SEC in-house judges ruling is the agency's latest in a string of losses

OCTOBER 2017 TERM

In June 2014, after a string of high-profile jury trial losses in insider trading cases, then-Director of Enforcement Andrew Ceresney announced a tactical retreat into the friendly confines of administrative hearings before the Securities and Exchange Commission's administrative law judges. The implications of this decision were lost on no one and were promptly criticized by the securities defense bar, federal judges, and even some SEC commissioners. Indeed, in February 2015, Commissioner Michael Piwowar stated that "this change has the appearance of the Commission looking to improve its chances of success by moving cases to its in-house administrative system."

The SEC's forum selection provides significant home-court advantages to the agency, as Commissioner Piwowar correctly observed, mostly because administrative proceedings lack many of the procedural safeguards available in federal court. For example, there is no right to a jury in an administrative hearing, which is decided by in-house administrative judges who are employed by the SEC and housed in the SEC's offices. Further, while the SEC may take years to conduct its investigation, a respondent in an administrative proceeding must go to a hearing in just a few months. Neither the Federal Rules of Civil Procedure nor the Federal Rules of Evidence apply in administrative proceedings, and respondents are permitted only limited discovery. Appeals are heard by the SEC itself, which initially approved filing the case. Not surprisingly, with all of these advantages, the SEC historically enjoyed a Harlem Globetrotters-like win-loss record in administrative proceedings.

The defense bar fought back against Ceresney's unfair tactical decision, lobbing continued constitutional challenges to the lack of due process in these administrative courts and the unconstitutional appointments of the ALJs themselves. Now, the U.S. Supreme Court has weighed in on the propriety of this forum and the result is clear: another bloody nose for the SEC.

On Thursday, the Supreme Court's decision in Lucia et al. v. Securities and Exchange Commission, 2018 DJDAR 5940, resolved the long-simmering debate on whether ALJs are "inferior officers," as that term is used in the Constitution. Until recently, ALJs were selected by the SEC staff. If ALJs were determined to be "inferior officers," the appointments clause of Article II of the Constitution requires that they be appointed by the SEC itself and not by its staff. The SEC had taken the position in lower courts that its practice for appointing ALJs was constitutionally permissible. As a precaution, however, while Lucia was pending, the SEC "ratified" the appointment of all of its ALJs in an effort to derail the appointments clause challenge. Nonetheless, in a highly unusual move, the government opted to switch sides while Lucia was pending to oppose the SEC's interpretation of the appointments clause.

In Lucia, while four justices weighed in with separate opinions, seven justices agreed that ALJs are "inferior officers" and, as a result, were appointed by SEC staff in violation of the appointments clause. The appointments clause provides that Congress may vest the appointment of inferior officers "in the President alone, in the Courts of Law, or in the Heads of Departments." Prior Supreme Court precedent established that an officer, unlike an employee, occupies a "continuing" statutorily defined position and exercises "significant authority pursuant to the laws of the United States." United States v. Germaine, 99 U.S. 508, 511 (1878), and Buckley v. Valeo, 424 U.S. 1, 126 (1976), respectively. Both parties requested that the Supreme Court refine the "significant authority" test. The court conceded that this test may need to be refined "one day," but declined to do so because Lucia could be decided by relying on prior Supreme Court precedent, Freytag v. Commissioner, 501 U.S. 868 (1991), which held that "adjudicative officials [U.S. tax court special trial judges] who are near-carbon copies" of the SEC ALJs were officers under this test.

Justice Elana Kagan, who authored the opinion, noted that Freytag "decide[d] this case." The Supreme Court found strong factual similarities between the SEC ALJs and the tax court special trial judges at issue in Freytag. Both positions are continuing, not temporary or episodic, and are created by specific statute. And both positions preside over adversarial hearings and issue rulings that may become binding on the participants, mimicking for all intents and purposes the substantial authority and discretion exercised by a judge at trial. Indeed, an SEC ALJ commands even greater authority than a special trial judge because the ALJ's decision may become final -- and "deemed the action of the Commission" -- even if the SEC decides not to review the decision. 17 C.F.R. Section 201.360(d)(2).

Lucia represents the most recent loss in a string of defeats suffered by the SEC in the Supreme Court. However, despite the clarity of its holding, Lucia's impact on SEC enforcement actions, if any, is difficult to predict. While the court declined to address the effect of the SEC's ratification of the staff's appointment of the ALJs, the SEC can simply appoint the ALJs itself and dispose of the appointments clause issue going forward. Prior administrative decisions decided by constitutionally suspect ALJs may be in jeopardy if the respondent makes a "timely" challenge to the ALJ's constitutionality. Lucia provides a roadmap for the steps needed to bring this claim, noting that Lucia's challenge was timely because he: "[1] contested the validity of [the SEC ALJ's] appointment before the Commission, and [2] continued pressing that claim in the Court of Appeals and this Court."

Lucia, and others like it, arose out of Dodd-Frank's expansion of the SEC's ability to have its enforcement cases tried in front of its own administrative law judges rather than in federal court. While the Supreme Court's decision corrects one constitutional infirmity presented by that expansion, other infirmities remain, such as the denial of a right to a jury trial and the abridgement of full and fair access to information through discovery. The Supreme Court has now disagreed with the SEC's interpretation of the Constitution and federal law in a series of significant cases: Gabelli v. SEC; Kokesh v. SEC; Digital Realty Trust, Inc. v. Somers; and now Lucia. The fact that the court issued its opinion in Lucia the same week it granted certiorari in Lorenzo v. SEC (a case that involves the question of who is a "maker" of a statement for securities fraud liability purposes) provides a subtle hint to court-watchers about the next shoe to drop on the SEC: a recognition that the SEC has overstepped its bounds in yet another way.