Recently, in Gupta v. SEC, No. 11 Civ. 1900 (S.D.N.Y.), Judge Jed S. Rakoff of the United States District Court of the Southern District of New York allowed the equal protection claim of Rajat K. Gupta to proceed against the SEC in federal court. In denying the SEC’s motion to dismiss, Judge Rakoff held that district courts can have jurisdiction over constitutional claims against the Commission and that there is no requirement that a plaintiff exhaust administrative remedies before bringing such a claim. Shortly following that ruling, however, the equal protection claim was settled with the SEC agreeing to bring its claims against Gupta, if any, in the federal court.  

Background

In March 2011, the SEC issued an Order Instituting Public Administrative and Cease-and-Desist Proceedings (“OIP”) against Rajat K. Gupta, a former board member of both the Goldman Sachs Group, Inc. and the Procter & Gamble Company. The OIP accused Gupta of knowingly disclosing material nonpublic information about these companies to Raj Rajaratnam, the head of Galleon Management, LP (“Galleon”), who allegedly traded on the basis of this inside information. Rajaratnam was convicted of insider trading crimes in May 2011.

Over the course of the year and a half prior to instituting proceedings against Gupta, the SEC brought in federal court a series of related actions charging 21 individuals and 7 companies with Galleon-related insider trading. These actions, like the action against Gupta, sought civil penalties, disgorgement and various forms of injunctive relief.

In response to the SEC’s institution of administrative proceedings against him while bringing its claims against other defendants in federal court, Gupta filed a lawsuit in the Southern District of New York. Gupta alleged that the OIP singled him out for uniquely unfavorable treatment, denying him ― alone out of the 28 individuals and entities similarly accused ― the opportunity to contest the allegations against him in federal court. The SEC’s action, Gupta claimed, thus violated his constitutional rights under the equal protection clause. Gupta accused the SEC of trying to gain an unfair advantage by depriving him of the protections he would have had if a case were brought against him in federal court, including full discovery, application of the federal rules of evidence, the ability to assert counterclaims against the SEC or third party claims for indemnification and contribution, and the right to a jury trial. These protections, Gupta emphasized, were made available to every other Galleon-related defendant as the SEC brought its actions against them in federal court. As the complaint alleged:

Against the history of [the other] Galleon-related actions for civil penalties already brought in this Court, there is no benign and non-discriminatory explanation for the Commission’s applying Dodd-Frank retroactively against Mr. Gupta, or more generally for filing the action against him administratively, rather than in federal court, as it has invariably done with similarly situated defendants. To the contrary, the only plausible inference is that the Commission is proceeding how and where it is against Mr. Gupta for the bad faith purpose of shoring up a meritless case by disarming its adversary.

Gupta also complained that the SEC was improperly trying to apply retroactively the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. Law 111-203 124 Stat. 1376 (the “Dodd-Frank Act”), to conduct that allegedly occurred in 2008-09. The Dodd-Frank Act, which was passed in July 2010, made available in administrative actions certain penalties that previously were only available in federal court.

The SEC moved to dismiss Gupta’s complaint on several grounds, arguing that (1) the federal court lacks a statutory basis for jurisdiction; (2) Gupta’s claims against the SEC are barred by the doctrine of sovereign immunity; (3) the doctrines of exhaustion and ripeness bar Gupta’s claims; and (4) Section 25(a)(1) of the Exchange Act, 15 U.S.C. § 78y(a)(1), when read together with Section 703 of the Administrative Procedure Act (“APA”), grants to the courts of appeal exclusive jurisdiction to review orders entered in SEC administrative proceedings.

The Motion to Dismiss Decision

In July 2011, Judge Rakoff denied the SEC’s motion to dismiss and ruled that Gupta could proceed with his equal protection claim against the SEC in federal court. First, the court rejected the SEC’s argument that the court lacked a statutory basis to assert jurisdiction. Since Gupta alleged constitutional violations, the court explained, jurisdiction exists under 28 U.S.C. §1331. The complaint also alleged the prerequisites for jurisdiction under the Declaratory Judgment Act, 28 U.S.C. § 2201. Second, the court disagreed that Gupta’s claims were barred by the doctrine of sovereign immunity. The court held that the SEC is subject to Section 702 of the APA, which by its plain language waives sovereign immunity for actions against any agency – indeed, for any action in a federal court – seeking relief other than money damages. As Gupta’s complaint sought injunctive relief, the waiver of immunity applied. Further, the court held that no statute expressly or impl

iedly forbids the relief sought. Addressing Section 25(a)(1) of the Exchange Act – the only statute that the SEC plausibly suggested forbids the relief sought – the court turned to Free Enterprise Fund v. Pub. Co. Accounting Oversight Bd., 130 S. Ct. 3138 (2010), in which the U.S. Supreme Court held that Section 25(a)(1) does not deprive district courts of original jurisdiction over suits against the SEC when certain criteria are met. The critical question, the court explained, is whether Gupta’s action meets the three-prong test set forth in Free Enterprise for when an action may be brought against the SEC in a district court.

The same analysis applied to the SEC’s arguments that Gupta must exhaust administrative remedies before seeking redress in federal court and that the instant action was not ripe for judicial review. As the court wrote, “[a]ll of the SEC’s asserted grounds for dismissal hinge on its fourth and final argument: that the special statutory scheme established by Section 25(a)(1) of the Exchange Act, 15 U.S.C. § 78y(a)(1), when read together with Section 703 of the APA, prevents the court from exercising jurisdiction over Gupta’s claims.” The court rejected the SEC’s contention that these two provisions, read together, establish that review of any SEC action is available only in a federal court of appeals and only after the administrative proceeding is completed. Rather, the court held, on their face the two statutes provide that a lawsuit challenging SEC action is appropriate “if the statutorily-provided review of final SEC orders by the courts of appeal is in some relevant respect inadequate.” The court explained that Free Enterprise settled any doubt on this score. There, the Supreme Court set forth a three-prong test for when a case could proceed against the SEC in district court, holding that Congress does not intend to limit jurisdiction if: (1) a finding of preclusion could foreclose all meaningful judicial review; (2) the suit is wholly collateral to a statute’s review provisions; and (3) the claims are outside the agency’s expertise.

The Three-Prong Free Enterprise Test

Applying the Free Enterprise factors to Gupta’s case, the court held that the action could proceed in district court; however, it narrowed the theory of the complaint to one of equal protection. At the outset, the court wrote that the third prong of the Free Enterprise test is easily satisfied, as Gupta’s constitutional claims are not peculiarly within the SEC’s competence or expertise; equal protection claims are in fact far more commonly reviewed by district courts than by the SEC. As to the second prong, the court held that only the equal protection claim is wholly collateral to the review provisions of Section 25(a)(1). That claim, the court noted, is entirely independent of the administrative proceeding – that is, even if the allegations made against Gupta in the OIP were true and he was fully guilty of the charges made against him in the administrative proceeding, his federal court complaint would still state a claim of unequal protection. Indeed, the court explained, even if the SEC were acting within its discretion when it imposed disparate treatment, arbitrary and irrational agency action would still state a viable constitutional claim.

In contrast, the court found that Gupta’s retroactivity claim did not meet the second prong of the Free Enterprise test. The court distinguished Gupta’s claim from others which have, for example, challenged the facial validity of a particular statute. Rather than challenging the validity of the Dodd-Frank Act, however, Gupta here was challenging only the retroactive application of one provision of that Act relating to only one of several penalties the OIP seeks against him – which the court deemed a potentially peripheral issue. The court also referenced general principles of conservation of judicial resources when it held that the retroactivity claim – which it noted could very well be mooted during the course of the administrative proceeding – should not proceed in federal court.

Lastly, the court held that Gupta’s equal protection claim satisfied the first prong of the Free Enterprise test – that a finding of preclusion would foreclose all meaningful judicial review – for two reasons. First, there was no reasonable mechanism for raising a constitutional claim in the context of the SEC administrative proceeding; the SEC’s Rules of Practice do not permit counterclaims against the SEC nor do they allow adequate discovery for such a claim. Second, the equal protection claim is entirely collateral to the issue of Gupta’s guilt for insider trading, and no evidence or findings from the administrative proceeding will bear on the constitutional claim.  

Thus, having determined that Gupta’s equal protection claim met the standards set forth in Free Enterprise, the court denied the SEC’s motion to dismiss. The court also explained that since Gupta sought injunctive relief engaging the SEC’s pursuit of its administrative proceeding against him, further proceedings were required on a moderately expedited basis.

In his decision, Judge Rakoff appeared to give some credence to Gupta’s substantive arguments, characterizing the OIP as a “seeming exercise in forum-shopping,” and emphasizing that its claims were not materially different from those in the complaints in the 28 other Galleon-related actions filed by the SEC in federal court. He distinguished the case from those that might be easily disposed of through dismissal for failure to plead a claim; rather, he wrote, “[h]ere . . . we have the unusual case where there is already a well-developed public record of Gupta being treated substantially disparately from 28 essentially identical defendants, with not even a hint from the SEC, even in their instant papers, as to why this should be so.”

The Settlement

On August 3, 2011, the parties signed a 2-page stipulation agreeing to dismiss both the administrative proceeding against Gupta and Gupta’s lawsuit against the SEC. Under the terms of the agreement, the SEC agreed not to bring any future administrative or cease-and-desist proceedings against Gupta based on the same factual allegations. In return, Gupta pledged not to bring any new lawsuit against the SEC regarding its administrative proceedings. While the SEC retains the ability to file an action against Gupta for insider trading, the settlement agreement provides that any such action must be filed in federal court in the Southern District of New York, and will be designated as related to the other Galleon cases pending before Judge Rakoff.