The Robare Ruling Regarding “May” Disclosures and “Willfulness”

Over the last year, the SEC has continued to intensify its focus on disclosures from investment advisers on Forms ADV regarding several issues, including—but not limited to—revenue sharing arrangements. Last week, the D.C. Court of Appeals handed down a decision that will likely have significant ramifications for investment advisers and the SEC’s Division of Enforcement (“Enforcement”). In Robare Group, Ltd., v. SEC, the D.C. Circuit upheld the SEC Commission’s decision that the use of the word “may” in a disclosure regarding an investment adviser’s conflicts of interest pertaining to revenue sharing violated the negligence-based fraud provision of Section 206(2) of the Investment Advisers Act of 1940 (“Advisers Act”).
On appeal, The Robare Group, Ltd., a Texas-based investment adviser, argued that the evidence presented by Enforcement in an administrative proceeding did not support the Commission’s ruling, upon review, that their disclosures regarding conflicts of interest relating to a revenue sharing agreement were inadequate. Sections 206(2) and 207 of the Advisers Act were at issue on appeal.

Robare used Fidelity Investments for execution, custody, and clearing services for its advisory clients. Robare entered into a revenue sharing arrangement with Fidelity Investments in 2004. Through that arrangement, Fidelity paid Robare when its clients invested in certain mutual funds offered on Fidelity’s platform. Robare received nearly $400,000 from Fidelity from 2005 to 2013 as a result of the arrangement.

Robare had modified its Form ADV disclosures in December 2011, after Fidelity advised Robare that it would cease making payments if the arrangements were not disclosed. Robare’s disclosures then stated that certain investment advisers “may receive selling compensation” due to “the facilitation of certain securities transactions on Client’s behalf” through certain broker-dealers, or “may also receive compensation resulting from the sale of insurance products to clients.” Robare further revised its disclosures to state, “Additionally, we may receive additional compensation in the form of custodial support services from Fidelity based on revenue from the sale of funds through Fidelity. Fidelity has agreed to pay us a fee on specified assets, namely no transaction fee mutual fund assets in custody with Fidelity. This additional compensation does not represent additional fees from your accounts to us.”

In 2014, Enforcement filed charges against Robare and its principals alleging that Robare had failed for years to disclose to clients and the SEC that it received shared revenue from Fidelity and the conflicts of interest that consequently arise therefrom. Enforcement alleged that Robare’s conduct violated Sections 206(2) and 207 of the Advisers Act. In 2015, an administrative law judge dismissed the charges. Enforcement appealed, and the Commission saw the situation differently. In the Commission’s opinion, it found that Robare negligently failed to adequately disclose said conflicts and willfully failed to provide enough information in its Form ADV filings.

In last week’s ruling, the D.C. Circuit agreed with the Commission and Enforcement that Robare’s disclosures “did not disclose that [Robare] had entered into an arrangement under which it received payments from Fidelity for maintaining client investments in certain funds Fidelity offered.” It further found that the Form ADV “in no way alerted its clients to the potential conflicts of interest presented by the undisclosed arrangement.” The D.C. Circuit agreed with Enforcement that Robare and its principals should have known that their disclosures were inadequate and, therefore, acted negligently in violation of Section 206(2).

The Section 207 charge as alleged, however, requires willful conduct. The SEC has steadfastly maintained over the years that “willful” under the federal securities laws simply means “intentionally committing the act which constitutes the violation” and not that “the actor [must] also be aware he is violating one of the Rules or Acts.” See Wonsover v. SEC, 205 F.3d, 408, 414 (D.C. Cir. 2000). The DC Circuit rejected Enforcement’s arguments that the challenged Section 207 negligent conduct constituted “willful” conduct and explained that “[t]he statutory text signals that the Commission had to find, based on substantial evidence, that at least one of [Robare’s] principals subjectively intended to omit material information from [Robare’s] Form ADV” to prove a violation of Section 207. It was established that Robare’s conduct was negligent, not willful, and the two are mutually exclusive. As a result, Robare was not found to be in violation of Section 207.

To be sure, the Robare decision bolsters the SEC’s longstanding position that disclosures using “may” are not sufficient when the adviser “is” receiving fees or “is” engaging in other practices that create a conflict of interest.

On the other hand, the Robare opinion and ruling with respect to “willfulness” is likely to significantly impact the SEC’s charging decisions with respect to Section 207 and certain other provisions of the federal securities laws, and the SEC’s ability to obtain certain remedies for which willfulness is required.

ALJ Deals Blow to SEC’s Fraud Case Against Hedge Fund Manager

An SEC administrative law judge recently rejected some of the SEC’s fraud charges against hedge fund manager RD Legal Capital, LLC and its owner Roni Dersovitz (“Respondents”) by finding that the SEC did not prove that Respondents made certain material misrepresentations and failed to establish that other alleged material misrepresentations were made with scienter. In the Matter of RD Legal Capital, LLC, and Roni Dersovitz, File No. 3-17342, Initial Decision (Oct. 15, 2018). While ALJ Jason S. Patil did conclude that Respondents were liable for negligence-based fraud violations, his rulings with respect to the scienter-based charges and the drastically-reduced penalties he ordered were largely a defeat for the SEC.

Background

In July 2016, the SEC instituted proceedings alleging, among other things, that Respondents defrauded investors by misrepresenting the types of legal receivables in which two funds managed by RD Legal Capital invested. Id. at 2. In particular, the SEC alleged that Respondents violated the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 by representing that the legal receivables invested in by two of their hedge funds all arose out of binding settlement agreements or judgments and therefore posed no litigation risk, when in fact four categories of legal receivable investments “involved matters that had not settled or reached final judgment at the time of the investments, or . . . were purchased from entities other than law firms.” Id. at 9. Those four categories were: (1) “purchases of attorneys’ and plaintiffs’ receivables arising from the 1983 Beirut barracks bombing” (the “Peterson receivables”); (2) “receivables of attorney Daniel Osborn” (the “ONJ receivables”); (3) “receivables of Barry Cohen” (the “Cohen receivables”); and (4) “receivables arising out of the 2010 oil spill in the Gulf of Mexico” (the “Deepwater Horizon receivables”).

In challenging Respondents’ representations to investors, the SEC specifically focused on the statements made in Respondents’ offering memoranda, marketing materials, investor-directed materials (such as Respondents’ website), and Form ADVs, as well as their  conversations with investors. However, Respondents argued “that they were permitted under the offering memoranda,” which contained “flexibility provisions,” “to make the investments challenged by the Division and, to the extent that other written or oral statements to investors were contradicted by the clear language in the offering memoranda, the terms of the offering memoranda control.” Id. at 59.

Respondents’ Representations

In deciding whether Respondents made material misrepresentations, Judge Patil found that he “should begin with consideration of the terms of the offering memoranda.” Id. He agreed with the SEC that those documents “gave investors the distinct impression that the Funds were invested exclusively in legal receivables from cases that were resolved by settlement, an agreement between parties, or, in some instances a judgment against a debtor—with little to no litigation risk,” and that “no offering memorandum ever advised a reader that the Funds had ever purchased a legal fee arising out of anything other than a settlement or judgment.” Id. at 59-60. Judge Patil also found that these impressions were reinforced by some of Respondents’ marketing materials and “[o]ther oral and written representations.” Id. at 62. Nevertheless, he determined that these statements were materially inaccurate only as a result of the ONJ and Cohen receivables, which presented a “different class of risks associated with contingent litigation-based receivables,” id. at 78, and found “that the Division failed to establish by a preponderance of the evidence that the statements were materially false or misleading with respect to the Peterson and Deepwater Horizon” receivables. Id. at 63.

Regarding the Deepwater Horizon receivables, Judge Patil held that “the opportunity was consistent with one of the emerging opportunities the Fund manager could reasonably take advantage of under the terms of the offering memoranda’s flexibility provision,” because, while the monies associated with these receivables were not advanced to attorneys, the settlement in that matter authorized “non-attorney representatives . . . to file claims against a settlement fund,” thus making them “something of a surrogate for law firms for purposes of the settlement process,” and otherwise, “the investments were . . . substantially similar to the core investments of the Funds.” Id. at 65-66. With respect to the Peterson receivables, which were the “[t]he focus of the Division’s case,” id. at 70, Judge Patil concluded that “[n]either the Division nor Respondents have convinced me,” and because the Division “bears the burden of proof or persuasion . . . the Division has not proved by a preponderance of the evidence that Respondents’ misrepresentations were material with respect to Peterson.” Id. at 78.

Respondents’ Intent

Next, Judge Patil found that, while Respondents made material misstatements concerning the ONJ and Cohen receivables, those misstatements were not made with scienter. Specifically, he reasoned that the following factors “rebut[] the allegation of scienter”: (1) Respondents’ provision of “quarterly ‘Independent Accountant’s Report[s] On Applying Agreed-Upon Procedures,’ which included detailed information concerning troubled assets . . . including the ONJ and Cohen investments;” (2) Respondents’ provision of “annual audited financial statements that identified the Funds’ top concentration of investments by payor;” (3) the hosting on Respondents’ website of documents “pertinent to the Funds, including the offering memoranda, subscription documents, financial statements, AUPs, and investor communications;” (4) the availability of “a detailed collection of information with respect to the legal receivables agreements;” and (5) the absence of a “policy or practice of denying or providing false information.” Id. at 80-82. In short, Judge Patil found that there was no “intent to deceive because Respondents did not attempt to hide the investments.” Id. at 81. Furthermore, he determined that Respondents’ conduct “did not rise to the level of extreme recklessness,” because, while “the most troubling misstatements were the express disclaimers of litigation risk in the” due diligence questionnaires, those questionnaires are “marketing materials, which investors should treat skeptically,” and “the misstatements were in answer to a question about the Funds’ strategy,” which Respondents testified did not include the ONJ and Cohen receivables, as they were “one-off workouts of other, strategy-compliant positions that had gone wrong.” Id. at 87. As a result of these findings, the SEC’s most serious claims—those under Section 10(b) and Rule 10(b)-5 of the Exchange Act and Section 17(a)(1) of the Securities Act—were dismissed.

However, while Judge Patil recognized that “the Division focused most of its efforts on supporting its claims requiring scienter,” he determined that the Division “did not thereby forfeit or waive its claims based on negligence.” Id. at 84. He further found that there was “sufficient evidence in the record regarding the standard of care to conclude that Respondents did not meet that standard,” and were therefore negligent in making material misrepresentations with regard to the ONJ and Cohen receivables. Id. Specifically, he concluded “that the offering memoranda language with respect to all legal receivables arising from settlements and judgments represented an inaccuracy that is inconsistent with the reasonable care a hedge fund should take when it in fact had substantial positions in receivables based on pending litigation.” Id. at 86-87. As a result, Respondents were found liable under Sections 17(a)(2) and 17(a)(3) of the Securities Act.

Penalties

Because he determined that Respondents did not act with scienter and it was shown that Respondents were not unjustly enriched and that most investors actually profited from their investments, Judge Patil found that only half of the maximum per-violation civil penalties were warranted. He based the penalties assigned to Respondents on the number of documents containing “actionable misrepresentations” and concluded that RD Legal Capital and Dersovitz should be fined $575,000 and $56,250 respectively. Id. at 96-97. In doing so, he rejected the SEC’s argument that Respondents should be penalized “for each defrauded investor who testified . . . as it could be based on tactical decisions by the Division about how many witnesses to call and who was available to testify.” Id. at 96. Furthermore, Judge Patil determined that disgorgement was not warranted, finding that to award the disgorgement of over $56 million sought by the SEC “may trigger constitutional scrutiny.” Id. at 98. Finally, while he also entered a cease and desist order and suspended Dersovitz from the securities industry for six months and prohibited him from working for an investment company for the same time period, Judge Patil declined to enter the permanent industry bar sought by the SEC.

Conclusion

While the SEC suffered several defeats in this case, it is important to note that despite being unable to prove that the Respondents acted with scienter, the SEC was able to hold Respondents liable for negligence-based charges. Because of the SEC’s ability to bring negligence-based charges, investment advisers must be extra vigilant about their disclosures and in ensuring that their trading practices are consistent with those disclosures.

Nevertheless, ALJ Patil’s decision signals that the SEC staff cannot rely on its “home court advantage” in every case. It also demonstrates that the SEC has a significant burden in proving “scienter” under Section 10(b) and Section 17(a)(1). It is also important that ALJ Patil recognized that the lack of scienter drastically affected the financial and non-financial remedies imposed against the Respondents.

D.C. Circuit Split on Constitutionality of SEC’s Administrative Judges

We previously blogged about the D.C. Circuit’s decision in Raymond J. Lucia Cos v. SEC, which rejected the petitioner’s constitutional challenges to the SEC’s use of administrative law judges that are not appointed by the President. Yesterday, the D.C. Circuit issued a two sentence per curiam order denying an en banc review by an equally divided court.

We noted that the panel’s original opinion was the first appellate ruling of its kind. Although the panel’s decision remains in effect because the full court did not rehear the case, the strength of that ruling is now severely undermined. As we previously reported, the Tenth Circuit has already disagreed with the D.C. Circuit’s panel and held that the SEC’s administrative law judges are subject to the Constitution’s Appointments Clause. Yesterday’s order likely sets the stage for a Supreme Court challenge.

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.

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.

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.