or alter the SEC’s practice of prosecuting the vast majority of its cases through in-house proceedings where it wins at an increased rate. As a result, defendants will continue to suffer arbitrary and unequal treatment, without the same evidentiary and civil procedure protections as those defending their case in federal court. Their cases will continue to be decided by SEC-employed judges rather than a jury of their peers. This unfortunate reality shall continue, unless and until Congress or our courts step in and require full and adequate protections to defendants.


  1. http://www.wsj.com/articles/sec-wins-with-in-house-judges-1430965803. [Back to reference]
  2. Anello, Robert, “Addressing the SEC’s Administrative ‘Home Court’ Advantage in Enforcement Proceedings,” Forbes (Sept. 7, 2015) available here. [Back to reference]
  3. See Ironridge Global IV, Ltd. v. SEC, No. 15-2512, 2015 U.S. Dist. LEXIS 156925, at *19-20 (N.D. Ga. Nov. 17, 2015); Hill v. SEC, No. 15-1801, 2015 U.S. Dist. LEXIS 74822, at *15 (N.D. Ga. June 8, 2015), rev. on other grounds, 2016 U.S. App. LEXIS 10946, *44 (11th Cir. 2016); Gray Fin. Grp., Inc. v. SEC, No. 15-0492, 2015 U.S. Dist. LEXIS 131792, at *26 (N.D. Ga. Aug. 4, 2015), rev. on other grounds, 2016 U.S. App. LEXIS 10946, *44 (11th Cir. 2016). [Back to reference]

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