DC Circuit Upholds Constitutionality of SEC’s Use of Administrative Law Judges in First Appellate Ruling

In the first appellate ruling of its kind, the District of Columbia Circuit upheld the SEC’s use of administrative law judges in administrative proceedings as constitutional. The court in Raymond J. Lucia Cos. v. SEC denied Mr. Lucia’s petition for review in which he claimed that the SEC’s use of administrative law judges was unconstitutional.

Lucia argued that administrative law judges are “Officers of the United States” within the meaning of the Appointments Clause in Article II of the Constitution. Lucia urged the court to rule that the SEC’s use of administrative law judges was unconstitutional because those judges have not been appointed by the President, as the Constitution requires. The three-judge panel disagreed and concluded that the SEC’s administrative law judges are inferior officers/employees who are not governed by the clause. In making this determination, the panel considered the significance of the matters resolved by the administrative law judges, the discretion the administrative law judges exercise in reaching their decisions, and the finality of the administrative law judges’ decisions. The court found the last factor dispositive because the Commission ultimately must act to approve an administrative law judge’s decision. “As the Commission has emphasized, the initial decision becomes final when, and only when, the Commission issues the finality order, and not before then . . . . Thus, the Commission must affirmatively act—by issuing the order—in every case. The Commission’s final action is either in the form of a new decision after de novo review or, by declining to grant or order review, its embrace of the ALJ’s initial decision as its own.” Op. at 13. In that sense, the court concluded, administrative law judges have not been “delegated sovereign authority” such that they would come within the purview of the Appointments Clause.

The DC Circuit’s decision deals a significant blow to litigants bringing similar challenges in other federal courts. As other cases become ripe for substantive consideration after jurisdictional hurdles are cleared, this decision provides the SEC’s with strong ammunition to oppose similar constitutional challenges. While the Second and Eleventh Circuits recently addressed issues relating to the SEC’s use of ALJs, the opinions focused on the district court’s lack of jurisdiction to hear the cases because the plaintiffs had not raised their challenges in the SEC’s in-house court first, not the merits of the issues. Unless and until another circuit court rules the SEC’s use of ALJs unconstitutional, creating a split, the issue will likely not reach the Supreme Court.

Sixth Circuit Weighs Challenge to its Jurisdiction in Lawsuit Brought by GOP Committees against the SEC

The Republican parties of three states—Tennessee, Georgia, and New York—recently brought a lawsuit in the Sixth Circuit Court of Appeals against the Securities and Exchange Commission to challenge revised Rule G-37, which the Municipal Securities Rulemaking Board (“MSRB”) published earlier this year to limit pay-to-play practices in the municipal securities area. The revision extended Rule G-37 to cover not only brokers and dealers of municipal securities but also municipal advisers. It prohibits those advisers from engaging in municipal advisory business with a municipal entity for two years if the adviser, its staff, or its political action committee made a significant contribution to an official who could influence the award of municipal securities business. The rule also requires certain covered entities, such as municipal advisers, to publicly disclose contributions to government officials. The plaintiffs claim this new extension of the rule infringes upon the constitutionally protected First Amendment right of municipal advisers to make political contributions.

This lawsuit is not the first time these plaintiffs have attempted to challenge the constitutionality of regulations that limit the political contributions of certain financial players. In 2014, the New York and Tennessee Republican Parties filed a similar complaint in federal court in the District of Columbia that challenged, among other things, the constitutionality of SEC Rule 206(4)-5, which prohibited investment advisers from receiving compensation for services to government pension plan clients when those advisers made campaign contributions to parties or candidates who had the ability to influence awards of public investment advisory contracts. The district court dismissed the complaint on a technicality because the Securities Exchange Act of 1934 gives the courts of appeals exclusive jurisdiction to hear challenges to final orders promulgated by the SEC and then only if such challenges are brought within sixty days of promulgation of the rule. The D.C. Circuit Court affirmed.

Back in the Sixth Circuit, the plaintiffs learned their lesson from the D.C. Circuit and timely filed this complaint with the court of appeals. However, last week the SEC filed a motion to dismiss for lack of jurisdiction and the Sixth Circuit issued a halt to the briefing schedule to decide the potentially dispositive motion. In its motion to dismiss, the SEC argued that the Sixth Circuit did not have jurisdiction over this controversy because the SEC did not issue a final order or perform any action that would provide the Court with jurisdiction over the MSRB’s amendment to Rule G-37. In fact, the SEC claims Congress precluded it from using any funds to finalize, issue, or implement an order regarding the disclosure of political contributions, which the recently revised Rule G-37 requires municipal advisers to do. The SEC contends this same prohibition may in fact prohibit it from using funds to defend the MSRB rule on its merits. In their opposition filed yesterday, the plaintiffs strongly disagreed with these contentions. With Citizens United as backdrop, a challenge to these types of rules, which curtail political contributions, may have some teeth if a court ever actually gets to the substantive merits. The SEC has handed the Sixth Circuit a procedural “out” with its motion to dismiss, and it will be interesting to see if the court decides to take it.

First Circuit Quietly Joins the “Personal Benefit” Fray

The First Circuit recently added to the increasingly ambiguous personal benefit requirement, finding that an alleged friendship and promises for free “wine, steak, and visits to a massage parlor” were enough to support a misappropriation theory of liability for insider trading. United States v. Parigian, — F.3d —, No. 15-1994, 2016 WL 3027702, at *2 (1st Cir. May 26, 2016). As highlighted in previous posts, the Second and Ninth Circuits have interpreted the personal benefit requirement differently, and in January, the Supreme Court granted certiorari to review the issue.

Parigian pleaded guilty to criminal securities fraud on the condition that he could appeal the denial of his motion to dismiss the superseding indictment for failing to allege a crime. Id. at *1. The indictment alleged that Parigian’s golfing buddy, Eric McPhail, provided nonpublic information to Parigian that McPhail had received from a corporate insider. Id. at *1–2. McPhail was not alleged to have engaged in any trading himself; instead, he was compensated for the information “with wine, steak, and visits to a massage parlor.” Id. at *2. Parigian argued the indictment failed to properly allege a “misappropriation” theory of liability for insider trading because, among other things, there was no personal benefit to McPhail. Id. at *3.

In Dirks v. SEC, 463 U.S. 646, 662 (1983), the Supreme Court ruled that the tippee in a traditional insider trading scheme cannot be held liable unless the insider “will benefit, directly or indirectly, from his disclosure.” The First Circuit has, by its own admission, “dodged the question” of whether “such a benefit need be proven in a misappropriation.” Parigian, 2016 WL 3027702, at *7. Instead, the First Circuit has twice considered the issue and determined that it was satisfied, if required, under the facts of those cases. Id. It was satisfied, the court said, because in one case the misappropriator and tippee were “business and social friends with reciprocal interests” and in the other case because “the mere giving of a gift to a relative or friend is . . . sufficient.” Id.

Although the court acknowledged the more recent decisions of the Second Circuit and the Ninth Circuit, the former holding that objective proof of a potential pecuniary gain is necessary and the latter holding that evidence of a close personal relationship is enough, the court refused to stray from its own precedent. Id. at *8. Under that precedent, the indictment adequately alleged a personal benefit because of the “friendship between McPhail and Parigian plus an expectation that the tippees would treat McPhail to a golf outing and assorted luxury entertainment.” Id.

Further clarity will have to wait for the Supreme Court’s decision next term.

Update: Eleventh Circuit Affirms Dismissal of Claims for Declaratory Relief and Disgorgement in SEC v. Graham, __ F.3d __, No. 14-13562, 2016 WL 3033605 (11th Cir. May 26, 2016)

We previously wrote about a decision out of the U.S. District Court for the Southern District of Florida in SEC v. Graham, 21 F. Supp. 3d 1300 (S.D. Fla. 2014), which involved claims by the SEC in connection with an alleged $300 million real estate Ponzi scheme. Echoing the Supreme Court’s reaffirmation in SEC v. Gabelli, 133 S. Ct. 1216 (2013), of the importance of statutes of limitation “to the welfare of society,” the district court had held that the five-year statute of limitations in 28 U.S.C. § 2462 is jurisdictional rather than a “claim-processing rule” and that the limitations period provided by § 2462 applies not only to civil penalties but also to equitable relief including injunctions, declaratory relief, and disgorgement. On May 26, 2016, the Eleventh Circuit affirmed in part, reversed in part, and remanded this decision for further proceedings.

The Eleventh Circuit disagreed with the district court’s characterization of injunctive relief as “nothing short of a penalty” and therefore subject to the § 2462 time limit on actions “for the enforcement of any civil fine, penalty, or forfeiture.” Noting that it was bound by its previous holding that “[t]he plain language of section 2462 does not apply to equitable remedies,” United States v. Banks, 115 F.3d 916, 919 (11th Cir. 1997), the court additionally explained that injunctions are not “penalties” because they are forward-looking rather than backward-looking relief.

Nevertheless, the court affirmed dismissal of the SEC’s claims for declaratory relief and disgorgement. The court reasoned that unlike injunctive relief, declaratory relief is backward-looking and “operate[s] as a penalty under § 2462” because “[a] public declaration that the defendants violated the law does little other than label the defendants as wrongdoers.” With respect to disgorgement, the court held that there is “no meaningful difference” between the plain-language definitions of “forfeiture” as used in § 2462 and “disgorgement,” and the court rejected the SEC’s distinction of the terms as “technical definitions” that Congress cannot be assumed to have meant to apply in the absence of clear indication in the statute. Having determined whether § 2462 applies to injunctive relief, declaratory relief, and disgorgement, the court declined to reach the issue of whether the limitations period is jurisdictional in nature.

Although the court agreed with the SEC’s position on injunctive relief, this holding is likely to be of little comfort to the agency. While reasoning that it would be “premature to review the precise nature of” an injunction the district court had not yet issued, the court noted that the injunction requested in the Graham complaint was the type of “obey-the-law” injunction—that is, an injunction prohibiting “the defendants from violating federal securities laws”—it has consistently held to be unenforceable. While the court reasoned that the issue was appropriate for consideration because it “is at least possible that the SEC could seek injunctive relief that would be specific and narrow enough that the parties would be afforded sufficient warning to conform their conduct,” it offered no opinion on what enforceable injunctive relief might look like.

U.S. Supreme Court to Take Up Issue of “Personal Benefit” in Insider Trading Context

The U.S. Supreme Court granted certiorari this week in a case that is sure to draw significant attention given its likely implications on insider trading liability. Bassam Salman filed the petition after the Ninth Circuit affirmed his insider trading conviction in United States v. Salman, 792 F.3d 1087 (9th Cir. 2015).

Salman was convicted of conspiracy and insider trading arising out of a trading scheme involving members of his extended family. During the time period at issue, Maher Kara, Salman’s future brother-in-law, had access to insider information regarding mergers and acquisitions of and by his firm’s clients that he provided to his brother, Michael Kara. Michael subsequently traded on the information. Michael then shared the information he learned from Maher with Salman. Salman also traded on the information.

Following his conviction, Salman appealed and argued that there was no evidence that he knew that Maher disclosed information to Michael in exchange for a personal benefit. The personal benefit requirement, first derived from the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983), requires that the insider personally benefit from the disclosure—including through pecuniary gain, a reputational benefit that will translate into future earnings, or where the insider makes a gift of confidential information to a trading relative or friend. Critical to the third manner of conferring a personal benefit, the Second Circuit recently held in United States v. Newman, 773 F.3d 438, 452 (2d Cir. 2014), that to the extent “a personal benefit may be inferred from a personal relationship between the tipper and tippee . . . such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”

Salman urged the Ninth Circuit to adopt the Newman court’s interpretation of Dirks to require more than evidence of a friendship or familial relationship between the tipper and the tippee. The Ninth Circuit declined, holding that doing so would require the court to depart from the ruling in Dirks that liability can be established where the insider makes a gift of confidential information to a trading relative or friend. The Supreme Court likely will resolve whether the concept of a personal benefit addressed in Dirks requires proof of an objective, consequential, and potential pecuniary gain—as the Newman court held—or whether it is enough that the insider and tippee shared a close family relationship.

The Newman decision has already resulted in the dismissal of insider trading charges against several individuals. The Supreme Court’s ultimate decision will therefore provide much needed clarity in this area, given the sharp split between the Second and Ninth Circuits on the issue.

SEC Awards More Than One Million Dollars to Compliance Officer

On April 22, 2015, the SEC announced an award of between $1.4 million and $1.6 million to a compliance officer who provided original information to the SEC that led to the successful enforcement of a covered action. Exchange Act Rel. 74781 (Apr. 22, 2015). The Dodd-Frank Whistleblower rules generally exclude information that is obtained by an “employee whose principal duties involve compliance or internal audit responsibilities … .” 17 C.F.R. § 240.21F-4(b)(4)(iii)(B). This rule would ordinarily prevent those employees from qualifying as a Whistleblower. An exception applies, however, when the employee has “a reasonable basis to believe that disclosure of the information to the Commission is necessary to prevent the relevant entity from engaging in conduct that is likely to cause substantial injury to the financial interest or properly of the entity or investors … .” 17 C.F.R. § 240.21F-4(b)(4)(v)(A).

The SEC determined this exception was applicable here. According to Andrew Ceresney, Director of the SEC’s Division of Enforcement, “This compliance officer reported misconduct after responsible management at the entity became aware of potentially impending harm to investors and failed to take steps to prevent it.” Press Rel. 2015-73. Despite the limitation on compliance and audit employees to qualify as Whistleblowers, this is the second time the SEC has relied on the exception to make an award to an employee with compliance or audit responsibilities. Last August, the SEC announced an award of more than $300,000 to an employee who performed compliance and audit functions. Press Rel. 2014-180.

SDNY Judge Deals Rejects Constitutional Challenge to SEC’s Use of Administrative Proceedings

A former executive of Standard & Poor’s (S&P) Rating Services has lost an early constitutional challenge to the SEC’s use of administrative proceedings.

Barbara Duka filed suit in federal court in January, following the SEC’s decision to bring charges against her for violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, which prohibits fraudulent conduct in the offer and sale of securities. Duka, formerly a co-manager of the commercial mortgage backed securities group of S&P’s Rating Services initiated the suit to prevent her from being compelled to submit to allegedly unconstitutional proceedings. Duka sought a preliminary injunction, arguing that administrative law judges (ALJs) who preside over administrative proceedings, are unlawfully insulated from oversight by the President in violation of Article II of the Constitution. Last week, District Judge Richard M. Berman of the Southern District of New York rejected Duka’s request.

Duka presented her claim as a facial challenged to the constitutionality of SEC ALJ proceedings, which aided the court’s determination that it had subject matter jurisdiction to entertain the suit.

Duka’s constitutional challenge was premised on the argument that SEC ALJs are “inferior officers” protected from removal by at least two levels of good-cause tenure protection and therefore the President cannot oversee ALJs in accordance with Article II. In considering the likelihood of success on the merits of Duka’s constitutional claim, the court rejected the argument that the Supreme Court’s decision in Free Enterprise Fund v. Public Accounting Oversight Board, 561 U.S. 477 (2010), supported the conclusion that SEC administrative proceedings are unconstitutional. In Free Enterprise Fund, the Supreme Court decided that the SEC’s Public Company Accounting Oversight Board created by Sarbanes-Oxley violated Article II because the act provided for dual for-cause limitations on the removal of board members. The Supreme Court held that “such multilevel protection from removal is contrary to Article II’s vesting of the executive power in the President” and that the President “cannot ‘take Care that the Laws be faithfully executed’ if he cannot oversee the faithfulness of the officers who execute them. Id. at 484.

Judge Berman noted that the issue of whether ALJs are “inferior officers” is subject to dispute, but he did not need to resolve that question because it concluded that the level of tenure protection afforded to ALJs was permissible. The court reasoned that the Supreme Court in Free Enterprise Fund addressed the narrow issue of whether Congress may deprive the President of adequate control over the board. The court also noted that ALJs were specifically excluded from the reach of the Free Enterprise Fund holding. Id. at 507 n.10 (“For similar reasons, our holding also does not address that subset of independent agency employees who serve as administrative law judges.”). In addition, the court noted, the decision in Free Enterprise Fund “supports the conclusion that restrictions upon the removal of agency adjudicators, as opposed to agency officials with ‘purely executive’ functions, generally do not violate Article II.” Op. at 19. Here, the court concluded, ALJs perform “solely adjudicatory functions, and are not engaged in policymaking or enforcement.” Id. at 20.

The Duka decision is a setback for defense bar challenges to the SEC’s use of administrative proceedings. As we have written in the previous post: “SEC Faces New Constitutional Challenge to Administrative Proceedings Based on Tenure Protection of Administrative Law Judges,” the SEC has faced a flurry of challenges to the use of administrative proceedings, which provide fewer protections to litigants than those provided in cases brought in federal court. Despite the decision, it is likely that the SEC will continue to face such challenges as they make their way through the federal appellate courts.

SEC Uses Books and Records and Internal Control Regulations to Extend Reach of Actions Beyond Fraud

Last year, we predicted that the SEC would increase its use of administrative proceedings to enforce strict liability violations such as books and records and internal controls. See Mary P. Hansen & William L. Carr, The Future of SEC Enforcement Actions: Negligence Based Charges Brought in Administrative Proceedings, The Investment Lawyer, Vol. 21, No. 9 (September 2014). In a recent action, announced on April 1, 2015, the SEC did just that.

According to the SEC, Timothy Edwin Scronce, the majority owner and CEO of privately held TelWorx Communications, LLC (“TelWorx”), falsified TelWorx’s books to inflate its revenues leading up to and after the acquisition of TelWorx by a public company, PCTEL, Inc. (“PCTEL”). Exchange Act Rel. No. 74626 (Apr. 1, 2015). In particular, prior to the acquisition, Scronce directed TelWorx’s Controller, Michael Hedrick, to inflate the value of certain inventory and to invoice certain orders before they had shipped and then reverse the invoices so they could be invoiced again during the subsequent quarter. After the acquisition, Scronce instructed Hedrick to create dummy invoices for orders that Scronce himself intended to make to further conceal his conduct. In addition, once Scronce learned that a large order that had been postponed would not be placed in time to help meet the quarterly results, he instructed the Vice President of Sales and Tech Services, Marc J. Mize, to solicit a straw vendor that would purchase the product on an intermediate basis with the intent to prematurely recognize the income from this sale. The timing on this transaction ultimately would not obtain the benefit Scronce intended, and he instructed Mize and another employee to reverse the invoice and to enter a revised, false purchase order into the system. All of these actions caused PCTEL to materially overstate its income during the relevant period.

Based on these allegations, the SEC instituted proceedings against Scronce for violation of (1) “Section 10(b) of the Exchange Act and Rule 10b-5 thereunder which prohibit fraudulent conduct in connection with the purchase or sale of securities”; (2) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (3) “Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading”; (4) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (5) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act.” Without admitting or denying the findings, Scronce agreed to disgorgement in the amount of $376,007; prejudgment interest in the amount of $29,212.47; and a civil monetary penalty in the amount of $140,000, and to a ten-year ban on acting as an officer or director of any issuer.

The SEC did not stop there, though. It also charged Hedrick and Mize for violation of (1) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (2) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (3) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act,” none of which requires the SEC to prove that an individual acted with scienter. In addition, the SEC charged Hedrick with causing Scronce’s violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder and with causing “PCTEL’s violations of Section 13(a) of the Exchange Act and rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading.”

Hedrick and Mize, like Scronce, agreed to resolve the charges without admitting or denying the findings. Each of them agreed to pay civil monetary penalties in the amount of $25,000. Notably, these sanctions do not reflect that Hedrick was charged with causing Scronce’s and PCTEL’s fraud violations, while Mize was only charged with strict liability violations.

We expect the SEC to continue using books and records and internal control charges to pursue companies and senior executives who play a role in fraudulent schemes, even where an individual did not act intentionally or even recklessly.