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.

Third Circuit Defined “Investment Adviser” In Sentencing Appeal

Everett C. Miller pleaded guilty to securities fraud after he sold more than $41 million in phony, unregistered promissory notes in his firm, Carr Miller Capital, LLC, that falsely promised high returns with no risk. As part of his plea, Miller and the government stipulated to what they considered to be an appropriate offense level under the United States Sentencing Guidelines (the “Guidelines”). At sentencing, however, the district court applied the four-level investment adviser enhancement provided for by the Guidelines for securities laws violations perpetrated by “investment advisers,” as that term is defined by the Investment Advisers Act of 1940, 15 U.S.C. § 80b-2(a)(11). See U.S.S.G. § 2B1.1(b)(19)(A)(iii). Due to the enhancement, Miller received a 120-month sentence.

On appeal, Miller challenged, among other things, the application of the investment adviser enhancement, arguing that he was not an “investment adviser” under the Investment Advisers Act. The Investment Adviser Act defines “investment adviser,” in part, as a person who “for compensation engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.” 15 U.S.C. § 80b-2(a)(11). Miller argued that he was not “in the business” of providing securities advice; he did not provide advice “for compensation”; and he was not a registered investment adviser.

The Third Circuit first ruled that Miller was in the business of providing securities advice. In so concluding, the Third Circuit looked to a 1987 SEC interpretive release (the “SEC Release”) that stated the SEC considers a person who “holds himself out as an investment adviser or as one who provides investment advice” to be in “in the business.” Applying that guidance, the Third Circuit found that Miller was in the business of providing securities advice because he held himself out as an investment adviser in personal meetings with investors and because he was associated with a registered investment adviser.

The Third Circuit also relied on the SEC Release to conclude that Miller provided the advice “for compensation.” The SEC Release defines compensation as “any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services rendered, commissions or some combination of the foregoing.” The Third Circuit found that the investors’ principal on the promissory notes “became Miller’s compensation—his ‘economic benefit’—when he comingled investors’ accounts and spent the money for his own purposes.”

Finally, the Third Circuit rejected Miller’s argument that he could not be considered an “investment adviser”  solely based upon his association with an investment adviser. The Third Circuit ruled that “[r]egistration is not necessary to be an ‘investment adviser’ under the Act” and thus “Miller was an ‘investment adviser’ under the Act, despite his failure to register as such.”

Given the facts of this case, and the interpretative guidance on which the Court relied, the decision does not come as a surprise.

Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors

On July 14, 2016, RiverFront Investment Group, LLC (“RiverFront”) agreed to settle charges brought by the SEC for failing to “properly prepare clients for additional transaction costs beyond the ‘wrap fees’ they pay to cover the cost of several services bundles together.” Press Release No. 2016-143. According to the SEC, participants in wrap fee programs usually pay an annual fee “which is intended to cover the cost of several services ‘wrapped’ together, such as custody, trade execution, portfolio management, and back office services.” Release No. 4453. The SEC found that under these wrap programs, a sponsoring firm will offer clients a selection of third-party managers, referred to as subadvisors, to have discretion over the clients’ investment decisions. When subadvisors execute trades on behalf of clients through a sponsor-designated broker-dealer, the transaction costs associated with the trades are included in the wrap fee. On the other hand, if a subadvisor sends a trade to a non-designated broker-dealer, a practice known as “trading away,” clients incur additional transaction costs beyond the wrap fee. Continue reading “Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors”