Compliance and Supervision Archives

SEC Speaks 2017 – OCIE Had Something To Say

Last week, the Securities and Exchange Commission (SEC) Acting Chairman, senior leadership across Divisions and Offices, and former SEC Commissioners spoke at the “SEC Speaks” Conference 2017. Senior leadership from the SEC’s Office of Compliance Inspections and Examinations (OCIE) used its panel and workshop to provide guidance on the reshaping of its examination programs that it began in 2016. Below we outline the revamped OCIE.

OCIE’s Reorganization & Reallocation of Resources

The OCIE panel included OCIE’s Acting Director and its Deputy Director. The commentators for the panel were former SEC Chairman Hon. Harvey L. Pitt and former SEC Commissioners Hon. Paul S. Atkins and Hon. Daniel M. Gallagher. At the beginning of the presentation, OCIE’s Acting Director reminded the audience that OCIE’s mission is to protect investors, ensure market integrity, and support responsible capital formation through risk-focused strategies that: 1) improve compliance; 2) prevent fraud; 3) monitor risk; and 4) inform policy. The panel explained that OCIE monitors and assesses its various programs to align with OCIE’s mission and strategies. The panel described that OCIE had developed and implemented a plan to revise its programs to better align with the evolving nature of the various registrants subject to its oversight.

The Investment Adviser / Investment Company Program

This past year, OCIE re-allocated 100 broker-dealer staff examiners to the Investment Adviser / Investment Company (IA/IC) Program, which increased the total number of OCIE staff in the IA/IC Program to over 600. OCIE’s Deputy Director reminded the audience that the investment management industry lacks a self-regulatory organization and that the number of investment advisers registered with the SEC continues to grow. For example, since January 1, 2017, approximately 200 additional investment advisers have registered with the SEC. Thus, the SEC and OCIE determined that a re-allocation of staff was necessary to manage the SEC’s responsibility as the sole inspection and examination authority for this industry. One of the goals of this reallocation appears to be to address the number of examinations per examiner, if feasible, from last year’s high of 4.91 per examiner. Following up on a proposal to the Commission last fall under Chair Mary Jo White, Commissioner Gallagher encouragingly questioned whether OCIE needs to consider the use of non-SEC, third-party examination firms. Although OCIE senior leadership did not seem enthused about this possibility, they replied that they would be willing to work with whatever ideas and initiatives the new Commission may have to assist with OCIE’s resource constraints, in particular with the continuing expansion of the investment advisory industry.

The Broker-Dealer, FINRA and Securities Industry Oversight, and National Broker-Dealer Exchange Group Programs

For the above three programs, OCIE has restructured its examination oversight of the brokerage industry and for certain other registrants. First and foremost, OCIE’s Broker-Dealer (BD) Program – as the industry has known it for the past few decades – no longer exists. Second, in addition to the reallocation of 100 examiners from the BD Program to the IA/IC Program, OCIE senior leadership outlined the creation and responsibilities of two new programs: the FINRA and Securities Industry Oversight (FSIO) Program; and the National Broker-Dealer Exchange Group (BDX) Program. While the BDX Program will maintain some broker-dealer examination staff, as explained below, this will be a significantly reduced number of examiners who will be focused on targeted examinations in coordination with FSIO’s oversight responsibilities.

FSIO is a national program with staff in the SEC’s home office and across various regional offices. OCIE created FSIO for several reasons, including avoiding the duplication of efforts and resources that sometimes occurred with FINRA. FSIO’s primary responsibility is the enhanced oversight of FINRA. FSIO also will oversee the Municipal Securities Rulemaking Board (for purposes of this blog, we focus on FINRA). While FSIO will maintain oversight responsibility, OCIE senior leadership emphasized that the plan is to work collaboratively with FINRA, as appropriate. FSIO’s Program will oversee FINRA in two ways; with programmatic and oversight examinations. The former will focus on FINRA’s programs and operations to provide guidance and recommended improvements, while the latter will involve specific FINRA examinations of member firms that FSIO will sample, examine, and provide feedback to FINRA.

The BDX Program has a broader mandate, including responsibility for: exchanges; transfer agents; the clearing and settlement program; (only) municipal advisors; the Securities Investor Protection Corporation; and the Public Company Accounting Oversight Board. BDX is also a national program with staff in the SEC’s home office and regional offices. As mentioned, the BDX Program also includes a limited number of broker-dealer examination staff to conduct targeted examinations and coordinate with FSIO regarding FINRA oversight examinations.

Conclusion / Takeaways

OCIE’s reallocation of staff resources to the IA/IC Program, dissolution of the BD Program, and creation of the FSIO and BDX programs reflect an SEC Office that is attempting to keep pace with the increasing and evolving registrant populations for which it is responsible by restructuring programs and targeting its limited resources. These efforts will likely have unintended (or intended) consequences for the investment management and broker-dealer industries. First, OCIE appears to be making its oversight of the investment management industry its main focus. This is the continuation of a multi-year effort, as this industry presents the greatest risk to OCIE and its understaffed IA/IC Program. That said, with a staff increase of 100 and the continuing emphasis on this program, the number of significant deficiencies and enforcement referrals generated by the IA/IC Program will correspondingly increase, as the quantity and frequency of examinations increases. With respect to OCIE’s BD, FSIO, and BDX Programs, with FINRA’s evolution and increased resources to examine the broker-dealer industry, it is not too surprising that the SEC, via OCIE, ceded responsibility to FINRA and dissolved the BD Program. A collateral result for the broker-dealer industry, however, will likely be an empowered FINRA that may seek to increase the assertiveness of its examination and enforcement programs. In conclusion, while the IA/IC Program and FINRA appear poised to enjoy increased authority, OCIE’s efforts are laudable in reorganizing itself to better allocate its limited resources to manage its responsibilities over its evolving registrant population.

Acting SEC Chairman Limits Delegated Formal Order Authority

Acting SEC Chairman Michael Piwowar has apparently revised the staff’s ability to subpoena records and investigative testimony (“formal order authority”) by returning the authority to grant formal order authority to the agency’s Director of Enforcement. While the SEC has not formally recognized this policy shift, multiple sources, including Law360 and the Wall Street Journal, have reported that Acting Chair Piwowar has recently implemented this change, which revokes the delegated authority to regional directors and enforcement associate directors to approve the staff’s requests for formal order authority.

In 2009, under Chair Mary Schapiro and as part of certain initiatives to enhance enforcement’s capabilities in the aftermath of the financial crisis, the SEC delegated its authority to authorize formal order authority to the Director of Enforcement. The Director of Enforcement, in turn, delegated this authority to regional directors and enforcement associate directors. As a result, the staff could, within an hour (when necessary) obtain formal order authority, as compared to the days, weeks, or at times months, that it had historically taken to obtain formal order authority from the Commission. Not unexpectedly, the number of formal investigations opened by the staff dramatically increased.

Acting Chair Piwowar’s recent move eliminates the second layer of delegation by limiting the 2009 delegated authority to the Director of Enforcement. While the effect of this change on the number of SEC investigations remains uncertain, multiple sources report that Acting Chair Piwowar enacted the policy not to reduce that number, but to bring greater oversight and consistency to the investigation process. Further, while he is not authorized to take the step alone, as it would require a vote of the Commission which is currently comprised of only two members, Acting Chair Piwowar and Commissioner Kara Stein, the acting chair has asked the SEC’s general counsel to consider whether the agency should further restrict formal order authority by returning the power to grant it to the SEC Commissioners. Thus, at Acting Chair Piwowar’s direction, the SEC is considering a return to the pre-2009 formal order authority review and approval process.

The revocation of the regional and associate directors’ delegated ability to approve formal order authority is the latest action taken by Acting Chair Piwowar, who stepped in as acting chairman after former Chair Mary Jo White stepped down at the conclusion of the Obama administration. His actions have included requesting that all authorities granted to staff members be reviewed and that public disclosure rules required by Dodd-Frank be reconsidered. Such actions indicate efforts to begin the reshaping of the agency as it awaits the confirmation of President Trump’s nomination for chairman, Jay Clayton.

District Court Invalidates Tolling Agreements in Criminal Securities Fraud Prosecution Case Due to Misunderstanding of Applicable Statute of Limitations

On January 30, 2017, the United States District Court for the District of New Jersey dismissed the government’s indictment against Guy Gentile for a pump-and-dump securities fraud scheme. After his arrest Gentile admitted to having engaged in the scheme and agreed to cooperate, which included signing two tolling agreements, each extending the statute of limitations for one year. In dismissing the indictments, the court held that the tolling agreements were invalid and the applicable statute of limitations for securities fraud was five years, not six years.

According to the opinion, Gentile engaged in a securities fraud scheme that indisputably ended in June 2008, at which time the statute of limitations for securities fraud was five years. In 2010, however, the Dodd-Frank Wall Street Reform and Consumer Protection Act extended the statute of limitations to six years for certain criminal securities fraud violations. Gentile was charged on June 25, 2012 and arrested on July 13, 2012, i.e. four years after the criminal conduct. Under interrogation, Gentile admitted to the fraud and agreed to cooperate with the government. Gentile entered into a tolling agreement with the government that tolled the limitations period from July 31, 2012 through July 31, 2013. Gentile subsequently signed a second tolling agreement, tolling the limitations period from July 31, 2013 through July 31, 2014. Gentile, however, refused to sign a third tolling agreement because he wanted all cooperation and criminal actions to be concluded by June 30, 2015. Critically, when entering the tolling agreements, both the government and Gentile assumed the statute of limitations was five years (the limitations period in effect at the time of the criminal conduct) and not six years (the limitations period in effect at the time of the arrest). Accordingly, at the time that the second tolling agreement expired, the government would have had to indict Gentile prior to July 31, 2015.

Unable to reach a plea deal, the government indicted Gentile in March 2016 and Gentile moved to dismiss. If the statute of limitations had been six years, the second tolling agreement would have presumably given the government until July 31, 2016 to indict. The court, however, disagreed. The court first found that, “limited to the specific facts of this case,” the tolling agreements were invalid because Gentile did not have a full understanding of the waiver. Slip Op. at 6. The court reasoned that “the waivers were executed unknowingly since Defendant clearly thought he was extending his exposure to criminal prosecution by two years when in fact, if the statute of limitations was six years, he was extending the period of exposure by three years.” Slip Op. at 7. That misunderstanding rendered the waivers invalid, with the effect that the statute of limitations was not tolled. Without a toll, the government’s deadline to indict was either June 30, 2013 (under the five-year limitations period) or June 30, 2014 (under the six-year limitations period). In either event, the March 2016 indictment was untimely.

After holding that the defendant’s ignorance of the potential six-year limitations period rendered the tolling agreements invalid, the court then held that the applicable statute of limitations is in fact five years, i.e., exactly what the Gentile had thought when he entered the tolling agreements. The court relied on the presumption against retroactivity absent express congressional intent. Since the applicable section of the Dodd-Frank act “contains no discussion nor mention of retroactivity, let alone clear intent that Congress intended th[e] section to apply to crimes committed prior to its enactment[,]” the six-year limitations period is not retroactive. Because the applicable statute of limitations was five years, even if the tolling agreements were valid, the indictment was untimely, as the tolling agreements would have only extended the statute of limitations until June 30, 2015.

FINRA Releases its 2017 Annual Regulatory and Examination Priorities Letter

Earlier this month, FINRA published its Annual Regulatory and Examination Priorities Letter (the “Letter”). This is the first Letter under the tenure of new FINRA President and CEO Robert W. Cook. Notably, Mr. Cook introduced FINRA’s annual Letter with his own “cover letter” in which he shared several thoughts with the broker-dealer industry, including a common thread running through FINRA’s Letter—specifically a focus on core issues of compliance, supervision, and risk management. Mr. Cook also discussed his “listening tour” to meet with member firms, regulators, and investor groups since joining FINRA in August. In doing so, he shared two takeaways. First, starting this year, FINRA will publish summary reports that outline key findings from examinations in selected areas to serve as additional tools that firms can use to strengthen their controls. Second, in response to feedback from smaller firms, FINRA will start providing more, and perhaps different, compliance tools to assist smaller firms in complying with regulatory requirements.

Turning to the Letter, FINRA annually publishes such a letter to provide its member firms with helpful insight into the focus areas for the upcoming year’s examinations. Though we encourage all clients, blog readers, and interested parties to review the Letter in its entirety, we have highlighted certain topics and points that we believe are the most important for our clients and followers, as discussed in more detail below. At the offset, however, we should note that in its introduction FINRA advised that starting in 2017 it will conduct electronic, off-site reviews in addition to traditional on-site examinations. These new electronic reviews will involve a select group of firms that are not currently scheduled for a cycle examination in 2017. These reviews will focus on selected areas including those identified in the Letter. In another change for 2017, FINRA will release a “compliance calendar” and a directory of compliance service providers, with the goal of helping small firms better meet their regulatory requirements.

In the body of the Letter, FINRA provides several broad categories for its priorities: (1) High-risk and Recidivist Brokers; (2) Sales practices; (3) Financial Risks; (4) Operational Risks; and (5) Market Integrity. Within these broad categories, FINRA also identified sub-categories. For ease of referencing the Letter, our summary below follows the organization of the Letter.

High-risk and Recidivist Brokers

Not surprisingly, FINRA will continue to devote particular attention to the member firms that hire high-risk and recidivist brokers and apply greater scrutiny to such firms. First, FINRA recently established a dedicated examination unit whose sole mission is to rigorously review and monitor high-risk and recidivist brokers’ interactions with customers. Second, FINRA will also focus on the ways that firms hire, retain, and monitor statutorily disqualified and recidivist brokers, and will also focus on firms that have a high concentration of brokers with significant disciplinary records, complaints, or arbitrations. Third, and more generally, FINRA is committed to ensuring that firms have sufficient inspection programs and supervisory systems for their branch offices and non-branch office locations, including independent contractor branches.

Sales Practices

Senior Investors – FINRA will continue to closely evaluate recommendations that senior investors purchase speculative or complex products, particularly in light of the investor’s profile and risk tolerance. Last year, fraud schemes involving microcap (or “penny”) stocks were on the rise, and often targeted senior investors. FINRA encourages firms to take steps to protect elderly customers from such fraud by contacting these customers to verify those types of transactions.
Product Suitability and Concentration – FINRA will continue to assess how firms conduct reasonable-basis and customer-specific suitability reviews, and will increase its focus on the controls firms have in place for recommending new products and for recommendations that result in excess concentration in customers’ accounts. FINRA makes specific reference to ETPs, non-traded REITS and BDCs. Furthermore, firms should be prepared to discuss how changes in the interest rate environment impact their recommendations to clients.
Excessive and Short-term Trading of Long-term Products – FINRA is clearly concerned about excessive and short-term trading of long-term products, as such activity is detrimental to clients but can bolster sales credits for registered representatives. FINRA makes specific reference to UITs. In addition to FINRA’s examination of this activity, FINRA urges firms to determine whether their control systems are sophisticated enough to detect deliberate attempts to avoid automatic surveillance for excessive switching activity.
Outside Business Activities and Private Securities Transactions – FINRA will continue to focus on firms’ controls, documentation, and evaluation of written notifications of proposed outside business activities by registered representatives and associated persons. In addition, FINRA will focus on associated persons’ notification of private securities transactions and firms’ ongoing supervision of approved private securities transactions.
Social Media and Electronic Communications Retention and Supervision – FINRA makes clear that both SEC and FINRA record-retention requirements extend to all business-related communications, regardless of the devices or networks used. FINRA will ensure that firms are complying with these retention requirements, as they are essential to a firm’s ability to detect inappropriate business conduct.

Financial Risks

Liquidity Risk – FINRA’s 2016 assessment of liquidity management practices at firms identified a variety of issues. As a result, in 2017 FINRA intends to focus on firms’ funding and liquidity plans to determine whether firms adequately evaluate their liquidity needs, develop contingency plans to handle market stresses, and effectively test those contingency plans.
Financial Risk Management – Furthering its attempts to understand how larger firms manage risk across their organizations, FINRA will ask a select group of firms to explain how they would react to specific stress scenarios, considering the areas of readiness, communication plans, risk metrics, and contingencies.
Credit Risk Policies, Procedures and Risk Limit Determinations Under FINRA Rule 4210 – On December 15, 2016, the first phase of the new amendments to FINRA Rule 4210 became effective. In 2017, FINRA will evaluate firms’ compliance with the first phase of the rule amendments and the corresponding supervision, policies, procedures and processes.

Operational Risks

Cybersecurity – According to FINRA, cybersecurity threats are one of the most significant risks for many firms. FINRA will focus on reviewing firms’ data systems, the controls designed to protect those data systems (including from insider threats), the strength of controls and practices at branch offices and independent contractor branch offices (which tend to be weaker), and firms’ compliance with Securities Exchange Act of 1934 (SEA) Rule 17a-4(f), which requires the use of write once read many (aka “WORM”) format.
Supervisory Controls Testing – FINRA reminds all firms of their obligations with respect to supervisory controls testing and chief executive officer certifications with specific reference to FINRA Rules 3120 and 3130.
Customer Protection/Segregation of Client Assets – Compliance with SEA Rule 15c3-3 is also a priority. FINRA will assess the sufficiency of firms’ documentation of the absence of liens and encumbrances on securities. In addition, FINRA will be examining whether firms are engaging in transactions that are designed, in whole or in part, to reduce a firm’s reserve or segregation requirements.
Regulation SHO – Close Out and Easy to Borrow – Due to recent SEC enforcement actions regarding SEC Regulation SHO, FINRA will focus on the locate processes employed by firms in connection with short sales, and emphasized that firms should closely monitor their close-out process to ensure they are complying with Rule 204 of Regulation SHO.
Anti-Money Laundering and Suspicious Activity Monitoring – Anti-money laundering programs will continue to be a FINRA focus in the upcoming year. Firms must incorporate anti-money laundering red flags into their trading surveillance systems, and should evaluate their controls around accounts held by nominee companies.
Municipal Advisor Registration – Firms that advise state and local governments on municipal securities should ensure that they are registering correctly with the SEC and the Municipal Securities Rulemaking Board and that individuals engaging in municipal advisory activities pass the Series 50 Examination made available on September 12, 2016. Firms that do not register but still provide services to municipal customers should ensure that they meet the appropriate statutory exclusions and regulatory exceptions.

Market Integrity

Manipulation – Manipulation is a perennial top priority for FINRA and FINRA is taking several steps to detect and deter such manipulation, including: (1) enhancing its layering pattern detection capabilities to look for larger groups of market participants engaging in this manipulative activity; (2) enforcing the recent amendments to the Order Audit Trail System (OATS) rules; (3) monitoring potentially manipulative trades surrounding market open and close; and (4) expanding cross-product manipulation surveillance to include exchange-traded products. Lastly, in 2016, FINRA introduced the Cross Market Equity Supervision Report Cards for layering and spoofing activity as a compliance tool to complement firms’ supervisory systems and procedures to detect and deter manipulative conduct by a firm or its customers.
Best Execution – FINRA emphasizes the importance of Regulatory Notice 15-46 and the importance of providing accurate payment for order flow disclosures. FINRA further advises that firms need to consider how the continuing automation of the markets for equity securities, standardized options and advances in fixed income markets affect order handling decisions, and factor these changes into their review of execution quality.
Audit Trail Reporting Early Remediation Initiative and Expansion – FINRA expects firms to address potential equity audit trail issues identified through the Audit Trail Reporting Early Remediation Initiative. If firms take quick corrective measures in response to these alerts and the problem is limited in scope, it is possible that a formal investigation can be avoided.
Tick Size Pilot – The Tick Size Pilot will continue in 2017, and FINRA notes that it is “critical” that firms submit accurate OATS and market maker data. FINRA intends to monitor compliance with these data requirements, and restrictions on quoting and trading.
Market Access Rule – Firms should focus on improving their compliance with the Market Access Rule. In this subsection, FINRA provides a list of best practices, including: implementing, memorializing, and monitoring pre-trade and post-trade controls; implementing procedures for the supervision, development, testing and employment of algorithmic trading, including code development or changes; and maintaining reasonable processes to monitor whether trading algorithms operate as intended, and processes to disable algorithms or systems that malfunction. FINRA directs firms to Regulatory Notice 15-09 for further discussion of effective electronic trading practices.
Trading Examinations – Conflicts of interest, the adequacy of alternative trading systems’ disclosures, and the handling of manual option orders by floor brokers and upstairs firms under their best execution obligations will be examination priorities this year. Also, FINRA intends to begin a pilot trading examination program to determine whether targeted examinations of smaller firms are worthwhile.
Fixed Income Securities Surveillance Program – FINRA will continue to focus on surveilling wash sales and interposing activity, and will review written supervisory procedures and systems designed to detect non-bona fide trading to create an artificial price level in a bond, in order to hide an excessive mark-up to a customer trade or reset the aging of positions held by the firm. FINRA will also continue its focus on securitized products. Also, in light of the TRACE reporting requirements, which are scheduled to become effective in July 2017, FINRA will develop ways to monitor compliance with rules applicable to U.S. Treasury securities.

Drinker Biddle Conclusion

Mr. Cook’s cover letter is revealing in terms of his initial views as FINRA’s new leader. Mr. Cook appears to aspire for increased and better communication with FINRA’s members. He also stated that one of his areas of focus will be the role that member firms “…play in facilitating capital formation by small and emerging growth companies, which are vital engines of our economy and job creation.” Turning to FINRA’s Letter, consistent with its mandate as the main self-regulatory organization for broker-dealers, the Letter and priorities ambitiously seek to cover all corners of the broker-dealer industry. That said, many of the plans discussed are continuations of long-standing efforts, though others are new priorities that demonstrate the ways in which FINRA’s oversight is evolving, expanding, and improving, such as the increased discussion of electronic and algorithmic trading. For our clients and readers, we will continue to monitor the way that FINRA’s priorities unfold over the course of 2017. In the meantime, if you have any questions about any of the topics covered in the Letter, please contact Sandy Grannum or Jim Lundy.

Update: SCOTUS Will Consider Statute of Limitations on Disgorgement

We previously wrote about how the SEC urged the Supreme Court to grant certiorari in Kokesh v. SEC, and on Friday, January 13, the Court did just that. In an order without comment, the Court granted certiorari after both the petitioner and the SEC requested the Court’s review, albeit for different reasons. While the petitioner believes he should not be subject to disgorgement for ill-gotten gains that were obtained more than five years ago, the SEC wants the Court to bring clarity to the circuit split that has developed since the Eleventh Circuit’s decision in SEC v. Graham, which held that the five-year statute of limitations applies to disgorgement. As we previously noted, the SEC argued that Graham impedes its ability to achieve uniformity in the administration of securities laws.

We will continue to monitor developments in this case, which is sure to shape the timing of future SEC enforcement investigations and actions and the remedies it will seek.

Congresswoman Seeks to Add Accountability to SEC Regulations, Past and Future

Republican Congresswoman Ann Wagner has sponsored the SEC Regulatory Accountability Act, H.R. 78, which requires the U.S. Securities and Exchange Commission to engage in more rigorous cost–benefit analysis before it can move forward with new regulations. Congresswoman Wagner called the bill “common-sense legislation” that regulators should already engage in.

Specifically, the Act requires the SEC to identify the nature, source, and significance of the problem each proposed regulation is intended to address; to adopt a regulation only after a reasoned determination that the regulation’s benefits justify its cost; to identify and assess available alternatives to additional regulation (including the alternative of not regulating); and to ensure that regulation is accessible and easy to understand. Under the Act, cost–benefit analysis requires the SEC to consider the impact of any regulation on investor choice, securities’ market liquidity, and small businesses. Costs and benefits are “both qualitative and quantitative.”

The Act also mandates additional action if the SEC amends or adopts a “major rule” in terms of economic impact. See U.S.C. § 804(2). Such amendment or adoption of a major rule requires the SEC to state (1) the regulation’s purposes and intended consequences, (2) metrics for measuring the regulation’s economic impact, (3) the plan to be used to assess whether the regulation has achieved its stated purposes, and (4) any foreseeable unintended or negative consequences of the regulation.

The Act, however, does not apply only to future SEC regulation. It also requires the SEC to review its existing regulations and modify, streamline, expand, or repeal those regulations that are outmoded, ineffective, insufficient, or excessively burdensome. The review must be completed within one year of the date of the SEC Regulatory Accountability Act’s enactment and every five years thereafter.

Congress passed H.R. 78 on January 12, 2017, but a motion to reconsider was laid on the table and agreed to without objection that same day. The bill is part of the Republican regulatory reform and will make it more difficult for the SEC to promulgate regulation. It has been attacked as protecting Wall Street interests and undermining investor protections.

Republican lawmakers have proposed the legislation before but have never cleared the Senate.

President–Elect Trump Nominates Jay Clayton For SEC Chair

On January 4, 2017, President-Elect Donald Trump announced that he intends to nominate Walter “Jay” Clayton for Chairman of the Securities and Exchange Commission (SEC). In response, Mr. Clayton stated that, “If confirmed, we are going to work together with key stakeholders in the financial system to make sure we provide investors and our companies with the confidence to invest together in America. We will carefully monitor our financial sector, as we set policy that encourages American companies to do what they do best: create jobs.”

Of the three pillars of the SEC’s mission statement – 1) protect investors; 2) maintain fair, orderly, and efficient markets; and 3) facilitate capital formation – Mr. Clayton’s deep experience as a “dealmaker” most closely aligns with the facilitation of capital formation pillar. Chair Mary Jo White’s primary prior experience as a federal prosecutor, in contrast, most closely aligned with the protection of investors. That said, while this announcement clearly indicates the incoming administration’s focus on that third pillar, with the latter part of this statement in his announcement, the President-Elect reminded the securities industry that the Chair and SEC will remain responsible for ensuring that the rules and regulations are followed, “Jay Clayton . . . will ensure our financial institutions can thrive and create jobs while playing by the rules at the same time.”

While Mr. Clayton has strong industry knowledge and experience, his lack of enforcement experience is comparable to Chair White’s lack of experience in the SEC’s regulatory and policy areas when she was appointed. Consequently, if his nomination is affirmed, Mr. Clayton’s choice for the next Director of the Division of Enforcement will reveal much about his enforcement objectives. In the meantime, one area that Mr. Clayton appears primed to de-emphasize is the SEC’s enforcement of the Foreign Corrupt Practices Act, based on this New York City Bar Association paper that he assisted in drafting. The President-Elect will also have more to say on the future direction of the SEC with his upcoming nominations to fill the two remaining open seats on the Commission.

10th Circuit Creates Split, Finds SEC’s Use of Administrative Law Judges Unconstitutional

The 10th Circuit recently found that the SEC’s use of Administrative Law Judges (“ALJs”) violates the Appointments Clause of the Constitution, creating a split amongst federal appellate courts and making it likely the Supreme Court will weigh in on the controversy that has been building over the last two years. More specifically, the court, in Bandimere v. SEC, held in a 2-1 decision that an SEC Administrative Law Judge is an inferior officer who must be constitutionally appointed.

Bandimere, a respondent in an SEC administrative proceeding, filed a petition for review after the SEC affirmed an initial decision entered by an ALJ that found Bandimere liable for violating a number of securities laws and imposed civil penalties against him. Bandimere raised a constitutional argument before the SEC, contending that the ALJ who presided over his hearing “was an inferior officer who had not been appointed under the Appointments Clause.” Op. at 3. The SEC rejected this argument, conceding that its ALJs are not constitutionally appointed, but ruling that they are not inferior officers subject to the requirements of the Appointments Clause.

Diverging from other federal courts, the 10th Circuit set aside the SEC’s opinion affirming the ALJ’s decision, holding that SEC ALJs are inferior officers who must be constitutionally appointed. In doing so, the court relied almost exclusively on Freytag v. Comm’r of Internal Revenue, 501 U.S. 868 (1991), in which “a unanimous Supreme Court concluded [that Tax Court] STJs [special trial judges] were inferior officers.” Op. at 13–14. The Bandimere court found that “Freytag held that [special trial judges appointed by the Tax Court] were inferior officers based on three characteristics”: (1) their position was “established by law”; (2) “the[ir] duties, salary, and means of appointment . . . are specified by statute”; and (3) they “exercise significant discretion” in “carrying out . . . important functions.” Op. at 18 (quoting Freytag, 501 U.S. at 881–82). The court concluded that like STJs, SEC ALJs possess all three characteristics. Specifically, the court found that the ALJ position was established by the APA and cited various statutes that “set forth SEC ALJs’ duties, salaries, and means of appointment.” Op. at 18. As to the third factor, the court focused on an SEC ALJ’s ability “to shape the administrative record by taking testimony, regulating document production and depositions, ruling on the admissibility of evidence, receiving evidence, ruling on dispositive and procedural motions, issuing subpoenas, and presiding over trial-like hearings.” Op. at 19. The court also highlighted an SEC ALJ’s authority to render initial decisions, determine liability, impose sanctions, enter default judgments, and modify or enforce temporary sanctions imposed by the SEC. Thus, because it determined that all three factors were satisfied, the court ruled that SEC ALJs “are inferior officers who must be appointed in conformity with the Appointments Clause.” Op. at 22. Because they are not constitutionally appointed, as the SEC conceded, the court held that SEC ALJs hold their office in violation of the Constitution.

In reaching this conclusion, the Bandimere court rejected the SEC’s position that its “ALJs are not inferior officers because they cannot render final decisions and the agency retains authority to review ALJs’ decisions de novo” and disagreed with the D.C. Circuit’s holding in Raymond J. Lucia Cos., Inc. v. SEC, 832 F.3d 277 (D.C. Cir. 2016), which used the same reasoning to conclude that SEC ALJs are employees rather than inferior officers. Op. at 23–24. The Bandimere court found that this argument misreads Freytag and “place[s] undue weight on final decision-making authority.” Op. at 24. The court held that while “[f]inal decision-making power is relevant in determining whether a public servant exercises significant authority . . . that does not mean every inferior officer must possess final decision-making power.” Op. at 28. Rather, the proper focus is the extent of discretion exercised and the importance of the duties carried out by an ALJ, both of which, the court found, weighed in favor of finding that SEC ALJs are inferior officers.

Similarly, the court also refuted the dissent’s attempt to distinguish SEC ALJs from Tax Court STJs by contending that unlike those of SEC ALJs, STJs’ initial decisions were binding even when the STJs did not technically enter a final decision. Contrary to the dissent, the majority found that the Tax Court did not merely rubber stamp STJs’ initial decisions, but rather ultimately “adopted opinions they had a hand in supervising and producing.” Op. at 34. Moreover, the majority found that approximately ninety percent of SEC ALJs’ initial decisions “become final without any review or revision from an SEC Commissioner.” Op. at 35.

The dissent also expressed concern that the majority’s decision “effectively rendered invalid thousands of administrative actions.” Dissent at 11. But the majority disagreed, and stated in response that “[n]othing in this opinion should be read to answer any but the precise question before the court: whether SEC ALJs are employees or inferior officers. Questions about officer removal, officer status of other agencies’ ALJs, civil service protection, rulemaking, and retroactivity . . . are not issues on appeal and have not been briefed by the parties.” Op. at 36.

Furthermore, Judge Briscoe’s concurrence suggests the dissent’s concern that the majority’s decision will have a wide-sweeping detrimental effect because it calls into question the constitutionality of past decisions rendered by ALJs is likely overstated. Citing Free Enter. Fund v. Public Co. Accounting Oversight Bd., 561 U.S. 477 (2010), the concurrence highlighted that “courts normally are required to afford the minimum relief necessary to bring administrative overreach in line with the Constitution.” Concurrence at 4. For example, in Free Enterprise Fund, the Supreme Court found the SEC’s Public Company Accounting Oversight Board (“PCAOB”) created by Sarbanes-Oxley violated Article II because the Act provided for dual for-cause limitations on the removal of board members. Specifically, PCAOB members could not be removed by the SEC except for good cause shown, and SEC Commissioners themselves cannot be removed except for inefficiency, neglect of duty, or malfeasance in office. The Supreme Court noted 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.” Free Enter. Fund, 561 U.S. at 484. The Supreme Court, however, did not find the PCAOB unconstitutional; it merely severed the for-cause removal provision of the PCAOB appointment clause, leaving the Board itself intact. Moreover, the Court rejected the petitioner’s argument that the constitutional infirmity made all of the Board’s prior activity unconstitutional.

In addition, this principle was recently applied in PHH Corp. v. Consumer Fin. Prot. Bureau, 839 F.3d 1 (D.C. Cir. 2016), in which the D.C. Circuit, rather than abrogating the entire Consumer Financial Protection Bureau (“CFPB”), “struck the single offending clause from the CFPB’s implementing legislation [the Dodd-Frank Act]” and simply altered the structure of the CFPB so that it conformed with constitutional requirements. Concurrence at 5. As an initial matter, the D.C. Circuit found that the CFPB’s construction as an independent agency led by a single Director (as opposed to a typical multi-member board or commission) who was removable by the President only for cause violated Article II of the Constitution because the Director exercised significant executive power largely unchecked. That is, the court found that the CFPB was “unconstitutionally structured” because it lacked the “critical substitute check on the excesses of any individual independent agency head” that a traditional multi-member structure would provide. PHH, 839 F.3d at 8. But rather than “shut down the entire CFPB . . . [t]o remedy the constitutional flaw,” the court “simply sever[ed] the statute’s unconstitutional for-cause provision from the remainder of the statute.” Id. The result was that the President was given “the power to remove the Director at will, and to supervise and direct the Director” as the head of an executive agency without otherwise disturbing “the ongoing operations of the CFPB” or its ability to uphold previously entered orders. Id. at 8, 39.

These decisions suggest that even if the Supreme Court agrees with the Bandimere decision, the probable remedy will be to modify the unconstitutional characteristics of the SEC ALJ structure. For example, it may consider altering certain conditions of the ALJs’ employment relationship. See Concurrence at 5–6. Moreover, as the dissent recognized, the Supreme Court could also make “an explicit statement that the opinion does not apply retroactively.” Dissent at 15 n.9.

Since 2010, in the wake of Dodd-Frank, the SEC has consistently increased its use of administrative proceedings. It seems likely now that there is a circuit split, and Supreme Court review seems certain, the SEC may well scale back its reliance on administrative proceedings until this constitutional issue is settled.

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Category: Compliance and Supervision