Hedge fund’s novel claim: SEC in-house judges are unconstitutional

October 2, 2014

(Reuters) – On Wednesday, the $200 million activist hedge fund Stilwell Value and its founder, Joseph Stilwell, filed a complaint against the Securities and Exchange Commission in federal court in Manhattan. Stilwell’s lawyers at Skadden, Arps, Slate, Meagher & Flom and Post & Schell are asking for a declaratory judgment to block the SEC from bringing an administrative proceeding against Stilwell, who has been under investigation since 2012 for interfund lending. According to Stilwell’s complaint, if the SEC follows through with its threats to sue him in an administrative proceeding – rather than prosecuting its case against him in federal district court – it will be breaching the U.S. Constitution.

I know what you’re thinking: This is another case claiming that SEC administrative proceedings violate defendants’ due process rights. We’ve seen those arguments before, from former Goldman Sachs director Rajat Gupta, who forced the SEC to refile its case in federal court after U.S. District Judge Jed Rakoff refused to toss Gupta’s constitutional claims in 2011, and more recently by “Big Short” investment advisor Wing Chau of Harding Advisory, who tried unsuccessfully to stop the SEC from litigating its claims against him in an administrative proceeding. Both Gupta and Chau argued that the SEC has unfair, and unconstitutional, advantages when it brings administrative proceedings since (among other things) are no juries, no federal rules governing discovery and no immediate rights to appeal outside of the agency.

Trust me: Stilwell’s constitutional theory is completely different and completely novel. What’s more, it has the potential to affect the regulatory regime not only at the SEC but at just about every federal agency with enforcement powers.

Stilwell’s lawyers contend that SEC administrative law judges – those SEC-employed officers who oversee administrative proceedings – are unconstitutional under the U.S. Supreme Court’s 2010 decision in Free Enterprise Fund v. Public Company Accounting Oversight Board. The PCAOB ruling, as you may recall, hinged on whether the president had the power to remove appointed members of the accounting board, which Congress had established in the Sarbanes-Oxley Act. The Supreme Court majority said that because PCAOB appointees were more than two layers removed from presidential control, the board was unconstitutional under the separation-of-powers doctrine. (I’m simplifying, but that’s the gist of it.) “This arrangement contradicts Article II’s vesting of the executive power in the president,” the opinion said. “Without the ability to oversee the board, or to attribute the board’s failings to those whom he can oversee, the President is no longer the judge of the board’s conduct.”

The same reasoning applies to SEC administrative law judges, according to Stilwell’s new complaint. These judges have “broad discretion to exercise significant authority,” the complaint said; their decisions aren’t even always reviewed by the commissioners, so their orders are sometimes deemed to be the actions of the SEC. That wide latitude, according to Stilwell, means that SEC ALJs are executive officers under Article II of the constitution. Yet they can only be dismissed by SEC commissioners, and only if a merits board finds good cause. Administrative judges’ accountability to the executive branch is even more attenuated because the president, in turn, can only get rid of SEC commissioners if they misbehave in office. Those multiple layers of protection, according to Stilwell, make proceedings before SEC judges unconstitutional under the Supreme Court’s PCAOB decision.

It would be momentous if U.S. District Judge Katherine Forrest of Manhattan, who has been assigned the case, were to agree with Stilwell’s novel postulation. The SEC, as you probably recall, has vowed to bring more, and more complex, enforcement actions before ALJs instead of district court judges. (The 2nd U.S. Circuit Court of Appeals, strangely enough, seemed to encourage the commission to use administrative proceedings when it limited trial judges’ oversight of SEC settlements in its infamous Citigroup ruling earlier this year.) Forcing the SEC to bring cases only in federal district court would hamper the commission’s enforcement abilities.

But the SEC is hardly the only agency that employs administrative law judges. There are more than 1,000 ALJs in the federal government, many of whom have powers similar to those of SEC judges. If Stilwell’s theory holds up, the entire administrative law process could turn out to be an unconstitutional violation of the separation of powers doctrine.

Justice Stephen Breyer, in his dissent in the PCAOB case, actually contemplated that hypothetical. The majority said that its holding did not specifically address administrative law judges, who, unlike members of the PCAOB, “perform adjudicative rather than enforcement or policymaking functions or possess purely recommendatory powers.” Breyer queried the majority’s carve-out for ALJs, who, he said, often have “important administrative duties beyond pure adjudication.” Did the Supreme Court majority, Breyer said, mean to suggest that the appointment and service of administrative law judges violates the separation of powers doctrine?

No one has answered Breyer’s rhetorical question in the years since the PCAOB opinion. But Stilwell’s complaint takes the issue out of the realm of hypothetical and into reality. This could be big.

The SEC declined a request for comment by my colleague Jon Stempel. Stilwell’s counsel declined to provide a statement.

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