Changes and Challenges in the SEC’s ALJ Proceedings

In recent years, when pursuing corporations and their officers for violations of the U.S. securities laws, the Securities and Exchange Commission (“SEC”) Division of Enforcement has increasingly brought its claims to the SEC’s in-house administrative law judges (ALJs) rather than the federal civil courts. In fact, last year, over 90% of the SEC’s actions against public companies were brought to the SEC’s ALJs—whereas five years ago, only 33% of those cases were brought as ALJ proceedings. The credit for this remarkable increase in ALJ proceedings belongs in large part to the 2010 Dodd–Frank Act, [1] which expanded the ALJs’ jurisdiction and authorized new penalties that ALJs could impose, making it unnecessary for the SEC to bring many claims in civil courts.

Compared to civil courts, the SEC’s ALJ proceedings certainly offer a streamlined procedure: once the SEC’s claims are filed, there are strict deadlines for the parties to seek discovery, for the ALJ to hold a hearing to assess the evidence, and for the ALJ to issue a decision on the matter. [2] As a result, many ALJ proceedings start and finish within a matter of months. Yet numerous critics have complained that the speed of ALJ proceedings may come at the expense of fairness to respondents. Critics note that the ALJs’ deadlines—as well as their rules limiting respondents’ own discovery—force respondents to rely heavily upon evidence gathered by the SEC, and give them little time to review that evidence. Moreover, they complain that the rules do not offer the same evidentiary protections that would ordinarily apply in civil courts under the Federal Rules of Evidence. Critics have also protested that the SEC’s ALJs are appointed and paid for by the SEC itself, raising questions about potential bias. And if respondents wish to challenge an ALJ’s ruling, they must first appeal to the SEC Commissioners themselves before having any remedy from federal civil courts, which are required to afford deference to the SEC’s conclusions. [3]

These concerns appear to be borne out by the numbers. In one widely-cited article published last year, the Wall Street Journal reported that “[t]he SEC won against 90% of respondents before its own judges in contested cases” between 2010 and 2015, compared to 69% of respondents in civil courts during the same period. Likewise, the SEC won 95%of its cases on appeal to the Commissioners. Further, Bloomberg reported in August that the dollar amounts of civil penalties imposed by SEC ALJs are increasing, and “[t]here have been more penalties over $2 million imposed this year than in any of the previous three years.” In a nutshell, if the SEC has brought a claim against you in an ALJ proceeding, the odds are that you will lose—and potentially receive a substantial penalty as a result.

Apparently responding to critics’ concerns, last September, the SEC proposed amendments to the procedural rules to make ALJ proceedings more closely resemble federal civil court proceedings. These amendments, which were adopted in July and took full effect on September 27, 2016, revise prior procedures in several significant ways. For example:

• Pre-hearing period lengthened: The “pre-hearing period”—after the SEC initiates a case, but before the ALJ’s hearing—is when respondents are able to conduct discovery and prepare their case. The length of this period varies depending on the deadline that the SEC has set for the ALJ to issue a decision (30 days, 75 days, or 120 days), which is determined (at the SEC’s sole discretion) by the “nature, complexity, and urgency of the subject matter” of the claims. Before the SEC’s amendments took effect last month, the pre-hearing period was as little as 30 days, and at most four months. Now, the ALJ may extend the pre-hearing period to four months for 30-day cases, six months for 75-day cases, and ten months for 120-day cases (17 C.F.R. § 201.360(a)(2)).
• Some depositions allowed: Previously, respondents could not take any depositions unless the pertinent witness was unavailable to testify at the ALJ’s hearing. Now, in 120-day cases (but not 30-day cases or 75-day cases), each party may subpoena up to three people for depositions, or five people in cases with multiple respondents (17 C.F.R. § 201.233(a)).
• Limits on admissibility of evidence: Before the amendments, any evidence (including hearsay) was admissible unless it was “irrelevant, immaterial, or unduly repetitious.” The rules now provide that evidence is also inadmissible if it is “unreliable” (17 C.F.R. § 201.320(a)). Hearsay is still admissible, but only “if it is relevant, material, and bears satisfactory indicia of reliability so that its use is fair” (17 C.F.R. § 201.320(b)).
• Request for appeal simplified: The amendments simplify the requirements for requesting an appeal. Previously, petitioners were required to “set forth the specific findings and conclusions of the initial decision as to which exception is taken, together with supporting reasons for each exception.” Under the revised rules, a party’s petition for review is limited to three pages, and it need only “set forth a statement of the issues presented for review” (17 C.F.R. § 201.410).

Although these changes are meaningful, they may not appease the SEC’s critics. For instance, the new rules allow depositions, but only in a limited subset of cases, and far fewer than likely would be allowed in a civil court. Likewise, although the amendments have substantially lengthened the pre-hearing period (and thus the time respondents have to gather and examine evidence), this period is still much shorter than it would be in a federal civil court; even ten months—the maximum amount of time allowed for a pre-hearing period under the new rules—can be a tight timeline in which to subpoena evidence, review thousands or millions of documents, take depositions, conduct briefing, and prepare for a hearing. Further, while the amendments impose tighter controls on the admissibility of evidence, respondents still do not have the protections they would otherwise enjoy in civil courts, such as the ability to exclude certain hearsay. In any event, none of the amendments address critics’ concern that proceedings before ALJs appointed by the SEC (and appeals before the SEC Commissioners) may be inherently biased.

Despite these continuing concerns, federal appellate courts have thus far rejected constitutional challenges to SEC ALJ proceedings. Although most of these challenges were dismissed on jurisdictional grounds, in August, the U.S. Court of Appeals for the District of Columbia Circuit issued a decision that upheld the constitutionality of ALJ proceedings on the merits. That decision, Raymond J. Lucia Companies, Inc. v. SEC, No. 15-1345 (D.C. Cir. Aug. 9, 2016), concluded that the ALJs were “employees” of the SEC, not “Officers,” so their appointment by the SEC did not violate the Appointments Clause of the U.S. Constitution. Separate constitutional challenges to the SEC’s ALJs are pending in other federal courts, [4] but Lucia does not bode well for these cases, particularly given the authority of the D.C. Circuit with respect to administrative and regulatory matters.

Given this state of affairs, most respondents to SEC ALJ proceedings (or threatened SEC ALJ proceedings) are faced with two basic choices, each of which may be equally unpleasant. First, they can choose to fight the SEC on its home turf, racing to review the SEC’s investigation file, collecting as many defensive documents as possible, identifying the key witnesses and deposing them (if they are allowed to do so under the new rules), and otherwise marshaling any evidence they can before the deadline for the hearing arrives. If the respondents lose the case, they may appeal to the SEC’s Commissioners, and if they lose before the Commissioners, they can take the case to a federal civil court. However, at that point, the court will be required to defer to the SEC’s rulings unless the SEC did not have “substantial evidence” to reach the conclusion it did [5]—a deference the SEC wouldn’t have enjoyed if it filed its claims in a civil court in the first place. Of course, depending on the strength of the respondents’ evidence, they may ultimately prevail in the SEC’s ALJ proceedings or subsequent appeals despite the long odds, but the respondents (or their insurance companies) still may have spent many thousands or millions of dollars defending themselves.

The other alternative is to settle with the SEC, a serious decision fraught with concerns regarding a potentially large fine, third-party litigation risk, and other collateral consequences. Nevertheless, faced with the prospect of enormous legal fees and a strong likelihood of defeat, many respondents ultimately may choose to settle the SEC’s allegations, but negotiate to reduce the proposed penalties and diminish the collateral consequences they would otherwise face by agreeing to a compromise. By choosing to settle before ALJ proceedings begin, a corporate respondent can also mitigate bad publicity by avoiding months or years of disclosures about ongoing ALJ proceedings and appeals. It is no wonder, then, that in 2015, over 95% of corporations that settled SEC ALJ proceedings did so even before the SEC filed its claims.

In short, Congress has handed the SEC an extremely powerful tool—one that allows the SEC to pursue civil securities claims with great success, whether by winning before an ALJ or compelling a respondent to settle for a significant penalty. However, many securities practitioners are wary that this success comes at the expense of protections that respondents ordinarily would have used to dismiss those claims in court.

Endnotes

1Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, § 929P, 124 Stat. 1376, 1862-65 (2010).(go back)

2The procedures for the SEC’s ALJs are codified at 17 C.F.R. §§ 201.100-900.(go back)

3See 17 C.F.R. §§ 201.101, 201.110–11 (role of ALJs in presiding over proceedings), 201.320 (admissibility of evidence), 201.360 (timeline for proceedings), 201.410–11(appeal to the SEC Commissioners).(go back)

4See, e.g., Bandimere v. SEC, No. 15-9586 (10th Cir.) (filed Dec. 22, 2015, oral argument held Sep. 23, 2016).(go back)

5See, e.g., Valicenti Advisory Servs., Inc. v. SEC, 198 F.3d 62, 64-65 (2d Cir. 1999) (“In reviewing the SEC’s opinion and order, we must affirm the findings of the Commission as to the facts, if supported by substantial evidence. The traditional standard used for judicial review of agency actions is deferential, and we may neither engage in our own fact-finding nor supplant the SEC’s reasonable determinations.”) (internal quotations and alterations omitted).(go back)