Why it matters: The SEC has of late come under attack in the courts and congressional hearings for the “Kafkaesque” nature of its administrative hearings. Specifically, critics argue that the administrative hearings deprive defendants of the due process protections afforded by the U.S. Constitution. The most recent legal challenge was filed in U.S. District Court on April 1, 2015 by New York financier Lynn Tilton in response to SEC proceedings initiated against her the day before. But Tilton and the other challengers could face an uphill battle in light of a recent federal court ruling dismissing a similar challenge on jurisdictional grounds, citing the plaintiff’s failure to exhaust administrative remedies in the very proceedings they are challenging.
Detailed discussion: On March 30, 2015, the SEC announced that it was charging self-described “Diva of Distressed” Lynn Tilton (Tilton) and her investment firms Patriarch Partners LLC and related Patriarch limited liability companies (collectively, Patriarch) with fraud and breach of fiduciary duty for, among other things, hiding from investors the poor performance of loan assets in three collateralized loan obligation funds they manage in violation of the federal securities laws. The SEC chose to bring these charges in its own administrative forum instead of in a United States District Court, having that day filed an Order Scheduling Hearing and Designating Presiding Judge (OIP). The OIP directed that (1) a public hearing be held within 60 days before a designated administrative law judge (ALJ) and (2) an initial decision be issued within 300 days addressing the veracity of the allegations contained in the OIP and determining what remedial action, if any, should be taken, including injunctive relief and/or the payment of monetary penalties and disgorgement. In its press release, the SEC stated that “[t]he matter will be scheduled for a public hearing before an administrative law judge for proceedings to adjudicate the Enforcement Division’s allegations and determine what, if any, remedial actions are appropriate.”
On April 1, 2015, Tilton fired back at the SEC by filing a complaint in U.S. District Court seeking declaratory and injunctive relief and demanding a jury trial. The complaint focused on the constitutionality of the SEC administrative hearing process, as well as the use of SEC-employed ALJs to preside over them, and the overall lack of constitutionally protected due process rights afforded in such administrative proceedings. In brief, Tilton and Patriarch alleged:
1. The U.S. District Court has lawful subject matter jurisdiction and the Court should exercise such jurisdiction in this case because “(a) without judicial review at this state, meaningful judicial review will be foreclosed; (b) Plaintiffs’ claim [that the SEC ALJ program is unconstitutional] is wholly collateral to the review provisions of the securities laws, and (c) Plaintiffs’ claim is not within the particular expertise of the SEC.” The complaint provides detailed facts and legal arguments throughout on each of these points in an apparent effort to defeat the SEC’s likely response that they failed to exhaust administrative remedies. One example: Even though Tilton and Patriarch had been under “wide-ranging and in-depth” investigation by the SEC for “an unusually prolonged” period in excess of five years prior to the issuance of the OIP on March 30, the OIP’s requirement of “curtailed” proceedings, including a “speedy” hearing within 60 days and a decision within 300 days, deprives Tilton and Patriarch of “meaningful judicial review.”
2. ALJs are U.S. “officers” that have not been appointed by the SEC Commissioners as required by Article II of the Constitution. Rather, they are hired by the SEC’s Office of Administrative Law Judges and their appointment and salary are specified by statute. They wield great authority and enjoy “at least two – and likely more” layers of tenure protection and thus cannot be easily removed, all in violation of Article II.
3. An SEC administrative proceeding lacks the due process rights afforded to defendants in federal court in that it is “an internal SEC hearing, litigated by SEC trial attorneys and governed by the SEC’s Rules of Practice . . . in which an SEC ALJ serves as finder of fact and of law.” Moreover, unlike in federal court, there is no right to a jury trial and neither the Federal Rules of Civil Procedure nor the Federal Rules of Evidence apply. The SEC’s Rules of Practice don’t allow for counterclaims or motions to dismiss, discovery is limited, and depositions are generally not permitted. Appeals from ALJ decisions go to the SEC itself, which has the discretion to deny them. Even though SEC decisions affirming ALJ rulings can eventually be appealed to a federal court, irreparable harm to the defendant’s (in this case, Tilton’s) livelihood, business and reputation will have been caused by the years-long delay and considerable expense of bringing such an appeal.
4. The securities laws, “guided by no statute, regulation, or established practice”, grant the SEC the discretion to commence proceedings against Tilton and Patriarch either in federal district court or an SEC administrative proceeding. There are no guidelines in place that govern how the SEC chooses the appropriate venue in a particular case, making the SEC’s choice arbitrary. The SEC had the full authority to bring Tilton’s case in district court, but its choice of an administrative proceeding is “inappropriate” because it is not supported by the SEC’s history or the underlying facts of this case.
Tilton’s complaint is just the latest constitutional challenge to SEC administrative hearings brought in the federal courts. For example, two recent complaints focused primarily on the ALJ constitutionality argument:Gray Financial Group, Inc. v. SEC, No. 1:15-cv0492 (N.D.Ga.), filed on February 19, 2015; and Stilwell v. SEC, No. 14-cv7931 (S.D.N.Y.), filed on October 1, 2014. The complaint in Bebo v. SEC, No. 15-cv00003 (E.D. Wis.), filed on January 2, 2015, raised both the lack of due process and the ALJ constitutionality arguments in its attack on SEC administrative proceedings.
Worth noting is that all three of the Gray, Bebo and Stilwell complaints contained almost identical language to that contained in the Tiltoncomplaint attempting to establish the court’s subject matter jurisdiction and to avoid dismissal based on failure to exhaust administrative remedies, namely that the plaintiff’s claims (a) will lack meaningful judicial review in the administrative proceeding, (b) are wholly collateral to the review provisions of the securities laws, and (c) are not within the particular expertise of the SEC. However, on March 3, 2015, the Bebocomplaint was dismissed for lack of subject matter jurisdiction. That court relied on an established line of “exhaustion of remedies” cases to justify its dismissal, stating that “Bebo’s claims are subject to the exclusive remedial scheme set forth in the Securities Exchange Act. Bebo must litigate her claims before the SEC and then, if necessary, on appeal to the Court of Appeals for the Seventh Circuit.” The court went on to conclude that “[u]ltimately, Bebo’s argument regarding the lack of meaningful judicial review lies in her objection to being subject to a procedure that she contends is wholly unconstitutional. But, as one judge observed, district court jurisdiction ‘is not an escape hatch for litigants to delay or derail an administrative action when statutory channels of review are entirely adequate.’”
It remains to be seen whether other courts confronting these constitutionality arguments targeted at SEC administrative proceedings will find the Bebo court’s dismissal precedential with respect to its finding that subject matter jurisdiction is lacking. The Stilwell case was settled on March 16, perhaps because the SEC did not want to adjudicate the issue. The Gray case is still pending. The plaintiff there filed an amended complaint on March 31 and a motion for limited expedited discovery on April 3, and to this date no motion to dismiss has been filed by the SEC. The Tilton complaint, filed after the Bebo dismissal, is certainly drafted to anticipate a motion to dismiss on the grounds of exhaustion of remedies.
Another recent development of note: On April 13, 2014, oral argument was heard before the D.C. Court of Appeals in the case of Jarkesy et al. v. SEC, No. 14-cv5196 (D.C. Cir.), regarding the constitutionality of the SEC’s administrative proceedings. George Jarkesy, a Texas-based hedge fund manager, had filed a complaint in district court on January 19, 2014 alleging due process claims similar to the other cases in connection with administrative proceedings instituted against him by the SEC. On June 10, 2014, Jarkesy’s complaint was dismissed by the U.S. District Court for lack of subject matter jurisdiction on exhaustion of remedies grounds. The D.C. Court of Appeals agreed to take the case on appeal, and oral arguments were heard on April 13. The D.C. Circuit’s decision will be greatly anticipated.
In the meantime, Congress recently held hearings regarding the due process fairness of the SEC’s administrative hearings. On March 19, 2015 (just in time for Tilton to reference it in paragraph 30 of her complaint), Director of Enforcement Andrew Ceresney had an uncomfortable interlude attempting to justify the SEC’s administrative proceedings in the Q&A following his testimony before the House Financial Services Subcommittee (the topic of which was “Oversight of the SEC’s Division of Enforcement”).
In his opening comments, Rep. Scott Garrett (R-NJ) said that “[w]hile bringing more cases through the administrative proceedings can lead to lower costs for the agency and increases in efficiency, it’s important to realize that those benefits come with a cost. The cost is less due process protections for defendants. Because the SEC’s administrative proceedings use the SEC’s procedural rules, respondents are forced to operate on a condensed timeframe, and do not have the benefit of some of the fundamental due process protections under the Federal Civil Procedures Act and the Federal Rules of Evidence, such as full discovery rights, and the right to a jury trial, and the exclusion of hearsay evidence.”
Garrett went on to express concerns about the difficult process of appealing ALJ decisions: “Moreover, initial appeals of administrative law judges—ALJ rulings—must be made to the full commission, and ALJ’s employer, rather than federal district court. While the commission’s decision may [then] be appealed to the D.C. Circuit Court of Appeals, the SEC’s interpretation of the securities laws generally will be given significant deference. Appealing an administrative decision is a time-consuming and expensive proposition.”
In the Q&A portion of the hearing, Garrett began by asking Ceresney about previous comments Ceresney had made that seemed to imply that the SEC “threatens” targets with administrative proceedings in order to force settlements (the implication: targets would rather settle than undergo an administrative hearing). Garrett asked how the SEC makes the decision to bring a case as an administrative proceeding over filing it in federal court, and whether Ceresney could provide the Committee with established written guidelines it follows in making its decision. Ceresney responded that “we use a number of facts and circumstances” as “internal guidance” for the staff, elaborating that the staff will choose administrative proceedings (1) in cases that “we can only bring as administrative proceedings,” such as “failures to supervise and causing violations,” (2) “cases where we need quick relief [for investors]” because “administrative proceedings can be much more quick than district court actions . . . we can get a decision within 300 days” and (3) cases involving “technical . . . complicated” rules that “sophisticated fact finders” such as ALJs can understand and which would be more difficult for a jury to grasp. However, with respect to Garrett’s question as to whether any of this is written down as official “guidelines,” Ceresney said he would have to consult his staff and get back to them.
During the course of the Q&A in response to different questioners, Ceresney gave the following 2014 statistics: The SEC brought a majority of its cases, or 57%, in federal court and 43% as administrative proceedings. The SEC was successful in 11 out of the 18 federal court cases (13 of which were jury trials), and it had a success rate of nearly 100% in its administrative proceedings. In response to these statistics, specifically the nearly 100% success rate in the administrative proceedings, Rep. Sean Duffy (R-Wis.) questioned sharply: “You won every case. How about with regard to the cases you brought in federal court? One hundred percent there? No? You won 11 out of 18 [cases]? . . . You think there could be any correlation when you actually hire the judges, and you set the rules, that you win all the cases? . . . And you might say ‘You know what, I want to bring more cases in front of the judges that I hire and abide by the rules that I set as opposed to letting these cases go to federal court . . . and, lo and behold, I win them all. And I believe in due process. That’s a great way to administer justice when you work at the SEC.” To this Ceresney replied, “We are not afraid to try cases in federal court. In fact, we won 11 of our last 13 jury trials in federal court . . . . And we still bring a majority of our cases in district court, so we are not shying away from using district court.”
One of the last questioners was Rep. Bruce Poliquin (R-Maine), who grilled Ceresney about the inherent unfairness in the SEC’s administrative proceedings process. After a back-and-forth where it was established that the ALJs are paid for by the SEC and the proceedings primarily take place in SEC headquarters, Poliquin said that “if you’re not in federal court to pursue these alleged violations of the securities law and they’re held, effectively on government property . . . and you folks . . . are hiring and paying for these judges, that I would make the argument . . . that they may not be completely impartial.”
Given the tenor of these congressional comments, it appears that Tilton may have chosen a good time to file her lawsuit as the drumbeat gets louder regarding the constitutionality of the SEC’s administrative proceedings. However, the Bebo court’s decision to dismiss that case for lack of subject matter jurisdiction due to the failure to exhaust administrative remedies signals that these challenges could face an uphill battle. And it remains to be seen whether recent congressional skepticism about this issue will translate into legislative action.
See here to read the complaint in Lynn Tilton; Patriarch Partners, LLC; Patriarch Partners VIII, LLC; Patriarch Partners XIV, LLC; and Patriarch Partners XV, LLC v. Securities and Exchange Commission, No. 15 cv 02472 (4/1/15).
See here to read the Decision and Order in Bebo v. Securities and Exchange Commission, No. 15-C-3 (3/3/15).
For more on this matter, refer to the congressional transcript of the House Financial Services Subcommittee on SEC Division of Enforcement dated 3/19/15.