On June 21, 2018, the Supreme Court resolved a circuit split concerning the constitutionality of the U.S. Securities and Exchange Commission's (“SEC”) administrative law judges (“ALJs”). In Lucia v. Securities and Exchange Commission, --- U.S. ---, 2018 U.S. LEXIS 3836 (June 21, 2018), the Court held that SEC ALJs are “officers of the United States,” and thus subject to the Constitution's Appointments Clause, which limits the power to appoint “officers” to the President, “Courts of Law” or “Heads of Departments.” Because the ALJ who presided over Lucia's administrative proceeding was not appointed by the SEC itself, the Court held that the ALJ's appointment was unconstitutional and ordered the SEC to provide Lucia with a new hearing in front of a new (constitutionally appointed) ALJ. The Court threw out the SEC's prior order finding Lucia and his firm liable for securities violations and imposing monetary and equitable sanctions. The Court's decision will likely have a significant effect on many pending and already-concluded SEC administrative proceedings but also leaves a number of questions unanswered.

I. Background

In recent years, the SEC has increasingly relied on in-house administrative proceedings to prosecute enforcement actions. There are at least three reasons for this shift. First, the Dodd-Frank Act gave the SEC the power to impose civil monetary penalties and cease and desist orders in administrative proceedings against non-regulated persons; prior to the Dodd-Frank Act, the SEC was required to sue non-regulated persons in federal district court in order to seek similar relief. Second, in 2012, Judge Rakoff of the U.S. District Court for the Southern District of New York initially refused to approve a consent decree approving a $285 million settlement between the SEC and Citigroup, and criticized the SEC’s practice of entering into no-admission settlements. Other judges also began to question proposed consent decrees more harshly. Third, at around the same time, district courts also increasingly began to deny requests from the SEC and the Department of Justice to stay civil enforcement actions during the pendency of parallel criminal proceedings. These developments encouraged the SEC to rely more heavily on administrative proceedings. Indeed, following the passage of the Dodd-Frank Act, the number of civil enforcement actions initiated by the SEC in federal district court dropped precipitously—with one study finding a decline of approximately 85% between 2010 and 2015 in cases brought against public companies. See Stephen J. Choi & Adam Pritchard, The SEC’s Shift to Administrative Proceedings: An Empirical Assessment, 37 Yale J. on Reg. 1, 18-19 (2017).

The SEC’s increased use of administrative proceedings has been subject to significant criticism. The defense bar has argued that SEC administrative proceedings deprive respondents of critical procedural protections and give the SEC an unfair home-field advantage. Statistics show that the SEC’s track record from October 2010 – March 2015 was significantly better in administrative proceedings than in federal district court, winning 90% of the time in administrative proceedings compared to 69% of the time in federal district court. See Jean Eaglesham, SEC Wins with In-House Judges, Wall St. J. (May 6, 2015). These concerns led to a number of cases being filed in federal district courts in which respondents sought to enjoin SEC administrative proceedings on various grounds, including: that the ALJs had been unconstitutionally appointed; that administrative proceedings violated the Due Process clause; and that the ALJs’ for-cause removal protection was unconstitutional. District courts in the Eleventh Circuit routinely stayed SEC administrative proceedings on these grounds, making it the preferred forum for raising such claims. Other courts, including the Second Circuit in Tilton v. SEC, 824 F.3d 276 (2d Cir. 2016), rejected these challenges, holding that respondents were first required to exhaust administrative remedies. 

In July 2016, the SEC attempted to address the criticism described above by amending its rules of practice. These amendments sought to align the SEC’s administrative proceedings more closely with federal civil procedure. While critics acknowledged that these amendments were a step in the right direction, they were nevertheless widely criticized by the defense bar for not doing enough to address the alleged issues of structural unfairness. The amendments, for example, did not address the inherent unfairness of the SEC deciding cases that it decided to prosecute in the first place.

II. In the Matter of Raymond J Lucia Companies, Inc. and Raymond J. Lucia, Sr.

In 2012, the SEC initiated an administrative proceeding against Lucia and his investment company under the anti-fraud provisions of the Investment Advisers Act. The SEC ALJ ultimately found that Lucia violated the anti-fraud provisions and imposed sanctions including a $300,000 penalty and a lifetime ban from the investment industry. Lucia appealed this decision to the SEC, arguing that the administrative proceeding was invalid because the ALJ adjudicating his case had not been appointed in accordance with the Appointments Clause. The SEC rejected this argument, maintaining that ALJs are “mere employees” who are not covered by the Appointments Clause.

Lucia then appealed to the U.S. Court of Appeals for the D.C. Circuit. A panel of that court affirmed the SEC’s position, holding that because the SEC’s ALJs technically lack the authority to issue final decisions (ALJs make “initial decisions” which can be accepted or rejected by the SEC), they could not be considered officers of the United States. Raymond J. Lucia Cos. v. SEC, 832 F.3d 277, 283-89 (D.C. Cir. 2016). This was consistent with the D.C. Circuit’s prior ruling in Landry v. FDIC, in which the D.C. Circuit held that FDIC ALJs were not “inferior officers” subject to the Appointments Clause because they could not issue final decisions. 204 F.3d 1125, 1130-34 (D.C. Cir. 2000). Lucia subsequently petitioned for rehearing en banc, which was granted. After oral argument, the en banc court issued a one-page per curiam opinion with an equally divided court denying the petition for review. See Raymond J. Lucia Cos., Inc. v. SEC, 868 F.3d 1021 (2017).

The D.C. Circuit’s ruling directly conflicted with a prior decision by the Tenth Circuit Court of Appeals holding that SEC ALJs were “inferior officers” subject to the Appointments Clause rather than mere employees. The Tenth Circuit held that an ALJ’s status as an officer did not hinge exclusively on final decision-making power. Bandimere v. SEC, 844 F.3d 1168 (10th Cir. 2016). Rather, the Tenth Circuit held that SEC ALJs held duties comparable to the special trial judges (“STJs”) in Tax Court who were found to be subject to the Appointments Clause in Freytag v. Commissioner, 501 U.S. 868 (1991).

In May 2017, in light of the Tenth Circuit’s denial of a rehearing en banc in Bandimere, the SEC issued an order staying all administrative proceedings in which a respondent had the option to seek review by the Tenth Circuit. The stay was intended to remain in place until the Supreme Court responded to the anticipated cert petition for Bandimere, and was issued only days before the D.C. Circuit Court’s en banc rehearing of Lucia

On November 30, 2017, the SEC “ratified” the prior appointments of each of its five ALJs; the ALJs had each previously been appointed through an internal hiring process that was designed to insulate ALJs from potential influence. The SEC took that step after the Solicitor General filed a brief with the Supreme Court agreeing with Lucia that SEC ALJs are subject to the Appointments Clause. The SEC maintained that by doing so it was resolving any concerns about Appointments Clause violations relating to its administrative proceedings.

III. Supreme Court Decision

In a 7-2 decision with Justice Kagan writing the majority opinion, the Court held that SEC ALJs are officers of the United States and thus subject to the Appointments Clause. The Court’s analysis relied extensively on its prior decision in Freytag. In Freytag, the Court applied what Justice Kagan refers to as the “significant authority” test to the role of STJs, judges that Justice Kagan described as “near-carbon copies of the SEC’s ALJs.” Lucia, 2018 U.S. LEXIS 3836 at *13. The significant authority test was based on two factors: (1) STJs held a continuing office established by law; and (2) STJs exercised “significant discretion” in their capacity to preside over adversarial hearings by taking testimony, conducting trials, ruling on the admissibility of evidence, and enforcing compliance with discovery orders. Freytag, 501 U.S. at 881-82. Even where the decisions of the STJs were not final (STJs had the power to issue final decisions in certain cases and initial decisions in others), the Court in Freytag found that they were officers rather than mere employees because it would have been impractical to hold that STJs were officers for certain purposes but not others. Id. at 873.

In Lucia, the Court found that SEC ALJs held the same degree of authority as the STJs in Freytag, given that they hold a continuing office established by law and “exercise the same ‘significant discretion’ when carrying out the same ‘important functions’ as STJs do, including via taking of testimony, conducting trials, administering of oaths, ruling on motions, and enforcing compliance with discovery orders.” Lucia, 2018 U.S. LEXIS 3836 at *15-16. The Court found not only that SEC ALJs matched the duties and powers of the U.S. Tax Court’s STJs “point for point,” but also found that SEC ALJs potentially exercise even more autonomy than STJs given that their decisions automatically become final if the SEC chooses not to review them (which is often the case). Id. at *17. The Court also ruled that a different ALJ, or the SEC itself, must hold a new administrative hearing for Lucia because the original hearing had been “tainted with an appointments violation” and that the prior ALJ could not “be expected to consider the matter as though he had not adjudicated it before.” Id. at *21.

The Court also left a number of important questions unresolved, including the effect of the SEC’s November 2017 ratification order and the double “for good cause” protections from removal afforded to SEC ALJs. While Lucia argued that the SEC’s order ratifying the prior appointments was itself invalid, the Court saw “no reason to address that issue.” Lucia, 2018 U.S. LEXIS 3836 at *21 n.6. The Trump administration also asked the Court to address the for-cause removal protections, but the Court explicitly declined the invitation. Lucia, 2018 U.S. LEXIS 3836 at *11 n.1. SEC ALJs are currently protected by two layers of “for good cause” protections from removal. SEC ALJs can only be removed by the SEC for good cause, and such good cause must be established by the Merit Systems Protection Board, whose members may only be removed by the President for good cause. In Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477 (2010), the Court struck down a similar arrangement for members of the Public Company Accounting Oversight Board because it excessively insulated members from presidential oversight. In Justice Breyer’s separate opinion, in which he concurred in the judgment in part and dissented in part, he argued that the removal issue was an important point that required the Court’s attention and asserted that the constitutional question of whether SEC ALJs are subject to the Appointment Clause could not be addressed without addressing the removal question. A ruling in the Trump administration’s favor on this issue could lessen the protection afforded to SEC ALJs against at-will removal and make them more accountable to (and potentially more subject to influence by) the regulatory agency that employs them. 

IV. Observations

The Court’s decision in Lucia provides defense counsel with new ammunition to challenge SEC administrative proceedings but also leaves open a number of important questions for further litigation.

Although the Court declined to address how administrative proceedings beyond Lucia’s should be handled, the Court’s decision strongly suggests that the SEC’s ratification order is insufficient and that many of these proceedings will need to start anew before new ALJs. We expect that many former respondents who lost on the merits will also seek to re-open their administrative proceedings. The SEC’s already limited resources are likely to be strained by having to handle this onslaught of new litigation. Respondents should have strong leverage to negotiate favorable resolutions in many instances (rather than re-litigating).

The Court also left open the question of whether respondents can waive their right to a constitutionally appointed ALJ. The Court in Lucia acknowledged that Lucia made a timely challenge to the validity of the ALJ’s appointment but did not hold that he was required to do so. We expect the SEC to argue that respondents should only be permitted to challenge an adverse finding under Lucia if they properly objected during the administrative proceeding. The practical effect of such a requirement, however, may be limited with respect to more recent administrative proceedings. For at least the past several years, respondents have routinely raised constitutional objections to the SEC’s administrative proceedings in anticipation of Lucia; however, it may serve to foreclose attempts to reopen older administrative proceedings.

The Court’s decision also left open whether the SEC’s “ratification” order was sufficient to cure the ALJs’ constitutionally defective appointments and whether the ALJs’ two layers of “for good cause” protections are constitutional under Free Enterprise Fund. We expect that respondents will also raise challenges to SEC administrative proceedings based on these grounds. If the “for good cause” protections afforded to SEC ALJs is found unconstitutional, SEC ALJs will become more directly accountable to the SEC, which may serve to exacerbate Due Process concerns with in-house proceedings

Finally, the majority’s reliance on the functional authority wielded by SEC ALJs without identifying a factor that would limit its ruling to the SEC exposes ALJs in other federal agencies to similar challenges. Such challenges have been brought against ALJs in other federal agencies in the past. For example, in Burgess v. FDIC, 871 F.3d 297 (5th Cir. 2017), the Fifth Circuit stayed an FDIC ALJ’s order, holding that the respondent was likely to succeed in his claim that the ALJ was unconstitutionally appointed. During oral argument before the Supreme Court, Lucia’s counsel stated that approximately 150 ALJs across the federal government had similar adjudicatory responsibilities to SEC ALJs. We expect more appointments challenges to be brought in connection with administrative proceedings by other agencies.