SEC commissioners order affidavits on hiring of in-house judges

May 28, 2015

(Reuters) – The commissioners of the Securities and Exchange Commission seem to think there may just be something to the latest defense arguments that its in-house administrative law judges are unconstitutional.

On Wednesday, the SEC issued an order instructing the Enforcement Division to provide affidavits detailing the hiring and selection process for the two administrative law judges who presided over a proceeding against the real estate investment manager Timbervest and four Timbervest principals. Timbervest and the executives are appealing to the full commission a 2014 initial decision putting them on the hook for $1.9 million for violations of the Investment Advisers Act. The commission, which also ordered supplemental briefing from both sides on Timbervest’s constitutional challenge, is scheduled to hear the case on June 8 – the first time the five SEC commissioners will consider arguments that the SEC’s use of administrative proceedings before in-house judges is a breach of the constitution’s separation of powers doctrine.

At the very least, Wednesday’s order signals that the commission wants a full record when it weighs whether its in-house judges are executive officers under Article II of the U.S. Constitution. “Any time they want to hear more, it is encouraging,” said Timbervest counsel George Kostolampros of McKenna Long & Aldridge. “That said, we know we have an uphill battle to have the commission find its own judges are unconstitutional.”

SEC defendants contend (apparently with good reason, based on a terrific Wall Street Journal analysis earlier this month) that administrative proceedings favor the agency and strip them of rights they would have if their cases were heard in federal court. In the past seven months, defendants have asserted two different theories for why the agency’s administrative law judge system is unconstitutional, both based on the U.S. Supreme Court’s 2010 decision in Free Enterprise Fund v. Public Company Accounting Oversight Board. Under the first Free Enterprise argument defendants devised, in-house judges are too remote from accountability to the president because they can only be dismissed by SEC commissioners, and only if a merits board finds good cause.

More recently, securities enforcement defendants have begun to argue the ALJ regime violates the Appointments Clause because the judges are hired through a bureaucratic process and not named by SEC commissioners.

The SEC’s new order in the Timbervest case addresses the Appointments Clause argument, which Timbervest advanced in a motion last week for additional discovery from the SEC. The commission already asked in January for supplemental briefing from Timbervest and the Enforcement Division on the ALJ tenure protection question. Both issues, in other words, will have developed records when the commissioners consider the appeal.

So far, defendants have not managed to persuade any federal district judges to enjoin SEC administrative proceedings via their separation of powers theories. In March, U.S. District Judge Rudolph Randa in Milwaukee said the ALJ tenure argument was “compelling and meritorious,” but found he didn’t have jurisdiction to resolve the constitutional question until the administrative proceeding was over. U.S. District Judge Richard Berman reached exactly the opposite conclusion last month in a case by former S&P executive Barbara Duka, holding that he did have jurisdiction but that Duka’s constitutional argument was unlikely to succeed. The judges’ reasoning was different but the outcome for both defendants was the same: The SEC was permitted to bring its case as an administrative proceeding.

The only SEC in-house judge to have considered a challenge to the constitutionality of his appointment, Administrative Law Judge James Grimes, ruled earlier this month that he didn’t have authority to decide. He did, however, point out that the Supreme Court’s Free Enterprise ruling suggested administrative law judges aren’t executive officers because they don’t have enforcement and policy power and their decisions are subject to the commission’s review. (Justice Stephen Breyer‘s dissent questioned whether the majority’s description of the ALJs’ power was really accurate.) Unless administrative law judges are ultimately found to be executive officers, defendants’ constitutional arguments under separation of powers doctrine are doomed.

The Timbervest case could end up answering that question. Defense lawyer Kostolampros said if his clients lose before the commission, they intend to appeal to either the 11th U.S. Circuit Court of Appeals or the D.C. Circuit.

An SEC spokesman declined to comment.

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