Skadden’s new theory on why SEC in-house judges are unconstitutional

April 2, 2015

For the second time in the last six months, Skadden, Arps, Slate, Meagher & Flom has reframed the debate over the Securities and Exchange Commission’s right to bring enforcement cases as administrative proceedings before in-house judges instead of federal court suits before U.S. district judges.

In October, as you may recall, Skadden and Post & Schell filed a complaint against the SEC on behalf of hedge fund founder Joseph Stilwell, asking for a declaration that the agency’s threatened administrative proceeding against Stilwell was unconstitutional. Stilwell’s complaint raised the due process arguments that have become a familiar refrain as the SEC has escalated its use of administrative proceedings for even complex cases. But Skadden and Post & Schell also made a novel argument that under the U.S. Supreme Court’s 2010 decision in Free Enterprise Fund v. Public Company Accounting Oversight Board, the administrative law judge regime violates separation of powers doctrine.

In Free Enterprise, the Supreme Court struck down the PCAOB because the board’s members were too insulated from accountability to the president to comply with the constitution’s vesting of power in the executive branch. The Stilwell suit claimed that SEC administrative law judges, who can only be dismissed by SEC commissioners if a merits board finds good cause, are even more insulated from presidential accountability than PCAOB members. (In the Free Enterprise decision, the majority carved out administrative law judges because they “perform adjudicative rather than enforcement or policy-making functions,” but in his dissent, Justice Stephen Breyer suggested that under the majority’s holding, the ALJ regime might be unconstitutional.)

Stilwell ended up settling with the SEC in March, before any resolution of his constitutional challenge to administrative proceedings. Other defendants in SEC administrative proceedings picked up his separation of powers argument but it hasn’t really been tested. In a decision last month, U.S. District Judge Rudolph Randa of Milwaukee said the theory was “compelling and meritorious” – but he also said he didn’t have subject matter jurisdiction to decide if it holds up. Defendants should raise affirmative constitutional defenses before SEC administrative law judges and before the commissioners, Judge Randa said. If those defenses fail before the SEC, he said, defendants can ultimately argue the constitutionality of administrative proceedings in federal appeals courts.

On Wednesday, Skadden advanced a new argument for why SEC ALJs are unconstitutional. In a declaratory judgment complaint in Manhattan federal district court, Skadden and Brune & Richard asserted that the SEC may not bring an administrative proceeding against the flamboyant distressed debt investor Lynn Tilton and her Patriarch family of funds. The ALJ regime, the complaint said, violates the U.S. constitution’s Appointments Clause because the in-house judges are hired through a bureaucratic process and not named by the SEC Commissioners.

This new theory also relies on the Supreme Court’s Free Enterprise opinion, though it’s more inferential than the removal powers argument from the Stilwell case (which Skadden and Brune & Richard also assert in Tilton’s complaint). Under Free Enterprise, the new theory goes, the Supreme Court defined the SEC as a department of the United States with the commissioners at its head. Those commissioners have the authority, through legislation enacted by Congress, to appoint lesser officials such as ALJs. But they can’t delegate that authority, according to Tilton’s complaint, to a bureaucratic hiring process.

“Commissioners have the power and responsibility to ensure that the office of ALJ – an office wielding significant authority – is filled by an individual whom commissioners have evaluated and deemed appropriate to this critical function,” the complaint said. “Without the scrutiny and approval inherent in collective appointment by the commissioners, ALJs lack the imprimatur of the department head necessary to carry out such a sensitive and powerful role. It is one thing for the commissioners appointed by the president and confirmed by the Senate to use their collective judgment to appoint individuals who preside over important administrative proceedings. It is quite different, and constitutionally infirm, to fill that crucial presiding role through bureaucratic means far removed from our elected president and Congress.”

The Tilton complaint, which is before U.S. District Judge Ronnie Abrams of Manhattan, also argues that the constitutional challenge must be decided by a district court judge and not by an ALJ because constitutionality is not the SEC’s expertise. “Plaintiffs here raise claims under Article II of the constitution, provisions of which do not ordinarily, if ever, present issues for adjudication by the commission,” the suit said. “Indeed, it would be inherently difficult for the commission to consider the claims here in a neutral way given its responsibility for its own administrative proceedings, its allowance of improper ALJ designations and the fact that it sent this complex, long-standing matter to an ALJ for resolution.”

SEC defendants have already failed (with one exception) to ward off administrative proceedings with due process and tenure arguments. Maybe the Appointments Clause will shift their momentum.

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