Since the passage of the Dodd-Frank Act in 2010, the securities defense bar has voiced concern that the Securities and Exchange Commission (SEC) receives an unconstitutional and inherently unfair "home court advantage" when it brings enforcement actions before administrative law judges (ALJs).1 Some recent, high-profile ALJ rulings in favor of respondents—including Lynn Tilton's victory last week—suggest that the public airing of these concerns may be leveling the playing field.
On Sept. 27, 2017, an ALJ dismissed in their entirety fraud charges the SEC had leveled against Lynn Tilton, in what had been a highly contentious and closely monitored proceeding. Portfolio Manager Tilton, founder and CEO of Patriarch Partners, raised $2.5 billion from investors through three funds to make loans to distressed companies. The SEC alleged Ms. Tilton misled investors by hiding the poor performance of the loan pools in which her funds invested, and thereby unduly collected $200 million in management fees.
After a two-and-a-half-year battle with the SEC, which culminated in a 14-day hearing before an ALJ that ended last November, Ms. Tilton has been vindicated. The ALJ concluded that "[w]hile respondents did not maximize the ease of finding it, they also did not conceal—omit to state—material information such as the amount of interest actually being paid and the interest rate and principal on the portfolio companies' loans."2 The ALJ also noted that the underlying financial statements were made available to investors that were sophisticated institutions, such as Barclays, SEI Investments, Värde Partners and MBIA, "not Mr. and Ms. 401(k)."
One month earlier, on Aug. 29, 2017, an ALJ cleared Barbara Duka, a former employee of Standard & Poor's Rating Services, of fraud charges. The SEC alleged that Ms. Duka relaxed S&P's rating methodology to benefit S&P's clients and promote more business for S&P. But the ALJ held that while Ms. Duka failed to properly disclose the change in the rating methodology, the evidence indicated she made that change for "analytical reasons"—not to manipulate, deceive or defraud investors. Ultimately, the ALJ found Ms. Duka liable for the lesser charge of negligence for failing to disclose the methodology change, and imposed a modest $7,500 fine (as well as an order to cease and desist from future violations).3
In the spring, another ALJ dismissed fraud charges against respondent Charles Hill, Jr., ruling that there was insufficient evidence that he traded on inside information. The SEC alleged Mr. Hill received material, nonpublic information from a personal friend, who received that information from the chief operating officer of Radiant Systems, Inc., a NASDAQ-listed company that, at the time, was involved in an acquisition deal. The ALJ determined that, while Mr. Hill's trading was suspicious, his pattern of trades "did not reveal what Hill knew or from whom he learned it."4
These decisions, involving fraud charges against respondents, serve as a reminder that scienter-based claims are difficult to prove no matter the forum. These decisions, taken in concert, also raise the specter that for fraud claims, ALJs may be as favorable as, if not more so than, a jury in federal court. All the public claims regarding the biased nature of these administrative proceedings may have, on their own, impacted how these claims are adjudicated.
Meanwhile, the debate rages on as to the constitutionality of these proceedings. In our earlier client alert, we discussed a circuit split over a larger issue that only the Supreme Court can resolve—whether ALJs are "inferior officers" under the U.S. Constitution. If ALJs are indeed inferior officers, then they must be appointed pursuant to the strictures of the Appointments Clause. That could be a problem for the SEC because its ALJs are not so appointed.5 As of this writing, the D.C. Circuit has held ALJs are not in fact inferior officers,6 while the Tenth Circuit has held they are.7 A petition for Supreme Court review of the issue is pending.
For both the SEC and party respondents to an enforcement proceeding, the question of where to bring or defend such an action remains an interesting one. On the one hand, the SEC wants to keep the ALJ forum as an option despite recent losses. On the other hand, respondents may change or at least expand their thinking on administrative proceedings (notwithstanding the constitutional challenge to such), given the ALJ's willingness to scrutinize fraud cases at a high level, rather than merely serving as a rubber stamp for the SEC.
1 We discussed the constitutional debate in an article published last year in the New York Law Journal. See Mark Kornfeld, Jessie Gabriel and David Choi, "Administrative Proceedings Remain Likely for SEC Enforcement Actions," N.Y. LAW JOURNAL, Sept. 21, 2016.
2 In re Lynn Tilton, Initial Decision Release No. 1182, at 51 (Sept. 27, 2017). Available at www.sec.gov/alj/aljdec/2017/id1182cff.pdf.
3 In re Barbara Duka, Initial Decision Release No. 1167 (Aug. 29, 2017). Available at www.sec.gov/alj/aljdec/2017/id1167jeg.pdf.
4 In re Charles L. Hill, Jr., Initial Decision Release No. 1123, at 23 (April 18, 2017). Available at https://www.sec.gov/alj/aljdec/2017/id1123jeg.pdf.
5 Under the Appointments Clause, Congress may "vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments." Because ALJs are not appointed directly by the president or SEC commissioners, but rather through government personnel offices, respondents in several cases have argued that the current method for appointing ALJs violates the Constitution.
6 The D.C. Circuit held in Lucia v. SEC that ALJs are not inferior officers because they do not issue final orders. It is ultimately up to the SEC to review and adopt the ALJ's findings, which "become effective only when the SEC issues a finality order." The D.C. Circuit granted Mr. Lucia's request for en banc review of that decision, which resulted in a 5-5 panel split among the judges that left the original decision intact. Mr. Lucia filed a petition with the Supreme Court in July, requesting that the Court address this circuit split. The Justice Department has until Oct. 25 to respond to Mr. Lucia's petition.
7 The Tenth Circuit held in Bandimere v. SEC that ALJs are inferior officers because, despite the need for the SEC to issue a finality order to effectuate the ALJ's decision, the ALJs "exercise significant discretion in carrying out important functions" in administrative proceedings. The SEC's request for en banc review of that decision was denied in May. As a result, the SEC issued an internal order suspending all administrative cases in jurisdictions covered by the 10th Circuit – that is, Colorado, Kansas, New Mexico, Oklahoma, Utah and Wyoming – putting the SEC in the awkward position of being unable to bring administrative proceedings in certain segments of the country.
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